CEO Pay – Is It Lake Wobegon Run Amok?

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A new research paper suggests that high CEO pay is a result of the Lake Wobegon effect. From the paper:

In this paper, we propose a new explanation for the recent increase in CEO pay at US firms. Our explanation, which is based on asymmetric information in financial markets, is motivated by a recent observation made by former DuPont CEO Edward S. Woolard, Jr.: "The main reason (CEO) compensation increases every year is that most boards want their CEO to be in the top half of the CEO peer group, because they think it makes the company look strong. So when Tom, Dick, and Harry receive compensation increases in 2002, I get one too, even if I had a bad year…. (This leads to an) upward spiral"

The authors lay part of the blame on U.S. capital markets and their accompanying short-term focus. The problem for me is one of value. I have no problem with CEO pay being 100 times the average worker for a CEO that provides that much value to the company. What I disagree with is using shareholder money to pay extravagant packages to CEOs who don't perform, or worse yet, are sometimes unethical.

Warren Buffett had some interesting thoughts on CEO pay in his latest letter to shareholders.

I mentioned last year that in my service on 19 corporate boards (not counting Berkshire or other controlled companies), I have been the Typhoid Mary of compensation committees. At only one company was I assigned to comp committee duty, and then I was promptly outvoted on the most crucial decision that
we faced. My ostracism has been peculiar, considering that I certainly haven't lacked experience in setting CEO pay. At Berkshire, after all, I am a one-man compensation committee who determines the salaries and incentives for the CEOs of around 40 significant operating businesses.

How much time does this aspect of my job take? Virtually none. How many CEOs have voluntarily left us for other jobs in our 42-year history? Precisely none.

Berkshire employs many different incentive arrangements, with their terms depending on such elements as the economic potential or capital intensity of a CEO's business. Whatever the compensation arrangement, though, I try to keep it both simple and fair.

When we use incentives – and these can be large – they are always tied to the operating results for which a given CEO has authority. We issue no lottery tickets that carry payoffs unrelated to business performance. If a CEO bats .300, he gets paid for being a .300 hitter, even if circumstances outside of his control cause Berkshire to perform poorly. And if he bats .150, he doesn't get a payoff just because the successes of others have enabled Berkshire to prosper mightily. An example: We now own $61 billion of equities at Berkshire, whose value can easily rise or fall by 10% in a given year. Why in the world should the pay of our operating executives be affected by such $6 billion swings, however important the gain or loss may be for shareholders?

Setting compensation for independently wealthy CEOs who are running the businesses they have built over a lifetime is surely different than doing so for most Fortune 500 companies. Still, Buffett makes some excellent points – most notably that compensation should be simple and fair. You wouldn't open a restaurant and pay someone 500K a year to run it, so why don't shareholders have the same mindset? Or, are they simply powerless to do anything?

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Comments

  1. S.M.Mehdi Hassan's Gravatar Comment by S.M.Mehdi Hassan on March 7th, 2007 at 2:22 pm

    Rob,
    YOU ARE THE MAN!! I just read about the wobegon effect. If the companies think that by keeping their CEO’s payment on the top ten CEO payments of the year would give them a strong image then they are totally wrong. They are just wasting shareholders’ money. I did not have time to read the research paper but I downloaded it and save in my hard drive to read it when I get time.

  2. laurence haughton's Gravatar Comment by laurence haughton on March 7th, 2007 at 2:55 pm

    As a child of the Watergate era I always try remember Deep Throat’s advice, “Follow the money.” I’ll bet directors get something for themselves (or their firms) when they vote for a “hard to justify” increase. And Warren is the skunk at the garden party with all his logic and fair dealing.

  3. Gary Bourgeault (managersrealm.com)'s Gravatar Comment by Gary Bourgeault (managersrealm.com) on March 8th, 2007 at 1:48 am

    I’ve always like Buffett’s insight into management compensation. It’s pretty simple: pay them for their performance. The idea of talking about whether a CEO is paid a certain number of times the salary of a worker has no bearing on anything at all. That’s just somebody coming up with their personal formuala.

    You never hear shareholders complaining about compensation when the CEO makes them money from year to year.

  4. Mike's Gravatar Comment by Mike on March 8th, 2007 at 10:23 am

    “Follow the money” is spot on! Warren actually addressed that in the letter:

    “In selecting a new director, we were guided by long-standing criteria, which are that board members be owner-oriented, business-savvy, interested and truly independent. I say “truly” because many directors who are now deemed independent by various authorities and observers are far from that, relying heavily on directors’ fees to maintain their high standard of living. These payments, which come in many forms, often range between $150,000 and $250,000 annually, compensation that may approach or even exceed all other income of the “independent” director. And – surprise, surprise – director compensation has soared in recent years, pushed up by recommendations from corporate America’s favorite consultant, Ratchet, Ratchet and Bingo. (The name may be phony, but the action it conveys is not.)”

  5. laurence haughton's Gravatar Comment by laurence haughton on March 8th, 2007 at 3:08 pm

    And the compensation could be invisible – like buying oodles of products from a director’s company (or client) instead of a better priced competitor.

  6. Charles H. Green's Gravatar Comment by Charles H. Green on March 13th, 2007 at 10:55 pm

    Wait a minute. S.M. Mehdi Hassan at least admitted he hadn’t read the article before commenting. Did anyone else read it either?

    Click through and check it out. The researchers say that their article was inspired by–inspired by–the claim of the Lake Wobegon effect. They then modelled it. Here is their ringing conclusion:

    “The three key assumptions of the Lake Wobegon effect are not sufficient to guarantee upward distortions in pay.”

    Doesn’t sound like a “case proven” endorsemeent to me. They go on to talk about “short-termism” as a factor affecting high CEO pay, and suggest it may be a particularly American disease.

    Interesting, though it doesn’t really seem to talk about “Lake Wobegon Run Amok” to me.

  7. Allen's Gravatar Comment by Allen on April 8th, 2007 at 3:09 pm

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