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Put a Cap on CEO Pay

Peter Drucker thought the top exec shouldn't get more than 25 times the average salary in the company. Here's why

For a guy whose astute counsel helped to make so many CEOs rich, Peter Drucker had an intense loathing of exorbitant executive salaries.

He hated high CEO pay on every level: what it said about the individual as a leader, how it undermined the smooth functioning of the organization, and the way it tore at the fabric of society as a whole.

Drucker's strong feelings on the subject—he once termed sky-high CEO compensation "a serious disaster"—are well worth revisiting in light of the news that the men who sat atop Fannie Mae and Freddie Mac (FRE) (BusinessWeek, 9/10/08) could be eligible for as much as $24 million in severance and other benefits after being ousted from their positions. Last week the federal government was forced to step in and rescue the faltering mortgage giants in a move that could cost taxpayers billions.

Although it wasn't immediately clear whether the two departing CEOs, Fannie's (FNM) Daniel Mudd and Freddie's (FRE) Richard Syron, would actually walk away with all that dough, the prospect of such a windfall has resonated on the Presidential campaign trail and helped to stoke a national debate about executive pay.

Drucker's stance on the issue, articulated consistently over many years, was controversial. But it was rooted in his belief that the best leaders are those who understand that what comes with their authority is the weight of responsibility, not "the mantle of privilege," as writer and editor Thomas Stewart described Drucker's view. It's their job "to do what is right for the enterprise—not for shareholders alone, and certainly not for themselves alone."

Last year, according to a report just issued by the Institute for Policy Studies and United for a Fair Economy, S&P 500 CEOs received pay packages worth, on average, $10.5 million. That was 344 times the earnings of the average American worker.

What Drucker thought was more appropriate was a ratio around 25-to-1 (as he suggested in a 1977 article) or 20-to-1 (as he expressed in a 1984 essay and several times thereafter). Widen the pay gap much beyond that, Drucker asserted, and it makes it difficult to foster the kind of teamwork that most businesses require to succeed.

"I'm not talking about the bitter feelings of the people on the plant floor," Drucker told a reporter in 2004. "They're convinced that their bosses are crooks anyway. It's the midlevel management that is incredibly disillusioned" by CEO compensation that seems to have no bounds.

This is especially true, Drucker explained in an earlier interview, when CEOs pocket huge sums while laying off workers. That kind of action, he said, is "morally unforgivable."

Notably, Drucker wasn't opposed to rewarding some people like kings. "There should, indeed there must, be exceptions," he wrote. "A 'star,' whether the super salesman in the insurance company or the scientist in the lab who comes up with a half-dozen highly profitable research breakthroughs, should be paid without any income limitation."

But the chief executive has a special duty to show that he or she is "just a hired hand," Drucker said, invoking the words of J.P. Morgan. "That's what today's CEOs have forgotten."

Not all of them, of course. Last year, Costco Wholesale (COST) CEO Jim Sinegal made $3.2 million, including a $350,000 salary, an $80,000 bonus, and stock grants and options valued at $2.6 million. While hardly chump change, that was far less than what his peers raked in—and far less than what Costco's compensation committee wanted to give him. But the panel said in a regulatory filing that it was willing to respect his "wishes to receive modest compensation, in part because it believes that higher amounts would not change Mr. Sinegal's motivation and performance."

Setting pay for top executives can be tricky, even for those whose instinct is to nip their remuneration. In the mid-1980s, after consulting with Drucker, furniture maker Herman Miller (MLHR) agreed that its CEO's pay would be restricted to 20 times the average of all its employees. "The subtle part of this limit was the message to the CEO: If you want to get more pay, you need to do it by raising the average pay" of everyone at the company, the man who used to hold the post, Dick Ruch, recalled in his book Leaders & Followers.

But in 1997, Herman Miller ditched Drucker's model. "From a competitive standpoint," Ruch said, "we needed to eliminate the cap to attract and retain the right people."

Drucker himself conceded that compensation formulas are inherently difficult to develop. "I would be the last person to claim that a 'fair,' let alone a 'scientific,' system can be devised," he wrote. Yet at the same time, he never gave up on the 20-to-1 rule for CEOs, touting it as the right thing for the good of the organization, as well as for the general health of society.

Allowing an enormous disparity in income to exist "corrodes," Drucker warned. "It destroys mutual trust between groups that have to live together and work together."

And, on occasion, bail each other out.

Join a debate about golden parachutes for CEOs.

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