The Myth of CEO Compensation

Recently this chart has been popping up in my feed again:

Now, this has sparked some of the same debates as when I last saw it. I would say that, broadly, there are two camps that people fall into when it comes to CEO compensation.

First, there are those that argue that this is morally wrong, and this growing inequality is a sign of moral bankruptcy in our society. The other argument that I see is that CEOs make, decisions with a much larger scale than the average worker. For example, a mistake that a worker makes could cost the company $10, while the mistake that a CEO makes could cost the company $10,000,000. This argument is usually also accompanied by the statement that since a good chunk of CEO compensation is in the form of stock and options, that this gives them an enormous incentive to align their decisions with the companies benefits.

Now, I believe that there are several problems with that second argument. First, is the fact that many of the CEOs with the highest compensation are the ones overseeing failing companies. For example, the CEO of GM, Mary Barra, who earns about $29M/year recently stated on CNN: "My compensation, 92 percent of it, is based on performance of the company. When the company does well, everyone does well."

However, she has been at the helm of GM since January 15th, 2014, and evidently the market does not believe that company has been doing very well during her tenure.

That's right, in the nearly decade that she has been CEO, GM stock has not only barely moved, it has gone down. Now, of course, GM does pay dividends, but when you factor those in, the picture is still pretty bleak. I used this stock return calculator to calculate total returns assuming dividends had been reinvested, which showed 6% return over that period, for an annual return of less than 1%.

Bear in mind that during this same time period, the S&P500 returned over 100%. The reason I mention Mary Barra, obviously, is because the UAW has been striking recently, motivated in part by their wages increasing just 6% in the past 4 years, while hers have risen 30%. That's right, while returning so little value to the shareholders, she has been getting raises.

But let's leave that issue aside, because I want to challenge the premise of the argument. The argument basically makes the case that because CEOs are in charge of such important decisions, they should be paid more. And while, yes, CEOs most likely do routinely make decisions with 400x the impact as the average worker, I believe this argument is fundamentally flawed.

As a firm believer in the free market, I believe that salaries should be based, at least in part, on market economics. I do not believe that CEOs are the exception. For the average worker, the salary is often a function of how much it would cost to train and pay a replacement worker. Therefore, in tight labor markets, like we have now, salaries should naturally rise, as we are seeing in many places.

To illustrate this point, consider the workers at a large factory or utility. NYC is supplied by 14 water treatment plants, meaning that each plant serves, on average, 600K customers. Presumably, the workers at the plant, whose decisions affect the lives of hundreds of thousands of their fellow New Yorkers make decisions that are similar in importance to that of the CEO of a small company. A mistake that they make could cost the city billions in economic, health and infrastructure damage. Despite this, I don't often hear calls to pay these workers millions of dollars a year. Why? Because they are easy to replace. If the workers earned millions of dollars each year, they would quickly become some of the most competitive jobs in the city to apply for.

So why are CEO compensations so different? Why is the average worker paid based on how much it would cost to replace them, but the CEOs are paid based on the scale of their decisions? Is it really that hard to find a CEO for GM who can return 0.66% per year? Surely it wouldn't be hard to find an upper level executive at GM, or a rival automaker, who could perform just as well, if not better. It just doesn't make sense.

I suspect the answer has to do with power and politics. The people who select the CEO of a company, the board of directors, have interests other than just the wellbeing of GM. Here is a list of the members of the board of directors at GM:

What stands out is that many of those who are in charge of picking a new CEO are also CEOs themselves (Mary Barra herself is also on the Disney board of directors). In other words, they have a vested interest in making sure that CEO pay remains high, because any significant change in CEO compensation practices in the S&P 500 would affect their pay as well.

To be clear: I don't believe that there is some conspiracy among C-suite members across the S&P500 to keep their compensation packages high. Having said that, I don't think you need a conspiracy when they all have similar incentives. As long as the majority of their compensation comes from their own highly paid role as CEO, there is no motivation to rock the boat, even if the stock in GM suffers slightly.

So what solutions are there? I think it would be good to look carefully at the incentives that these high level actors have. Ideally, their incentives would all be aligned. Just like I believe politicians should not be allowed to consort with business interests, I don't believe it is appropriate for CEOs of one company to be unnecessarily involved with other corporations in this way. The board of directors should be solely focused on the success of just one company; if this means that they must give up their role as CEO at another company, so be it.

Why is this important? It's not just about fairness, although that is the main argument that those who argue for lower CEO compensation make. It is also about restoring a free market which has been corrupted by perverse incentives and opaque, overlapping power structures. Whenever markets are free, efficiency, and therefore prosperity, are increased.