The Illusion of Leadership: Are CEOs Paid For Luck?


I think some CEOs are overpaid. No, I'm not going to give you some leftist mantra about how no one should make $50 million a year because I don't believe that. What I believe is that there are other people capable of doing the job of CEO that would do it for less money. I think boards spend too much time looking for proven superstars than for up can coming managers who would love to take the top job for less than the current CEO makes. Now a recent research paper backs up my view, but for a different reason. This paper argues that there is a significant component of CEO pay that is based on luck.

According to the standard principal-agent theory CEO pay should not respond to exogenous forces beyond CEO control, yet the data shows that CEO pay substantially responds to exogenous shock casting doubt on the appropriateness of the principal-agent model in the CEO pay context.

In other words, this paper argues that the CEO gets credit for things that are beyond his or her control, creating what the author calls the illusion of leadership. Here is the author summarizing his findings.

An interesting and previously not documented result emerges from my empirical analysis. I show that there was no pay for luck in the 80s, a period of the US corporate history distinguished by active market for corporate control (large number of hostile takeovers and leveraged buyouts(LBOs)). It seems that when the incumbent management could be (and often were) challenged by shrewd outside investors, management and the board of directors were getting the compensation schemes right. On the other hand after the end of 80s when court decisions and legislation in the US brought the hostile takeover market to virtual halt (Jensen, Murphy and Wruck, 2004, page 23), economically large and statistically significant pay for luck emerges. The interpretation of the result seems clear. When the market for corporate control works, the internal governance of the corporation also works. When the market for corporate control is impeded by managerial lobbying for protection and by ill-advised court decisions and legislation(Jensen, Murphy and Wruck, 2004, page 28), pathologies in CEO compensation (part of the internal corporate governance) develop.

In other words, the market for corporate control is broken because CEOs don't want to be held accountable. At first glance, this may seem to contradict the current evidence that lousy CEOs are booted from power quicker than ever before, but it doesn't. This paper doesn't focus on that case. It focuses on the situation where random good things happen to the company and the CEO gets credit and additional compensation as a result.

I wonder if the author tested this hypothesis in a way that factored out the changes in accounting and tax treatment of CEO compensation. Those changes encouraged compensation via stock options, which is one reason CEO pay since the early 90s has tracked stock prices more closely. Regardless, it makes logical sense that CEO pay could be affected by some form of "survivorship bias," where their string of successes is due much more to luck than anyone realizes.

*Click on the picture for a larger version of MC Escher's "Ascending and Descending"