Are CEO’s overpaid?

ceoYou may have seen headlines saying that CEO’s make 300 times more money than the average worker. These can be deceptive. The data may not be comparable, or cherry-picked for “wow” factor based on only the largest companies.

I realize this post may be unpopular, even though it is not a full defense of CEO pay. That’s OK. Facts, truth, and reason are more important.

Focus on large companies misleading

It is misleading to focus on CEO pay for just a few hundred of the largest companies. The actions of a CEO with 200,000 employees carry greater value than the actions of a CEO with 200 employees, so the large-company CEO is paid more.

It’s different for the average worker. A welder is not that much more valuable at a large company than a small company, so the large-company pay difference is not as wide.

Therefore, the ratio of CEO to average worker pay should be higher for the very largest companies.

Deceptive data

Here’s an example of a recent deceptive headline. The AFL-CIO issued a report saying that the average CEO makes 347 times more money than the average worker. Mark Perry at AEI ably debunks the biased math behind this calculation:

  • CEO pay was based on 419 of the largest companies, while worker pay was based on a broader group of several thousand companies.
  • CEO pay included benefits, while worker pay excluded benefits.
  • CEO’s work 50-90 hours per week versus only 33.6 hours for the average worker (includes part-timers!!?).

Perry corrects the calculation to make it an apples-to-apples comparison of total compensation for Russell 3000 CEO’s versus Russell 3000 full-time workers. Assuming a 60-hour work week for CEO’s, the ratio drops from 347 to 41.

Why are CEO’s paid so much?

Still, 41 times more is a lot more. CEO’s for larger companies are paid millions. Why are CEO’s paid so much?

Because the right CEO that makes the right moves at the right time can create tremendous value. Great CEO’s transform their companies. Great CEO’s create value that far exceeds their pay. Company boards know this and pay up to attract a great CEO.

The real problem is that many CEOs are not so great. Companies offer large pay packages to attract good CEO’s, but some are not worth it. Unfortunately, it’s hard to know ahead of time if a CEO will be great.

The situation is sort of analogous to NFL quarterbacks. A great QB can make an average team good, or a good team great. Mediocre QB’s are over-paid because of this, but the great QB’s are not overpaid relative to the value they provide. And it’s similarly difficult to project how well a young QB will perform as an NFL starter.

Minor economic issue

Although some CEO’s are overpaid, I don’t see this as a major economic issue. The number of CEO’s is tiny, so the impact on the economy is not significant.

CEO pay is usually a tiny fraction of a company’s total costs. Although median pay is $3.9 million for Russell 3000 CEO’s and $11.5 million for S&P 500 CEO’s, that’s not as large as it sounds compared to the size of the companies they run.

A study done by Institutional Shareholder Services of 2,200 companies showed median CEO pay equated to 0.3% of company revenue. CEO pay typically falls into the 0.1% to 0.4% range.

For additional perspective, here’s some data for a large well-known company that I’m familiar with. This CEO made over $19 million last year, so clearly not a low-paid CEO. If half of this CEO’s pay was redistributed to customers via lower prices, it would provide a price drop of only $0.06 per unit (on products that sell for $75 to $100). If half of this CEO’s pay was redistributed evenly to all employees, paychecks would increase only $12 per month (before taxes).

The facts suggest that the economic impact of CEO pay is not that significant.

Major emotional issue

The emotional impact is a different story. CEO pay stirs up lots of emotions. People get outraged. It fans the flames of resentment and envy. It arouses concerns about overall inequality, even though the number of CEO’s is small.

These negative emotions are understandable to some extent, although some people overdo it. I agree that it’s distasteful and unfair when a bad CEO is paid millions.

Should we limit CEO pay?

So, what should we do about it? It’s easy to gripe, but difficult to come up with practical solutions.

Some people think government should limit CEO pay to 20 times the average worker’s pay, or some such ratio. Many years ago, I thought this was a smart idea. I no longer do.

I’m more skeptical of government action these days. Why should government decide CEO pay? Are we sure that government will do a better job?

Government usually does not make decisions as well as those with direct knowledge of the situation. Governmental one-size-fits-all solutions often do not work.

There is a market for CEO’s. It’s a thin market, and sometimes makes mistakes. It’s not perfect. But it seems better than government deciding.

Besides, any rule to establish the allowed ratio of CEO to worker pay will face difficult implementation questions:

  • Who will determine the acceptable ratio?
  • What methodology will they use?
  • Will the methodology be flexible enough to allow higher ratios in years when the stock price goes up?
  • How will the method account for differences in average worker pay?
    • For example, comparing Company A with mostly low-paid entry-level workers (e.g., restaurants) to Company B with mostly high-paid experienced workers (e.g., engineering consulting).
    • For example, comparing Company C with half their workforce based in low-wage Bangladesh to Company D with half their workforce based in high-wage Germany.
  • How will adherence to the policy be monitored? Enforced?

These are serious issues. People exaggerate the ability of government to successfully create rules like this. Don’t assume that someone in Washington knows just the right ratio and has all the right answers.

In closing

CEO pay seems less important than popularly portrayed:

  • The CEO to worker pay ratio isn’t as bad as many headlines trumpet.
  • Some CEO’s are overpaid, but not all. A good CEO is worth the high pay. A bad CEO is not worth the pay, but we don’t know in advance.
  • CEO pay is not a major economic issue because the number of CEO’s is small.
  • Any government solution to limit CEO pay would be fraught with difficulties (and lobbying).

You may still be outraged, but I hope I have at least injected some facts and reason into this emotional debate.


I encourage you to enter comments or questions below. Two rules: 1) be reasonably polite, 2) address the issue and avoid personal attacks.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s