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Executive pay is an issue that often causes public uproar. But it’s not as greed-driven as we might think. Razvan Chisu/Unsplash

The uproar over executive pay isn’t entirely warranted

For those inclined to view big business as irresponsible, poorly governed and out of touch, CEO compensation provides the biggest and juiciest target.

The average annual pay for a CEO of a Canadian company hit a record $10.4 million in 2017, more than 200 times the average employee’s salary. A public uproar ensued last year when it was revealed that executives at troubled Bombardier gave themselves hefty pay raises after receiving hundreds of million of dollars in taxpayer subsidies.

People throw paper airplanes during a demonstration in Montreal in April 2017 to protest pay hikes and bonuses to Bombardier’s top executives. THE CANADIAN PRESS/Graham Hughes

Last year in the United States, CEOs at the largest companies received the highest compensation increases since the Great Recession. The trend has angered some shareholder activists who have staged rebellions against company boards for approving huge paydays to senior managers.

For economists, CEO compensation has been a source of spirited debate. Some say that high executive pay is merely a reflection of supply and demand and the stock-based incentives built into compensation packages. They point to standard economic models in which compensation packages are designed to encourage CEOs to maximize company value.

But that’s been hard to square with the empirical evidence that CEO compensation has often more to do with luck than with the value CEOs create.

CEOs rewarded for luck?

Many critics will argue that, notwithstanding the deliberations of board compensation committees, chief executives tend to be rewarded for factors outside their control.

Those may include a favourable business cycle or a change in the price of key commodities, such as oil, that can shape the fortunes of key sectors of the economy.

President and CEO Bharat Masrani speaks at the TD Bank Group annual general meeting in March 2017. Masrani pulled in $10.85 million in compensation in the 12 months that ended Oct. 31, 2017. THE CANADIAN PRESS/Frank Gunn

One way to understand this is to consider that compensation packages are designed to not only provide incentives but also to attract and retain key executives. In a marketplace for senior executive talent, different types of firms compete for different types of CEOs.

This is the perspective that Nicolas Sahuguet and I took in our study on executive pay. For one thing, some firms do a more thorough job of monitoring — for example those with very large shareholder blocks or powerful boards.

They are able to get more and better information on CEO performance and ability, which means these firms have the confidence to hire untested and inexperienced CEOs and to dismiss those that under-achieve.

This is important because inexperienced CEOs arrive with a lot of uncertainty about how they’ll perform once they’re at the helm and have to make high-stakes decisions. A few good or bad months often go a long way towards determining their value going forward.

Close monitoring

So companies with strong boards that can closely monitor a CEO’s performance will take a chance on an inexperienced CEO and pay them according to their performance — how well they build the firm’s value — rather than on the vagaries of prevailing business conditions.

By contrast, experienced CEOs — say former General Electric CEO Jack Welch or onetime Hewlett Packard CEO Meg Whitman — arrive with extensive media recognition.

Meg Whitman is seen in this 2015 photo at the New York Stock Exchange. (AP Photo/Richard Drew)

In their case, the unknown is the possibility of disruptive change in business conditions.

This CEO will likely be hired by a firm with relatively weak monitoring abilities — for example, firms with more diffuse ownership and weak boards. Since board members of these companies kowtow to senior executives and find it harder to dismiss a CEO, they look for a known quantity. And they will more likely pay that known quantity based on business conditions (or “luck”) rather than performance.

In sum, firms with strong governance end up paying their CEOs mostly for performance, whereas firms with weak governance end up paying theirs mostly for luck.

Interestingly, contrary to a naïve interpretation, governance does not have any direct causal effect on pay-for-luck. Instead, the cause-and-effect relationship has more to do with the fact that different types of firms hire different types of CEOs. In particular, firms with a good corporate governance system will be less reluctant to hire a promising yet inexperienced CEO.

Size of firm correlated to CEO pay

As for the increase in the compensation of large firms’ CEOs since the early 1980s, the most striking empirical fact is that the pay increases are very strongly correlated with the significant expansion of those companies.

Indeed, CEO pay is very strongly correlated with firm size both over time and across firms. The explanation is simply that a CEO will have more impact in a larger firm, so increases in firm size increase firms’ willingness to pay to attract CEO talent. It’s similar to how professional athletes earn higher wages when the value of their sports franchise increases.

Does poor governance allow executives to increase their compensation? This idea is hard to reconcile with the fact that governance has generally improved over the last few decades while top executive compensation has also increased.

And if faulty governance were really the reason behind excessive CEO compensation, then a governance improvement plan in a firm would be accompanied by less generous compensation packages. Such governance improvements typically take place when a company is taken over by a private equity fund. Yet they are often accompanied by rising rather than falling executive compensation, notably via stronger pay-for-performance.

This may not make you feel any better about seemingly high CEO compensation or why CEOs can be rewarded for favourable business conditions yet go unpunished for poor performance.

Of course, as in any sphere of life, some top executives will abuse their positions and extract undeserved benefits. As a whole, however, trends in executive compensation are consistent with fundamental economic forces.

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