Why are CEOs Paid So Much?

…while their employees are paid so little – Amid the current economic crisis, the debate over CEO pay has intensified. Now more than ever, people are asking, “Are CEOs overpaid?”

Psychologist Jerald Greenberg says, “As resources become scarce, we become increasingly careful about how to spend them, so if a CEO’s salary appears to be wasted, people become concerned about it.”

Psychologist Edwin Locke says that there is no set level of pay that is “fair” or that would make a CEO “overpaid.” He thinks that, instead of thinking in terms of “is a certain amount of pay too much,” we need to look at the market. He says, “Fair is really, at least at the time of hiring, what the market price is. What’s the intrinsic value of a baseball player? What the fans are willing to pay to see a ball game.”

But economist Albert Cannella disagrees, and says, “That statement is much more correct if CEO salaries were established in a marketplace where there’s a lot of buying and selling going on. That would arguably be the case if CEOs changed companies frequently, and we could observe a lot of CEOs leaving their current positions for other CEO positions at higher salaries. However, this is extremely rare. The evidence suggests that CEO salaries arise from private?i.e., covert?processes that they have significant control over.”

Cannella says that one of the factors leading to extremely high salaries is that CEOs often exert a huge influence over the boards of their organizations and, thus, over their own compenstion. “Boards don’t have to agree to these contracts in the first place, but they do. A lot is done in the honeymoon period following the CEO’s hiring when everyone feels great about the person.” (if only it worked that way for the average employee, who usually starts with low pay and has to work his or her way up!)

“CEOs also get paid a lot because there are relatively few of them in the workforce. That puts them in an exclusive and highly paid ‘CEO Club,’ where salary levels often become a form of competition among CEOs,” Cannella says. What frustrates the taxpayers who are currently bailing out their companies is that they don’t seem to have made very good decisions!

Locke agrees with this and says, “Good CEOs are extremely difficult to find. There aren’t that many and you have extremely high turnover.” He thinks that’s because running a company is much more complicated than it used to be.

All 3 experts agree that pay increases for executives whose companies are performing poorly is a bad idea. But Locke says, “If the CEO makes a lot of money for the company in the short term but the company eventually fails because of poor investments, then that would be a negative long-term performance. On the other hand if you fail in the short term, there is no long term.”

And Cannella reminds us that measuring the outcomes of a CEO’s work isn’t always easy. “What exactly did the CEO accomplish over the year? What value creation can be attributed to him or her? That’s very difficult to figure out.”

Meanwhile, the pay discrepancy between CEOs and employees has widened over the past few decades. The first study of CEO pay comparing this gap was done in 1986. Cannella says, “Back then we thought CEOs were making a lot of money. The CEO was making 50 to 60 times what the entry-level employee was making. Now it is hundreds of times more.”

But Locke says, “There is no intrinsic amount of difference that there should be between the CEO’s salary and the other employees. If a CEO is doing a good job, he might be the reason the company’s doing well and the reason employees still have a job.”

So what can companies do to make sure their CEOs salary hasn?t gone off the deep end? Cannella suggests that CEO pay should be at least partially recallable?in other words, if the company doesn?t do well, their salary gets docked. Greenberg agrees and says, “A formula that rewards executives for what they do to bring value to the company?long-term, short-term, and ethical goals should be met?is key. Fixed sums, such as the US government’s $500,000 salary to bank executives, are severe disincentives. This is a great time for paying for performance.”

Art credit: freeimages.co.uk

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