The real reason CEO compensation got out of hand.

The search for better economic policy.
May 11 2009 6:08 PM

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The real reason CEO compensation got out of hand.

CEO.
How did CEO compensation get so out of control?

Last fall, with headlines of million-dollar Wall Street bonuses appearing amid the worst economic crisis in a generation, I attended a lecture on corporate ethics by the CEO of one of America's most venerable corporations. This captain of American industry was critical of the compensation committees and formulas that generated these outsize payouts and felt that in his own case, he didn't deserve more than $10 million, regardless of what the committee came up with.

It is truly a statement of the times we live in that a self-imposed $10 million pay cap is a sign of modesty and virtue. Half a century ago, the median pay of top executives in U.S. companies was 30 times an average worker's salary; by 2005, the ratio was nearly 110. How did we get here?

The popular (and populist) perception is that of America's CEOs greedily rubbing their hands together as they approve their own paychecks, and there certainly has been some of that. Others argue that in most cases CEOs are richly compensated because they're so good at what they do.

Several recent studies stake out a middle ground, assuming that CEOs are neither villains nor business masterminds. These studies argue that the seemingly innocuous practice of benchmarking pay against other companies' CEOs may be to blame, because the list of comparable executives is often formed selectively to include highly paid peers and to omit lower-paid ones. Though this opportunistic selection of peers may result in only a small bump to CEO pay in any particular year, over time, the rising tide of peer pay may well account for much of the increase in corner-office salaries that we've seen in recent decades.

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If bosses set the salaries of their workers, who decides what the bosses earn? In a modern corporation, the task of setting the CEO's pay falls to the board of directors, typically a subgroup of board members on its compensation committee. A CEO's pay is partly a reward for leading the company and partly an inducement to keep him from leaving for greener pastures.

How much is enough? It makes sense to see what competing firms—the ones that might try to lure your CEO away from his current job—are spending to reward and retain their leaders. That's where the peer-group comparison comes in. But who is the "right" peer? You probably want to pick someone running a company in the same industry, of similar size, of comparable profitability, and with similar experience (similar tenure at the firm and so on). Depending on your industry, however, there might still be dozens of CEOs who meet these criteria—how do you decide who makes your list of comparables?

Compensation committees use their discretion, and that has led to claims of abuse by committees with too-cozy (or just plain incestuous) relations with the CEO. (Compensation consultants, often brought in to help figure out the "right" pay, have also been accused of currying favor with executives in the hope of securing other, more lucrative business from the company.) To shed more light on what had been a less-than-transparent process, the Securities and Exchange Commission mandated in 2006 that companies had to make their peer lists public.

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