Executive Compensation: What Happened?

By Paige Churchman (New York City)

The overpaid executives have become a lightning rod for our rage. Everyone’s jumping in. The President calls them shameful. The Merrill Lynch cafeteria workers, who make about $410 a week (paid by their contractor Aramark), take to the streets with a picture of John Thain’s $87,000 area rug. The exorbitantly paid have gone from star status to villains. Not so long ago, Thain was hailed as “Mr. Fixit.”

The problem started sneaking up on us about thirty years ago. According to the Economic Policy Institute, in 1965 US CEOs in major companies earned 24 times more than the average worker. That seemed about right. The ratio had been around 20:1 for most of the twentieth century. Then in the late seventies the gap slowly began to grow, reaching 35:1 in 1979. But in the 1990s, the gap broke into a full gallop, hitting 275:1 in 2007. In other words, says the report, “a CEO earned more in one work day…than the typical worker earned all year.” Occasionally, when a study drew attention to the growing imbalance, there was some shock, but it didn’t stay on our radars. The economy was strong. A President spoke of “trickle down.” People were happy. Until the economy fell apart. Now the gall of those overpaid guys is all we hear about, and President Obama has just announced a $500,000 cap for executives at companies receiving the largest amounts of bailout money.

How Did It Come to This?
The star system has been a big part of the problem says Rakesh Khurana, a Harvard Business School associate professor and author of Searching for a Corporate Savior: The Irrational Quest for Charismatic CEO. Right about when this started happening, in the late 1970s, there was a rise of institutional investors. These investors had the clout to pressure boards of failing companies to remove their CEOs. Not a bad thing. So boards went outside, seeking big personalities and charisma to save their companies. “A famous CEO was preferred over a low-profile CEO, as the former was seen as a boost to public and investor confidence—and share prices — fast,” says Khurana. But in doing so, they were bypassing industry wisdom and experience from the company’s internal talent. It created the “fiction that there is actually a real CEO labor market,” says Khurana. But market forces don’t play much of a role. Though the CEOs were compared with star athletes, the analogy doesn’t hold up. The boards are not sports teams negotiating for the best interests of the team. They are more like country clubs, a closed culture of other CEOs, socially and economically linked. Another difference — sports teams don’t try to hide what they’re paying in complicated compensation packages.

SEC Commissioner Roel C. Campos offers another reason for inflated CEO packages. Boards hire compensation consultants to help them determine a CEO’s compensation. Campos says it’s like what happens when you find a house to buy and hire someone to appraise it. Think about it. Does the appraiser ever come up with a number less than what you’ve agreed to pay? Of course not. “It is extremely difficult to avoid using high comparables,” says Campos, “And consultants can pretty much find high comparable income data to support paying a high amount to the CEO.”

If you think disclosure might be the answer to runaway pay, think again. In Executive Compensation: The Fallacy of Disclosure, Paulo Cioppa shows that attempts at disclosure have actually driven compensation numbers even higher. In 1992, the SEC adopted executive compensation proxy disclosure rules, hoping that the transparency would make executives more accountable to their shareholders. Instead, CEOs and CFOs have used the data to demand equal pay, threatening to go elsewhere. The Sarbanes-Oxley Act of 2002 had the same effect. Of course, now things are a little different.

What Could They Be Thinking?
Why is it that what’s so obvious to the rest of us — that these guys are vastly overpaid — they just do not see? Only 3.4 percent of CEOs thought that excessive CEO pay occurred frequently, said a 2006 study by Steven Hall & Partners. Maybe it’s those big star personalities and the tough hides they’ve had to develop. How else can one human being think he can actually manage a corporation that’s merged its way up to Spruce Goose size? In 2006, a couple of CEOs spoke out informally during a heated discussion on CEO pay at a gathering reported in Fortune. “The last thing you want to do is withdraw into a fetal position on some of this stuff,” said Bob Nardelli, who was still head of Home Depot at the time. He was making $250 million, even though the stock fell during his watch. He left Home Depot in January 2007, reportedly ousted by the board. He is now CEO of Chrysler where he makes $1 a year. Hank McKinnell, then Pfizer CEO, said, “There’s a much larger issue here; compensation is being used as part of a battle over control of the corporation itself.” Most shareholders, he said, “are pretty happy with the way companies today are being run.” A few weeks later, he resigned. He was slated to have the biggest pension payout in 2008 of any Fortune 500 CEO at the time – over $71 million. And, of course, there’s the more recent example of Ford CEO Alan Mulally who, when asked by a Congressman if he’d reduce his $21.7 million salary, responded “I think I’m OK where I am.” On his next trip to Congress, he promised to take a salary of $1 a year if Ford were given bailout money.

Vilifying the people on top is a way to make us feel that we’d never be so out of touch. We’d never fall prey to such delusions, grandiosity or greed. But maybe these guys aren’t so different from you and me. You may find that you’ve already fallen into some of the 45 moral traps described in The Ethical Executive: Becoming Aware of the Root Causes of Unethical Behavior by Robert Hoyk and Paul Hersey. Have you ever done what your manager wanted even though it seemed wrong to you (Trap 1: obedience to authority)? Some of the other traps are small steps, tyranny of goals, indirect responsibility, faceless victims, desensitization, “we won’t get caught,” and low self esteem.

Women Have a Different Take
Decades ago, a young developmental psychologist named Carol Gilligan was frustrated that research on moral reasoning used mostly male subjects. So Gilligan began listening to girls and women, and in 1982 she published In a Different Voice. Males, she found, are more oriented towards justice. When making moral decisions, they value reciprocity, equality, rights, impartiality, objectivity, generalization, fair rules and logical reasoning. Females though are more oriented towards responsibility and relationships. They make moral decisions based on care, love, trust, dealing with people, compassion, mercy and forgiveness.

Rakesh Khunara thinks business managers should have their own version of a Hippocratic oath and that we need to see our institutions as a way for creating value for society rather than as a way for individuals to enrich themselves. Catharine Austin Fitts was once Assistant Secretary of Housing under the first Bush, a managing director and board member at Dillon Read, and is now founder and managing member of Solari Investment Advisory Services . She’s a woman who has found her voice, and she did exactly what Khunara is calling for today. She wrote herself an oath:

“Long ago, I made a promise that I would never act against the best interests or the excellence of my own people—that I would do my best to ensure that we were worthy of the stewardship of our world and that we did our best to leave a better world for generations yet to come. To make and keep such a promise is to understand that money and position are tools, not goals, and that death is not the worst thing that can happen. Some would probably accuse me of ‘fighting the tape’ and not being ‘good at the game.’ I would tell those people that now is not the time in the history of our people for a failure of imagination.”

Gilligan said that the differences between women and men “center on a tendency for women and men to make different relational errors — for men to think that if they know themselves, following Socrates’ dictum, they will also know others, and for women to think that if only they know others, they will come to know themselves.”