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Hosken: Are CEOs Overpaid?

Eric Hosken|Compensation Advisory Partners
Monday, 18 Jun 2012 | 11:25 AM ET

There is continual uproar and frustration regarding the levels of CEO compensation at public companies. In any given year, it’s not hard to identify the “poster child” CEOs receiving outsized compensation, in spite of the many failings of their companies.

The public’s frustration is not completely misguided; however, there are reasons why CEOs are paid the way they are and it is not clear that there are great alternatives available that will benefit shareholders. Rather than obsessing over the dollar amounts of CEO pay packages, investors should focus on ensuring that CEO compensation is delivered in a way that rewards positive performance and the creation of shareholder value.

Popular frustration is based on the inequity between CEO pay and that of the rank and file worker. Public outcry over the inequity of pay has grown so substantial that under Dodd-Frank, companies are now required to show the ratio of the median worker’s pay to that of the CEO. Presumably, the idea behind the legislation was that companies would be shamed into lowering or capping pay for CEOs as a way of narrowing the pay gap over time.

Underlying the anger over pay gaps is a belief that people should be paid somewhat similarly for a hard day’s work. However, such a view oversimplifies the way labor markets work.

The nature of a CEO’s role provides the individual with a broad span of control. Most employees will typically impact a limited area of the organization while the decisions of the CEO can affect the performance of the entire organization. Since many public companies have market values in the tens or hundreds of billions of dollars, a mere one percent change in the value of the company could have a huge impact. As such, there are compelling reasons for a company to want to pay millions of dollars if they can find a CEO they think will create value for the organization relative to other candidates.

What might happen if there were caps on the pay for CEOs of public companies or if CEO pay came under such scrutiny that compensation committees made moves to restrict CEO pay levels on their own? All else being equal, CEOs would begin to look elsewhere for employment. Some CEOs would go to work for private companies and some may go to work in other countries where pay levels are not restricted. Public companies will still be able to fill the role of CEO, but it will be with less experienced and less talented executives. This would likely put public companies at a competitive disadvantage relative to private companies.

Attracting and retaining a top CEO requires a company to provide the opportunity to earn compensation comparable to their next best alternative job. Compensation Committees typically estimate the market pay rate by examining the pay practices of similar-sized companies in the same industry. The CEO’s alternatives may be broader than just the peer group, but peer group data provides a valuable baseline for establishing target pay levels. Of course, actual pay levels for CEOs will be driven by the actual performance of the company and actual movements in the company’s stock price over time.

The bottom line is that it is misguided to focus on CEO pay in isolation. The absolute level of compensation alone is generally not sufficient information to know if he or she is overpaid. While a CEO earning $20 million for a year’s work may seem excessive, if the typical pay for a comparable sized company in the industry is $20 million, the case could be made that the CEO is underpaid if his or her company is a top performer.

Caution should used in trying to “fix” executive pay. Past attempts to regulate executive pay, such as IRC Section 162(m) that limits the amount of annual non-performance based compensation public companies may be deduct for each of its top four executives to $1 million, have been counterproductive and may have actually helped to increase overall compensation levels. If people are frustrated with the unequal outcomes of society, other remedies such as changes to the tax code may be more appropriate than limiting the compensation provided for one job relative to others.

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Eric Hosken is a partner with Compensation Advisory Partners LLC(CAP) in New York. He has over 12 years of executive compensation consulting experience working with senior management and compensation committees on all aspects of executive compensation.

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