CEO Pay: No Easy Answer

The free market may at times overcompensate. But there's not a better system
Kevin Criff/Corbis

Top managers in the U.S. and Europe have been harshly criticized for their growing salaries and bonuses. Is the problem bad communication or greed? — Stefan Eiselin, Zurich

You can be sure both bad communication and greed have something to do with the heated controversy over executive compensation. Some companies certainly are not clear or candid enough in explaining why their top people earn what they do, and some top people want to earn more than they're worth. That said, we would suggest another reason for all the recent sound and fury over CEO pay: clashing ideologies.

That's right. We think the debate over executive compensation is exactly as it appears: a philosophical divide. On one hand, you have activist shareholders (and just regular people) who believe that many CEOs make too much money compared with average workers and their relative value to the organization, and that someone—be it shareholders themselves or government regulators—must close that gap. Outsized CEO compensation, this group generally believes, is bad for society and morally wrong.

On the other hand, you have people who believe...well, they generally don't say what they believe because it's so politically incorrect. But allow us to step in, because we share their view, which is that, yes, most CEOs make a ton of money, and sometimes they make too much, but in a market economy salaries are set by supply and demand. We also live in a market economy where companies that field the best teams win, and, because of global competition, the best teams tend to be expensive.

Now, is this free-market system of pay perfect? Absolutely not, which is why underperforming CEOs sometimes end up getting huge sums of money just to go home. While such situations enrage many, they can be hard to avoid, given market dynamics. Some chief executives—Carly Fiorina at HP (HPQ), for example—are given large severance deals at the front end as an incentive to sign on. Other CEOs, such as Chuck Prince at Citigroup (C) and Stan O'Neal at Merrill Lynch (MER), exited their troubled companies with more money than some people liked because of stock grants and compensation earned over many years when results were good. Such endings look wrong and quite understandably give critics a platform.

But from where we stand, no overall system of setting pay is better than the free market. Indeed, one of the best things about it is that it rewards companies that perform well, and those tend to be the talent magnets that pay everyone well, from the CEO to the front lines. Moreover, there's just no better alternative. Government involvement? Forget it! What a mess that would be, with grandstanding politicians vying to outdo each other with vows of putting chief executives in the poorhouse and CEOs (and their lawyers) appearing at Capitol Hill hearings every year to explain their business models, describe their competitive situations, and defend pay packages as they relate to both. Now there's a productive use of everyone's time!

As for shareholders setting pay, the problem comes less in the ideology than in the logistics. How can thousands of people formulate a company's pay levels? The insurer Aflac (AFL) recently agreed to let its shareholders vote annually on the compensation of its top five managers. The vote is nonbinding, but perhaps it will meet the needs of its supporters for some sense of input.

And a sense of input is actually about all that shareholders should have, because it's ultimately their elected representatives, the board, that must set compensation. Sure, cronyism is always a worry when boards determine the top team's pay. Luckily, there's a check and balance in the company's financial performance and stock price. A board can overpay a CEO, but not forever.

The debate over executive pay, by contrast, may last that long. One side wants the community, or some subset of it, to set CEO pay; the other believes market forces should play that role. Perhaps, as you suggest, greed and bad communication are involved in the mix, but as ideological debates go, this is one for the ages.

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