Chapter :

CEO Pay: What Owners Need to Know

(The excerpts you will read here use Canadian examples, but the issues and ideas revolving around working and middle class ownership of big business apply to all developed countries.)

Your comments, please! This is a draft version of Chapter 1, provided here for the purpose of getting reader feedback. This feedback will be incorporated into the final version.

When he was a young teen, my son Scott discovered he could earn a better than average teen income by being a hockey referee and linesman. At first, he officiated at the games of very young players, and as he developed, he took on games with increasingly older players. At each stage, there was a steadily increasing emphasis on speed, strength, knowledge, and the ability to make instant decisions in a pressure-filled environment.

He earned more for games with older players because the pool of referees and linesmen had narrowed, and narrowed for two reasons. First, because of the skill level required, and second because of abuse by players, coaches, and fans. In other words, the positions now demanded strength of character, discipline, and focus as well as technical knowledge and skills (not surprisingly, many referees and linesmen are off-duty police officers).

By the time he was in his mid-teens, Scott had moved up to games where fist-fights became standard, and the pool narrowed again, because not all officials had the physical strength to manhandle fighting young, adrenaline-driven players, the personal presence to (usually) maintain order among, or any desire to officiate in these games.  
 
By the time he had reached his late teens, Scott began to see a possible career in officiating, and worked toward it. He officiated in Western Hockey League games, one level below the National Hockey League. At this level, all of the character and technical issues had ramped up to yet another level. In addition, travel also came into the picture. For a very modest stipend, plus mileage, referees and linesmen often travel for several hours, work for two intensive hours, hit the showers, and then drive home again, often on snowy highways in the middle of winter, at night.

Which leads us to ask, why would anyone put up with all this? The answer: For a chance to work in the National Hockey League. While not as lucrative as being an NHL player, referees and linesmen are still very well paid, and enjoy a prestigious vocation. Rewarding enough, in other words, to make it worthwhile to pay a lot of dues along the way, even if the odds of making it seem slim.

Only a few of the many who try make it to the NHL. At this level, the pool has narrowed to its ultimate; only a handful get an invitation to try out, and only a few of those few get a contract offer. 

The quest for the NHL will help us understand how and why CEOs earn what they earn, and perhaps add to our appreciation for those who get to the top of the business and organizational game.

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Are CEOs overpaid, even grossly overpaid? If you follow the news, it's quite likely you'll think so. After all, hardly a day goes by without yet another story on the subject.

But, have you stopped to consider the basis for the claim? Look below the surface of these stories and you'll find they're usually based on moral judgements, uninformed moral judgements. More specifically, they're based on the envy factor: "I'm a good person, and I work hard, but I don't get paid millions of dollars a year!"

Or you can head to the website of the Canadian Centre for Policy Alternatives, a left-wing think tank. There you'll find (as of May 2010) the CEO Pay Calculator. You enter your annual salary in the interactive form, click Submit, and you'll get back information on the difference between your pay and the average pay of the 100 highest-paid CEOs in Canada.

Now, I'm all for keeping CEO salaries down. After all, some of that money comes out of my shareholder pocket, and some comes out of my consumer pocket. I can even sympathize with the Centre's argument that the average CEO salary is now 173 times that of the average Canadian, compared to 103 times a decade ago.

But, do I really want to make important financial decisions based on envy? Of course not. No intelligent investor would. Decisions made on the basis of emotions never quite work out the way we want. We end up hurting ourselves more than we hurt our targets.

And, let's not forget that one of the legacies of the Industrial Revolution was the application of reason to business issues. In part, we owe our current prosperity to the separation of church and business, just as the separation of church and state led made modern democracies possible. The separation of church and business means we now can take moral issues out of business decisions.

So, let's take an objective, or at least relatively objective, look at CEO pay. We'll examine the factors that make it what it is, as opposed to what we think it should be. Don't expect any magic formulas for reducing their pay, though – most such solutions have unintended consequences that backfire.

We'll start with another glance back at the Canadian Centre for Policy Alternatives, and its CEO Pay Calculator. Reflect on what they're telling you for a moment, and you'll discover a blunder in their logic (one of the consequences of envy, no doubt). If you were hiring a new CEO, you wouldn't start searching among Canadians earning average paycheques. You wouldn't even start by searching among the brothers and sisters at the union hall.

Managing a big, modern corporation demands tremendous personal knowledge, skills, and strength of character. It's not unlike being a referee in the seventh game of a Stanley Cup final. The pressure is intense, and only a select few have what it takes to do the job.

Beginning with the matter of knowledge, almost all CEOs have at least one university degree, maybe even two or three. One of the most common is the MBA (Master of Business Administration degree). Incidentally, there are no black arts in an MBA; it's simply a series of courses in which students learn about the key elements of business, including accounting, finance, human resources, marketing, operations management. As with most graduate degrees, the curriculum is demanding, and the pressure is intense.

You can expect, then, that people who spent six years at a university earning that degree won't be cheap. They gave up an average of perhaps $30,000 a year for six years to get that piece of paper. That's a total of $180,000 and they should get a return on it; let's say 15% a year. 15% of $180,000 equals $27,000 a year that you can expect to pay on top of whatever salary  managers and executives would otherwise earn.

Similarly, a company might hire a Chartered Accountant (CA) or lawyer. But, as you can image, anyone with even a few years experience in either of those professions will want a significant salary. They, too, expect some sort of compensation for the years they spent studying, and for the modest wages they received while articling, rather than earning.

We also need to take into account the hours a CEO is expected to work: 60 to 80 per week, which means candidates expect roughly double what they would otherwise accept. CEOs sacrifice family and friends for the job, so they're going to ask for bigger paycheques.

Good judgement and good decision-making skills take more than good character. They come from an intimate knowledge of the company, its industry, and the general environment in which the company operates. That's why many CEOs spend their weekends reading and studying, rather than doing things with their families.

If that wasn't enough, you can't just hire any MBA, CA, or lawyer for that matter. Not only do you want candidates who have proven themselves by earning degrees, but you also want people who can lead other people. Boards want someone who has a vision for the future of the organization, has the drive to push toward that future, has the skills required, especially communication skills, and is liked and respected by people with whom he or she has worked,

Naturally, the field of potential candidates narrows down, way down when you introduce s set of requirements. Just as you can't hire a CEO from the pool at the union hall, you can't just hire from a pool of well educated people either. You need someone who has superior people skills as well as knowledge.

What's more, almost all candidates in any CEO pool already have good jobs, and already enjoy a nice package of pay and benefits. You're going to have to pay a premium to get them to move. At the same time, once you've hired a new CEO, you need to keep him or her from being lured them away by another company. 

To keep the CEO you hire, you need to compare the salary you're paying with the salaries paid by comparable companies. That, in turn, leads to a vicious circle. In what's known as ratcheting up or positive feedback loops, an increase paid to one CEO leads to increases for other CEOs in comparable companies, and on and on it goes.

These are a few of the issues involved in setting the cash pay, or base salary, for a CEO. But, we're not finished. We want the CEO to treat our business like it was his or her business. The most effective way to do that is to give stock incentives. Giving stocks is a relatively recent recent addition to CEO compensation, and an unintended consequence of earlier government regulations that sought to keep down CEO pay. They're also help explain why CEO pay has increased so dramatically in recent years.

This extra level of compensation goes by several names: pay-for-performance, variable pay, and stock plans. Whatever the name, boards of directors aim to 'align' the CEO's efforts with the objectives of the corporation. So, if a board of directors decides the stock price matters most, then they'll issue a certain amount of stock to the CEO if he meets an initial threshold, and more if he or she reaches a 'stretch' target. Generally, boards and their compensation committees aim to find some balance between long- and short-term goals.

To avoid a short-term mindset among CEOs, boards normally average stock incentives over a three to five year time span. That practice explains why so many CEOs collected seemingly big packages in 2009, despite the cratering of their company's stock in the crash of 2008. While 2008 may have been a terrible year, the previous years were not, and helped keep the average higher than uninformed observers might have expected.

Now, let's turn to some specifics. We'll start by visiting the website of PayScale Canada, and take a look at average salaries for Chartered Accountants and lawyers (as of May 13, 2010). The site's numbers for Chartered Accountants look like this:

"Salary: C$48,448 - C$77,415 
Bonus: C$1,504 - C$7,603 
Profit Sharing: C$509 - C$4,936 
Commission: C$333.00 - C$4,913 
Total Pay: C$49,038 - C$81,618
(Total Pay combines base annual salary or hourly wage, bonuses, profit sharing, tips, commissions, overtime pay and other forms of cash earnings, as applicable for this job. It does not include equity (stock) compensation, cash value of retirement benefits, or the value of other non-cash benefits (e.g. Healthcare)."

• Pay scales (not including stock incentives) are roughly what we would expect, given the both qualifications and the bargaining power of the few who make it to the end of the funnel.
• Although not often discussed outside informed circles, stock incentives help align CEO interests with the interests of shareholders, overcoming what's known as the agency problem (where managers act in their own interests, not those of shareholders). 
• Stock options (in two out of our three examples) are what push CEO compensation to stratospheric levels, to the levels where they garner widespread condemnation and scorn (whether deserved or not).

The latter point about stock options leads us to an answer to the question, "How come the pay of CEOs has gone up so much faster than the pay of the average worker?" Academics Xavier Gabaix and Augustin Landier of New York University have an answer that is both scientific and simple, "The sixfold increase in CEO pay between 1980 and 2003 can be attributed to the sixfold increase in market capitalization of large U.S. companies during that period." "Why Has CEO Pay Increased So Much?", Xavier Gabaix and Augustin Landier,  Quarterly Journal of Economics, vol. 123(1), 2008, p. 49-100, Technical Appendix. In other words, CEO pay had been hitched to a rising tide. We assume the same conclusion holds for Canadian CEO pay, since Canadian and American stock markets generally experience similar results.

For shareholders, that's not particularly good news. Not only do stock option incentives dilute our ownership, but it also means we haven't captured as much from market gains as we might have. We've given up some of those gains to CEOs and other senior executives who get stock.

Still, you won't find investors, whether individual (retail) or institutional, too concerned about CEO pay. There's little evidence they buy or do not buy because of CEO pay, or that they shy away from certain companies and their shares because of the level of CEO pay. And, we know that investors collectively can and will discriminate when they feel their interests are being compromised. For example, they bid down the price for stock in companies with dual-class shares (which enable a small group of insiders to control a company).

What investors do care about are earnings. In fact, one of the fundamental measures that investors check before buying is called the P/E, Price to Earnings ratio. It plays a big part in determining what investors are willing to pay to buy shares of a company. And, they hold CEOs responsible for the earnings half of that ratio. CEOs who don't consistently deliver what investors think the companies are capable of earning will soon find themselves unemployed.

How can investors assess how well CEOs are doing? Well, the Financial Post offers a useful annual report called the CEO Scorecard. The magazine describes a key part of the scorecard this way, "BANG FOR THE BUCK: This measurement aims to determine whether a CEO is overpaid or underpaid. A proprietary algorithm compares the CEO's three-year average compensation to the scorecard average ($4.2 million). It compares the three-year average revenue of the company to the scorecard average ($4.8 billion). And it compares the company's three-year return on investment to that of the relevant S&P/TSX sector index, which serves as a peer group." The magazine scores the CEOs of each of the top 200 Canadian public corporations, indicating whether they were overpaid, underpaid, or paid appropriately based on its criteria. (Guide to using the CEO scorecard, Financial Post Magazine, Monday, November 02, 2009)

It is a fact of corporate life, unfortunately, that some CEOs will be overpaid. Not in the sense suggested by uninformed critics such as the Canadian Centre for Policy Alternatives, but in the sense of failing to deliver value to shareholders. Issues such as ratcheting up and cronyism may be responsible; in other cases, it may be a failure to anticipate the future or even as simple as hiring the wrong person. In these cases, the shareholder takes a hit. A highly-talented, prospective CEO will ask for, and get, a strong contract that guarantees his future, regardless of how it works out with the company. In that sense, it's not unlike an NHL team signing a multi-million dollar contract with a player; you pay your money and you take your chances.

Now, let's take a look at the idea of Say on Pay, which gained a lot of prominence following the stock market collapse of 2008. The idea is simple enough: A corporation's shareholders get a voice in the amount paid to senior executives, something that's never been a right in law to Canadian owners. By law, the right to set compensation is vested solely with the board of directors, and given that most shareholders don't have much of a voice in choosing or electing directors, it's meant shareholders have had essentially no say at all.

With some large institutional investors (pension funds and mutual funds) getting behind the idea, shareholders are proposing, and sometimes passing, resolutions at annual general meetings. While any initiative that gives owners the rights of owners should be welcomed, the effectiveness of Say on Pay has yet to be seen. If it's only a populist reaction based on envy, we can't expect much. If it increases shareholder returns by reducing costs, it's a good thing. But, will shareholders want to reduce the pay of a CEO who's bringing in good earnings, quarter after quarter and year after year? Probably not. So, Say on Pay may turn into a rhetorical flourish aimed at letting boards of directors, and executives, know that they're being watched.

As with everything else connected to CEO pay, it all comes down to value. Asking how much money a CEO has added to our retirement income is almost always the right first question. Only after we've answered it, can we intelligently ask and answer the question, "How much was the CEO paid?"

Next...

Is it okay to buy products made in 'sweatshops' in poor countries? I'll tell you how you can decide, by asking one simple question. Read The Question: Free Trade & Globalization .

Please send me your comments and questions. Send an email to wordengines@gmail.com . Thanks!

Bob Abbott

People, Profits, & Pensions: The Ownership Revolution, Copyright Robert F. Abbott 2010