Why CEO Salary May Come Back to Earth

Compensation packages for chief executive officers in the U.S. have careened out of control. However, the stage is set for what could be a major correction in CEO salary as the American public and shareholders alike find more and more reasons to question the status quo. More information is the key.

In October, the Securities & Exchange Commission (SEC) is expected to release the final rules for a controversial proposal that would require every publicly traded company to disclose its CEO-to-worker pay ratio. The Dodd Frank Act charged the SEC with the responsibility to make the rule, but it has taken this long for the SEC to make any headway. During the SEC's public comment phase, 128,000 comments flooded in about the rule. It was a lightning rod for controversy as governance advocates and business interests argued the pros and cons of CEO salary disclosure.

Now that progress is on the horizon, many CEOs will have something to sweat about. The data could lead many investors to wonder whether CEOs' job performance really warrants their big paychecks, and it could also raise regular folks' ire and overall distrust for corporate America.

The skyrocketing ratio

AFL-CIO data shows that the ratio of median CEO pay to the median pay of average American workers hit 331-to-1 in 2013. When CEO pay is stacked up against minimum-wage employees' paychecks, the ratio more than doubles to an eye-popping 774-to-1.

Naturally, CEOs should be paid more than rank-and-file workers -- especially if they're truly the cream of the crop. But such a huge gulf is unacceptable, if not ludicrous. In a strictly business sense, out-of-control pay can represent a serious strategic disadvantage. Peter Drucker, widely considered the father of modern management theory, warned that when this ratio rises above 20-to-1, employee morale can deteriorate. The ripple effect of disengaged or even disgruntled employees can lead businesses to falter.

The "pay for performance" joke

Advocates for high CEO salary argue that paying "market rates" or higher lures and retains the very best talent at the top. Yet that idea is flawed not only because the policy tends to push all CEOs' pay upward, but also because, in many cases, the highest-paid CEOs aren't even the best performers.

True, some outstanding corporate leaders take home reasonable, or even modest, paychecks in return for their hard work -- usually choosing to do so themselves. But for the typical chief exec, a huge salary is a given, and across corporate America, CEO "pay for performance" is largely a joke.

Many organizations have revealed data showing that sky-high pay doesn't always add up to business or stock outperformance. Just last month, Towers Watson released some relevant findings. The consulting company analyzed 50 companies that had outperformed peers in the S&P 1500 over a 15-year time frame. It turns out these companies' executive compensation had been targeted below the median CEO salary, not above.

Keep in mind that these CEOs' realizable pay was significantly boosted beyond the median rate through stock options, and options can sometimes artificially boost pay, which is another subject of debate in the CEO salary arena. On the other hand, when options and stock-based compensation are used in the way they were originally intended -- to align CEOs' interests with shareholders' interests in order to encourage long-term outperformance -- they can reward exceptional CEOs well and enhance companies' true performance.

Shine the spotlight on pay ratios

Most CEOs are given the benefit of the doubt every step of the way toward an inflated pay package. In some cases, we could call it money for nothing. Consider that new CEOs often bag eye-popping sign-on bonuses before they show any performance at all, while goodbye packages -- even for disgraced executives -- often represent more money than regular Americans can even dream of.

Disclosing the CEO-to-worker pay ratio will give much-needed perspective to the discussion and force boards of directors and shareholders to scrutinize CEO compensation more closely. It should also lead to deeper thought about how we define performance and merit in America. Outrageous CEO salary is overdue for an overhaul, and increased awareness may be the catalyst for change.

Check back at Fool.com for more of Alyce Lomax's columns on environmental, social, and governance issues.

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Read/Post Comments (17) | Recommend This Article (37)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 08, 2014, at 8:58 AM, CoyoteMoney wrote:

    While this proposal might improve the situation from an HR and political perspective, I don't feel it will have enough impact where it matters most, the market for executive talent. Incentives for headhunters and corporate compensation committees will still trend towards CEO wage inflation.

    A better first step might be to develop a meaningful analog for ROI, Return on Executive Compensation. Such a metric would allow both retail and institutional investors to compare companies with regard to compensation vs profitability and make investment decisions accordingly. Such market pressure might do far more to restrain pay growth than the current proposal.

  • Report this Comment On August 08, 2014, at 6:06 PM, learningfool1873 wrote:

    I have been an advocate of paying CEO's a reasonable wage, with appropriate bonuses, etc., for a long, long time. There are many CEOs's & top management who have run their companies into the ground, yet receive huge pay packages! There is NO valid reason for this. If the average worker messed up as many times as some of these top mucky-mucks, they would have been fired, with no goodie bag & no recomendation to give to a prospective employer. WHY should the lousy CEO fair any better?

    When I feel the compensation committee has gone too far in compensating the top earners, I vote against the CEO being on the board, each member of the committee, & the "say on pay" that I realize is non-binding. I can only hope there are a lot of other shareholders who feel the same, & vote the same. We probably don't come close to having enough shares to make a difference (I'm figuring most other stockholders own more shares than I do), but if there are enough of us, SOMEONE may actually notice & take heed. Since income disparity is becoming more & more of an issue, it MAY even lead to things changing for the better one day.

  • Report this Comment On August 08, 2014, at 6:46 PM, lepera347 wrote:

    One reason why there would be a negative correlation between stock price and CEO comp is all the tech companies. Jobs, Zuckerberg and crew have all accepted $1 salaries and their companies have killed it.

    Yet they're in a position to accept that given their already large stake in their respected companies, given that they founded it. CEOs are paid in company stock to tie their pay to the performance of the company, so the incentive was already there with tech CEOS.

    I do agree, however, that CEO comp is higher than it should be. Mostly this reflects a tournament scheme with those working below the CEO making much smaller salaries and thus compete for the big money. Still, if the movement to lower their salaries catches steam, then its likely shareholders would expect to see salary reductions across the board, and punish companies that didn't oblige.

  • Report this Comment On August 08, 2014, at 8:18 PM, vidar712 wrote:

    I disagree with your premise, that publicizing the CEO-to-worker pay ratio will influence change.

    The problem I have with it is that other companies will be used for comparison. Since the majority of companies have outrageous executive compensation, it will appear to be normal compensation for a CEO.

    It may even have the opposite of the desired effect.

  • Report this Comment On August 09, 2014, at 11:25 AM, ETFsRule wrote:

    "One reason why there would be a negative correlation between stock price and CEO comp is all the tech companies. Jobs, Zuckerberg and crew have all accepted $1 salaries and their companies have killed it.

    Yet they're in a position to accept that given their already large stake in their respected companies, given that they founded it. CEOs are paid in company stock to tie their pay to the performance of the company, so the incentive was already there with tech CEOS."

    Jobs and Zuck were also the founders of those companies, which is why they had the large ownership share. And that "model" of compensation has worked out just fine, IMO. They deserve whatever they've gotten.

    The issue is more with CEO's who are hired, and were not the founder of the company. What are they worth and how do we determine it?

    I think the CEO/worker info is a good start. Give the shareholders this information & let them cast their votes. It doesn't make any sense to invest ridiculous amounts of money in an unproven CEO. And "golden parachutes" make even less sense.

  • Report this Comment On August 09, 2014, at 11:26 AM, ETFsRule wrote:

    CEO's are just another employee hired by a company. Their pay should be performance-based.

  • Report this Comment On August 09, 2014, at 1:21 PM, TopAustrianFool wrote:

    The more regulations you have the less competition in every market that is regulated. With less competition, prices increase. CEO are a highly regulated and restricted commodity. Deregulate and you will see salaries set by the market.

    More regulations will only lead to more disparity.

  • Report this Comment On August 09, 2014, at 4:52 PM, Tiger69 wrote:

    I agree that some CEOs and other high management are overpaid. My solution: if the shareholders (largely institutions) condone it, there isn't much you can do. BUT, if we have an oligarchy forming of obscenely high paid management, then it is time to have a steeply progressive income tax on pay, including stock bonuses, of over, say, $1 million per year. Is anyone really worth that much for a year's work?

  • Report this Comment On August 10, 2014, at 7:45 AM, toobusyboop wrote:

    If someone has amazing talent as a CEO, maybe they should be given a sign on bonus to be paid at the conclusion of the first year, assuming they perform at a level that proves they deserve it, as demonstrated by x, y, z.....to be defined by the board of directors. After that, there should still be raises tied to performance, just like the rest of us!

  • Report this Comment On August 10, 2014, at 8:00 AM, Mathman6577 wrote:

    Will this effort work better than the government's effort to control wages and prices (yes Virginia The government did do that) did in the 1970's here and in Latin America in the 1980's and beyond? I doubt it. We will be arguing about this forever. My advice: If you don't like what the CEO makes leave the company and go somewhere else.

  • Report this Comment On August 10, 2014, at 12:40 PM, AaronRogers wrote:

    That is the most ridiculous and ignorant response any person can give. "If you don't like it leave." How about I don't like it so lets attempt to change it. More over, as the U.S. increasingly becomes an oligopoly the response simply is go where? That statement implies a person cannot disagree and voice concerns. Status quo is never acceptable and ignorant responses supporting the quo are not either.

    As a shareholder we should be fully entitled to knowing a CEO's salary and questioning the worth of said CEO. After all, every dollar they get is a dollar shareholders don't.

  • Report this Comment On August 11, 2014, at 1:52 AM, CHill8008 wrote:

    Wealth is generative, or informational, or generally it is functionally unbounded... the best kind of unbounded;-). This would best be modeled by a "fourth-quadrant" scenario, or a "black swan event."

    You reference the phenomenon here:

    http://www.fool.com/investing/general/2013/11/07/how-the-cli...

    We are each fundamentally self-employed. Without an evaluation of money, the unit-standard of this measurement, this is all meaningless. The ratio of Drucker is arbitrary: why not 21:1 or 19:1? The generation of money is of interest...

  • Report this Comment On August 11, 2014, at 6:45 AM, Mathman6577 wrote:

    Ha ha ha. Mr. Rogers. Here's another ignorant response: if you don't like how much the CEO makes don't invest in the company. The government tried to control wages (and prices) in the early 1970's with absolutely zero success. Feel free to try to change it if you'd like but you will not succeed. Your time would be better spent trying to control the government's excessive spending and taxes which hurt you far more than what a CEO makes.

  • Report this Comment On August 11, 2014, at 4:50 PM, HoosierRube wrote:

    They can just take their compensation in dividends (ala Warren Buffet) and then help out the president raise payroll taxes by declaring that your secretary pays more taxes than the boss.

    That way, the railroad you own which is the only source for getting oil out of Cushing Oklahoma can be protected from a pipeline being built.

    But thats just crazy talk right?

  • Report this Comment On August 12, 2014, at 5:45 AM, Mathman6577 wrote:

    Buffett gets a pass no matter how much he makes because he's in with the left-wing on trying to control CEO salaries.

  • Report this Comment On August 13, 2014, at 8:43 PM, ETFsRule wrote:

    "The ratio of Drucker is arbitrary: why not 21:1 or 19:1? The generation of money is of interest..."

    Yes it should be tied to the generation of money. Or, perhaps more meaningfully, the CEO's pay should be tied to the earnings of their company in relation to analyst estimates, to the overall market, to their competitors, or to some other benchmark.

    You bring up another interesting point though, and I agree that 20:1 is pretty much arbitrary. If a ratio is the answer, it should also account for the size of the company. You can think of the CEO as a manager, and he is responsible for all the employees of the company. So if he is responsible for managing 10,000 employees, he should get a higher pay ratio than if he were only responsible for 100 employees.

  • Report this Comment On August 16, 2014, at 11:47 AM, Wildflyer wrote:

    Fund managers(mutual, others) have long held the power to control exec salaries and call out the complicit behavior of board members by voting "no" with your shares.The question is: why haven't they?

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