Regulating CEO Pay Is Not the Answer

We're at a crossroads for CEO pay - and by extension for corporations and competition in general.

The conventional wisdom says executive pay played a substantial, perhaps dominant, role in the financial crisis and recession by encouraging excessive risk-taking. As a result, there's huge public support right now for the idea that the basic executive pay model should be changed that it should be rethought, reformed, legislated, and regulated. This is a natural reaction to unprecedented events. And the Obama administration is about to present its own philosophy on CEO pay in the form of compensation rules for twice-bailed-out companies.

But legislating and regulating executive compensation has the capacity to do real damage. Our research has shown that the traditional executive pay model using cash and stock incentives continues to work for the vast majority of companies. It motivates leaders to steer their companies toward high performance. Luck plays a part in whether or not the companies actually get there, but the pay-for-performance model certainly sets companies up to succeed. Our research shows that in general, high-performing companies' CEOs get paid a lot, and low-performing companies' CEOs get paid much, much less.

Furthermore, CEO pay is already self-correcting. Boards have heard the outcry from shareholders, activists, the media, and the public. All across corporate America, the compensation committee debates of the past few weeks have been notably different from previous years'. To borrow President Obama's language, the board members "get it." We survey directors annually and have found they have become far more conservative in making their CEO pay decisions.

An important factor prompting this change in board behavior has been the freezing up of the CEO labor market. This year, CEOs don't have as many employment alternatives as they used to. In past years, the intense competition for good CEOs helped boost executives' pay packages. In fact, a poor understanding of the executive labor market underpins much of the conventional wisdom about CEO pay. Many assume that some chief executives must browbeat their weak-willed boards into giving them lucrative deals--even in bad years. But in the vast majority of cases, that's simply not so. Boards do "buckle," in a sense, but only to the realities of the labor market. Big-company directors are convinced that the right CEO can add billions of dollars' worth of value for shareholders, and in most years, the right CEO is a scarce commodity.

CEO pay will self-correct in another sense too: Profits and stock prices are likely going to increase more modestly in the coming months and years, and that slower rate of growth will affect chief executives' realizable pay--the true value they earn in incentive and equity pay.

So I would suggest not a wholesale rethinking of the traditional executive-pay model but a more measured approach that specifically counters the role that pay may have played in causing excessive risk taking. As many have argued, perhaps it was the failure of the financial firms' risk models to identify the true downside risks that led to this crisis.

While this moment in history presents challenges for corporations, it also presents an opportunity for boards to get rid of executive pay components that irritate shareholders and employees. And that is what we recommend. Directors now have more clout to stand up to CEOs and refuse things like lucrative severance packages in case of takeovers, and they have eliminated some prerequisites. CEOs often don't realize how big an impact some of these perks can have on people's attitudes. We recommend protecting core incentives and minimizing the irritants, with an eye on balancing the risk components in the pay program with the pay-for-performance components.

But our recommendations are always framed in practical, economic, rather than moral, terms. Outraged employees and investors are bad for the CEO and bad for the company. For example, if employees are annoyed at their leader, productivity and thus profitability might slip. What matters to me isn't whether there's a moral crisis in executive compensation but whether companies can stay competitive and balance pay for performance with the right risk profile.