Several years ago working for a large company I was proposing to hire a manager for an opening I had in my part of the organization. In a discussion with our VP of Human Relations I was telling him who I had decided I wanted and what salary I was planning to offer. He looked at me and said, “Can’t you find someone who will do that job for less money?”
The way he had framed the question surprised me, but after thinking about it for a few seconds I said, “Yes I probably can, but then, I’d do Dave’s job for less than you’re paying him.” (Dave was the president of our subsidiary and while I was a couple of levels below him, his salary was about 4 times mine. I would have been happy to take on his job for less than he was making, but I knew there would be serious questions about my qualifications by his superiors.) Hiring a person, particularly an outside person, is risky. One would like some assurance that the person would perform the job at a high level. Despite the fact that we require written qualifications and interview candidates, it’s difficult to know exactly how it will work out. And the higher up in the organization the job is, the more the pain it will likely cause if it doesn’t work out.
Promoting from inside can be less risky because we have more first hand knowledge of the candidates. As we discussed in Part 1, In the 50s and 60s, corporations were doing that for the CEO positions. These candidates were not only better known by the people doing the selecting, but internal candidates would have first hand experience with both the industry and the company operations. If one believed the prevailing paradigm of the time, that needed management skills could be learned by people of reasonable intelligence, then promoting from within was the safest course. Raises in salary given to internal candidates would have been tied to their previous salary levels and to the company’s salary job ladders. This seemed to be working well for at least 2 decades or more after WWII. CEO salary levels were reasonable and the US companies in that time seem to have no industrial peer.
But in the 1970s the quality of US industry and management came into question because we were not competing well with Japanese imports. By the late 70s, a lot of people were saying that the US had lost it’s edge. The question was of course; Why? The suspect of course was senior management. As we saw in Part 1, there were two primary theories that were advanced which I believe were primarily responsible for the much higher compensation levels that we see today. One had to do with motivation and the other with the candidates qualifications. They were not mutually exclusive, and I believe that there is some truth to both. So lets look at each in turn.
The first that I remember seriously entering the discussion on compensation was the idea that the professional managers had become caretakers rather than innovators. The Japanese had obviously made innovations in manufacturing that let them produce higher quality goods at less cost. Why had not the US companies found ways to innovate? If one believed that the current managers were competent, then perhaps it was a matter of motivation. The members of the Jekyll Island Club came by their super wealth, not so much because of high salaries, but because they held significant ownership stakes in the companies they had formed. They got rich because the companies did well. The professional managers compensation was mostly salary and although they had some stock, it likely wasn’t that significant. If they tried something new and innovative that was successful, and resulted in say, 50% higher earnings and a comparable rise in stock price, they might get a 10% raise. If on the other hand, the new idea failed so that earnings and the stock price went down by 50%, they could be out of a job. While their salary might not make them super rich, it certainly was enough to provide a comfortable life. So why should they take unnecessary risks? And risks were unnecessary because US companies were all ready doing well. If they stayed with the conventional processes and procedures, and things went down, they would not necessarily be blamed and their world would remain in tact. (There’s a saying heard from time to time in the business world that “nothing fails like success” because we become complacent and stop looking for new and better ways to do things.)
The fix for this was seen to be to make the CEOs compensation more like an entrepreneur’s. Give them a larger stake in the ownership so that the rewards would be large enough to give them incentive to take the risk of attempting innovative changes. The obvious way to do this was to increase their ownership interest through the award of either stock or stock options or both. The question that comes into the discussion at this point is how, how much, and on what basis to make these awards. These are questions of how to judge CEO performance. If the CEO is responsible to the stock holders, in what are the stockholders interested? Return on stockholder investment through dividends and an increase in the price of the stock would likely be the majority answer. Both are obviously driven by earnings, but dividends tend to be the most stable of the two variables with stock price the most variable. So the simple answer has become stock price – this was reinforced by financial advisors in the 80s and 90s telling clients to go for capital gains because of lower tax rates and mutual funds which tend to mask dividend rates in their reporting. So the popular media and many investors have tended to gravitate to stock price as the single measure of performance.
The difficulty with this is that variation in earnings and stock price can be significantly influenced by things outside a CEO’s control. One of the tenets of Human Resource practitioners is that performance measurement should hold employees responsible for only those things under his/her control. Indeed, some of the likely best performances by CEO’s has been in down markets. In a company’s earnings go down 10% in a market that has declined 25-30%, is that better or worse than the performance of a company increase of 10% when industry has improved by 25-30%? Most would say the former is better than the latter, but it becomes a public relations problem when the medial reports only the company’s change. However, many if not most companies have included a comparison with peers as part of their compensation process.
The purpose of significant portion of a CEO’s compensation being stock and stock options is to provide more incentive for risk taking – trying to find new and innovative ways to do things. In the implementation of these concepts increasing the percentage of “at risk” compensation was done by adding these non-cash awards to the existing salary which was not generally lowered. This has tended to make compensation levels higher by the amount of the “at risk” awards. This, by itself, has tended to raise overall compensation levels from the 60s and 70s levels. The perception of the increase, however, has been made worse because some things that were not required to be reported as part of the total individual compensation 30 years ago, now must be included. This of course, makes the increase look even higher than they would other wise be.
Even so, what I believe to be the bigger factor in the rise of CEO salaries is attributable the second paradigm change that we will talk about in Part 3