Monday, 30 January 2012

CEO Pay: Houston (Toronto, London), we have a problem

People may have noticed the rich pay for CEOs in 2010 reported in Canada's CEO Elite 100 and dismissed it as the usual envious chatter emanating from a left-leaning policy institute. From my perspective as an investor with holdings in all these companies, direct or indirect (we pretty well all do through our pension savings, ETFs, mutual funds etc) I think they have a point.

An epidemic of overpaid CEOs
The plain fact is that CEOs earn too much. All the pay-for-performance, maybe-they-earned-it arguments fall by the wayside when one realizes that CEO pay has been rising much faster than employee wages in those companies. The pre-amble to the CEO report says the average CEO collected 189 times the average Canadian wage in 2010, up from 105 times in 1998. Have we entered a golden age of company profits and investor returns? Have CEOs been responsible for all good things in industry such that they merit the lion's share of any gains?

A long-developing epidemic across industries and major countries
It's not just the current whipping boys in the banks and the financial industry either. The phenomenon cuts across all industries. It's not just Canada either. The same meteoric CEO pay increase has been happening in the USA (e.g. see this recent academic paper by Jerry Kim, Bruce Kogut and Jae-Suk Yang on SSRN which refers to many studies on the topic, or Meritocracy vs Plutocracy on The Big Picture blog) and in the UK (see Pay and Performance: creating a fairer share of rewards) where it is such an issue that Prime Minister Cameron is promising to legislate shareholder votes on CEO pay that bind the corporation.

The research papers document that the epidemic began around 1980 and really took off during the Internet boom. The Kim et all paper maintains that though the Internet stock price bubble popped, it did not pop on pay. Instead the bubble caused a lasting upward shift in the norm for CEO pay expectations.

Update March 27 - Two other papers reinforce the idea that a problem exists by showing a longer historical perspective and pinning down wages as the main culprit. Note how the top income earners are getting a bigger share since around 1980 in TOP INCOMES IN THE UNITED STATES AND CANADA OVER THE TWENTIETH CENTURY by Emmanuel Saez:

Note also how wages is the main driver of this trend in this chart:

The Rise of Canada's Richest 1% by Armine Yalnizyan of the Canadian Centre for Policy Alternatives has this chart that shows the trend continuing unabated up to 2007. Table 2 in the paper also confirms that wages are the main component of top earner incomes.

CEOs acting like children and playing leapfrog
Every parent will recognize the basic mechanism by which CEO pay goes up. If one child gets something then the other expects the same thing. Peer comparison is the most important factor by far in establishing the pay level for a CEO. Despite all the complicated schemes (read the details for any public company in its annual Management Information Circular which is available on Sedar - click on Search Database then Search for Public Company documents - for every Canadian TSX listed company), they all boil down to more or less what similar companies pay. Apart from the academic studies that confirm the fact, the telling and remarkable result of these complex compensation plans is that somehow, year after year, whatever company financial results or stock performance, CEO pay almost always rises, often in huge upward leaps, and almost never goes down.

A paper by Thomas DiPrete, Greg Eirich and Matthew Pittinsky says that the few CEOs who manage to leapfrog each year to the upper end of the pay scale pulls every else along in a chain reaction. A governance failure in one firm propagates through all companies.

CEO Myths - motivation, retention and talent
It is astounding that CEO performance motivation is constantly invoked as a primary justification for high pay and big bonuses. Hey, I went to business school too where I learned that Maslow and Herzberg long ago determined that pay is not a performance motivator. At best it is a potential dis-satisfier.

There is evidence from Harvard Law School that high CEO pay harms a company - "Corporate Pay Slice [CPS = CEO's percent take out of the top five execs] is negatively associated with firm value" - in CEO Pay Slice by Lucian Bebchuk, Martijn Cremers and Urs Peyer.

Another oft-cited reason is that should the big pay not be granted, the CEO will leave and perhaps the Board will resign too. Fine, let's call their bluff, let 'em resign. In the UK, Easyjet founder and major shareholder Sir Stelios Haji-Ioannou denounced fatcat bonuses proposed by the Board, noting that the Board and executives could be easily replaced. One of the things you quickly learn in the corporate world is that life goes on without you, you can quickly be replaced and forgotten.

There are plenty of competent people around. The plain fact is that almost all of the so-called corporate superstars are nothing of the sort. Most are managers, keeping things going that others have created with improvements at the margin. Very few make orders of magnitude positive difference. Many destroy a lot more value than they create.

How many real business superstars are there? Think of the difference between the ultimate results of true superstar Steve Jobs and former Apple CEO John Sculley (isn't it interesting that Sculley was the highest paid executive in Silicon Valley in 1987). A corporation is a team and the CEO may have an important role as the captain but without the rest of the players, he or she won't succeed. The CEO Forum has a good discussion of the matter in Is talent overrated? (the answer is yes it is).

CEOs get their real reward from the feeling of power, of being the top guy. Pay only matters to the extent that it is close enough to peers.

Set the ball rolling in the other direction.
A few days ago, Royal Bank of Scotland CEO Stephen Hester turned down a bonus of £963,000 (it is interesting in itself how many news reports talked of a £1 million figure, as if the difference is inconsequential; I daresay most taxpayers would be overjoyed to receive that £37,000 in small change, which was treated as a rounding error) just after the RBS Board Chairman Philip Hampton had himself decided to forego his £1.4 million bonus. The fact that the RBS came to be majority owned by the British taxpayer during the credit crunch gave politicians the leverage to cause the bonus refusal.

But hey! Now we have a new peer reference point for Canadian banks to apply the peer reference method so cherished by compensation schemes! Hester's salary is £1.2 million, or about $1.9 million. The CEO of Canada's own Royal Bank, Gordon Nixon, pulled down $11.8 million in 2010 according to the CEO Elite report. Hmm, that looks to be about $9.9 million too much. Since RBS is actually more than twice the size of RBC - £1522 billion (CAD$2395 billion) in 2010 assets vs $718 billion - Nixon should get about half what Hester gets, shouldn't he? Yet, even including the refused bonus Nixon made almost four times as much as Hester.

Another peer benchmark possibility, since most of these CEOs are not much more than bureaucrats - indeed it is debatable whether a CEO's job is tougher than a senior civil servant who has to contend with public politics not just the corporate variety - would be to benchmark CEO pay against the civil service. The feds pay a maximum of $360,600 in the top GCQ-10 scale and $513,000 at the top of the crown corp scale.

What's comparable anyway? "Long time ago, a CEO explained to me the only difference between big business and small business was the number of 0s after the number" from FrontOfficeBox.

Compromise CEO pay proposal
Let's set the maximum ratio of total CEO compensation to a firm's median employee pay at 40 times (e.g. if median employee is paid $40,000, CEO gets at max $1.6 million) which was more or less the situation around 1980 when things started down the wrong path. Let Boards figure out whatever arcane method they wish to arrive at that result. 40x is very generous, as the CEO earns in one year what it takes the employee 40 years, almost a whole working career, to earn.

Putting fatso CEOs on a money diet
Many of the mainstream proposed solutions to reign in CEO pay involve improving corporate governance. These include: limiting poison pills, eliminating golden parachutes, stopping so-called shareholder rights plans that entrench management, enhancing board independence etc. But governance has been improving in the last decade at least, while CEO pay has continued to rise disproportionately, so it's doubtful that will have a big effect.

Perhaps "say-on-pay", especially if it is mandated by legislation, would have some effect. Since Canadian governments have said not a peep even about advisory say-on-pay, I'm not holding my breath.

The most effective mechanisms would affect what I think is the root cause of this long-lived bad trend. A culture change is required. Corporate Board and executive thinking needs to change.

Hit 'em in the ego where it matters. Praise the good guys for reasonable pay, dump on the greedy, make reasonable pay a morality issue, practise social ostracism - something like the drinking and driving campaigns that transformed attitudes and behaviour. A good example of that kind of expression of disapproval is the stripping of the knighthood granted to the man whose actions as RBS' boss almost sank the bank, Fred Goodwin. Apparently he cannot find a new job. Good, Goodwin's kind of "talent" isn't really needed by the world of business. The hysterical reaction of the British business community indicates the arrow of scorn has hit its mark.

Canada could stop awarding honours like the recent the Order of Canada to people such as Calvin Stiller, notorious as founder of the horrible money sinkhole investment fund, the labour-sponsored Canadian Medical Discoveries Fund. To add insult to the financial injury to investors, the Order cites his "his leadership as a medical entrepreneur"! Check out the Morningstar price chart for CMDF, see what people on Financial Webring think of it, a sentiment with which I totally agree since I lost 80% on my own investment in CMDF). Perhaps Stiller is an outstanding doctor but a successful entrepreneur he ain't.

Canadian CEOs bloated from eating too much shareholder lunch
On my other blog recently, I posted my choice of the worst CEO pay offenders, like Marc Tellier of Yellow Media and Frank Stronach of Magna International.

To keep the proper positive outlook for the future, next post will cover some of the few Canadian companies that I think are closest to being on the right pay track.


Jamie Alport said...

I agree that CEO's are overpaid across the board but what is the solution? One company can't just come out and say "We're not paying that much anymore", because they won't be able to attract the talented leadership they need. The best CEO's will just move to the companies willing to pay the bill.
It's kind of like professional sports, they need a salary cap or else owners will compete financially for talent with no ceiling.
I'm not sure what the solution is, a salary cap on CEO pay? All the best CEO's would move to a country where there was no cap. It's a systematic problem, not a CEO problem.
Great read, but I'm still searching for a solution.

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