More Evidence of the Damage Done by Kleptocrat CEO Pay

I have been writing about the problems of overpaid executives that has lately become so bad that “overpaid executives” doesn’t capture the nature of the problem. Today I see many CEO’s are acting as kleptocrats do – taking food out of others mouths to build their castles. The damage done to everyone else involved is of no concern. Both groups love bankers that flood them with cash for new and larger castles at the expense of the futures of their company (or country).

This paper does a very good job of providing more evidence of the damage done by these kleptocrat CEOs and their apologists.

Are Top Executives Paid Enough? An Evidence-Based Review by Philippe Jacquart and J. Scott Armstrong

Our review of the evidence found that the notion that higher pay leads to the selection of better executives is undermined by the prevalence of poor recruiting methods. Moreover, higher pay fails to promote better performance. Instead, it undermines the intrinsic motivation of executives, inhibits their learning, leads them to ignore other stakeholders, and discourages them from considering the long-term effects of their decisions on stakeholders. Relating incentive payments to executives’ actions in an effective manner is not possible. Incentives also encourage unethical behaviour. Organizations would benefit from using validated methods to hire top executives, reducing compensation, eliminating incentive plans, and strengthening stockholder governance related to the hiring and compensation of executives.

Many of the problems with the poor thinking around executive pay stem from the failure to grasp ideas Dr. Deming wrote about decades ago.

Executives are often evaluated on the basis of the success or failure of the business units for which they are responsible. In practice, many internal and external factors influence outcomes for firms, and assessing the role played by a given executive is not possible. For example, should a manager get credit for a firm’s success when the economy is booming or blame for the firm’s losses during a recession? When answering such questions, evaluators are biased toward ignoring contextual factors and overly attributing outcomes to leaders. This bias was illustrated in a laboratory experiment in which groups of participants had to solve a coordination task. In the experiment, group size varied, and participants could perceive that the task was harder when the group was larger. Despite this, participants credited group leaders for the success of small groups and blamed them for the failure of large groups (Weber et al. 2001).

The quote from their paper show a failure to understand variation (attributing variation to those near the variation at the time – good marks when the variation is good, bad marks when it is bad). And a failure to understand the organization as a system (the results of any subsystem are greatly influenced by the whole system and the conditions outside the system (the economy, the macro-economic conditions for the industry…). And a failure to understand the theory of knowledge: people should know our brains leap to causation explanations when the evidence doesn’t support it. Then confirmation bias and psychology lead us to accept the data that supports our biases.

Nonexperimental studies also find that increases in CEO compensation occur following increases in firm performance that result from factors beyond the CEO’s control—CEOs are paid for being lucky. For example, CEOs in the oil industry were compensated for increased profits resulting from fluctuations in the price of crude oil—a factor beyond their control (Bertrand and Mullainathan 2001).

You see this just looking at the money heaped onto executives (in addition to the already huge payments taken) in industries whenever those industries (not individual companies, the entire industry) have macro-economic windfalls.

I would like to see a company try this:

Sealed bids, a commonly used market-based procedure for hiring contractors of all types, might be considered for hiring top executives. Applicants using sealed bids would describe what they could do for the organization, what relevant skills they have (and support for their claims), how much they would require in remuneration, how long a contract they would need, and whether they would require any payments should they be asked to resign. The proposals would be cleaned to eliminate information that does not relate clearly to job performance (e.g., gender, race, religion, weight, height, voice, or looks). The bids would then be sent to a screening committee who would make blind, independent ratings using a structured rating sheet.

I think it is a huge fallacy to believe there are not many many many qualified candidate who would be glad to lead companies with much less onerous terms than the current crop is taking. There is the problem that a great deal of turnover is costly. Once you make someone a CEO and they succeed (which if you have a good management system should be nearly guaranteed) others will seek to hire them.

So turnover could be an issue with not massively overpaying executives. Granted I think a much smaller issue than the damage done by massively overpaying them, still an issue to deal with. Contracts that require a certain period of performance seem sensible to me. That idea of using sealed bids is a bit beyond what I thought of (and a bit crazy – which I like). My guess is few places will go this far (sealed bids) unless they see lots of other people do it and then they don’t have to fear being odd and they can just follow the fad. If they have the cover of the fad then I could see many places going along with such a system. I am not at all convinced this is really the best idea, but it is interesting and certainly much better than the current practices.

As I have said before I wouldn’t think of having people that demand kleptocrat level wages lead my company. If that is how much they demand to accept the job they are not the person hold a leadership position in the company. I will be happy for them to pass by the chance to lead our organization.

Corporate governance plays an important role in keeping executive compensation in check. For example, in the aforementioned study of CEO compensation in the oil industry (Bertrand and Mullainathan 2001), pay for luck was 23 to 33 percent lower in firms where CEO power was weaker because of the presence of a large investor on the board.

A study of how CEO compensation changed in response to luck (i.e., events affecting firm performance beyond the CEO’s control) between 1992 and 2011 showed that pay was about 25 percent higher when luck favored the CEO. However, this effect was evident only in poorly governed firms (Garvey and Milbourn 2006).

This paper is another good look at the poor practices currently used by most companies. The paper includes many references for anyone interested in digging into the detailed evidence.

Related: Massively Unjust Executive Compensation Damages Companies and Investments – New Deadly Disease, Extremely Excessive Executive Pay – CEOs Plundering Corporate Coffers for Personal Gains Because They Can Get Away With It – Too often, executive compensation in the U.S. is ridiculously out of line with performance – Warren Buffett (2006 – it is even worse today) – Executives Again Treating Corporate Treasuries as Their Money

High CEO pay hurts American companies, stockholders by J. Scott Armstrong and Philippe Jacquart

2. There is no evidence that higher pay produces better executive performance. Instead, there is evidence that higher compensation undermines the intrinsic motivation of executives, inhibits their learning, leads them to ignore some stakeholders, and discourages them from considering the long-term effects of their decisions.

3. It is impossible to devise incentive schemes that relate executives’ actions to the performance of the firm. Incentive systems in organizations can only work when an employee has full control over the outcomes, as with highly repetitive tasks that require little thinking or learning. This, of course, is not the case for top executives.

4. Incentives are likely to encourage unethical behavior. Stock options became infamous when the public discovered that grant dates of CEO options were being manipulated to increase the personal benefits of CEOs at the expense of the firms’ owners.