A thought provoking article by LSE Professor Eleanor O’Higgins in the latest issue of Accountancy Ireland. (This is a link to the e-version of AI, so it may take some time to load). For anyone that’s interested, here is my take.

I don’t disagree with Professor O’Higgins’ answer. I disagree with her question.

In effect she is asking “is executive pay warranted?” rather than “is it necessary?”. I don’t think anyone would argue that paying someone ten times their salary would make them work ten times harder. But the employment market is subject to the same rules of supply and demand as any other market. The price of anything is not determined by some objective intrinsic value, but by the amount the seller (in this case the executive, who is selling their labour) is willing to accept. The scarcer the item, the fewer the sellers, and the higher the price they are able to charge. With many buyers and few sellers, the only limit on the price is the buyer’s budget. In the case of public companies, that is hardly a significant restraint.

Companies pay large sums of money for executives not primarily because they want to motivate them or feel they deserve a large sum, but because they understand that picking the right candidate over the “wrong” one could mean the difference between them being the next Apple or the next Amstrad. That difference dwarfs any difference in the candidates’ desired pay. The more they offer, the larger a pool of candidates they will have to chose from, the more candidates they can chose from the more likely they are to get the best one.

Companies are competing for a tiny pool of executives with successful track records. The bigger problem, and to my mind the likely reason for the low correlation between executive pay and share price, is that an executive’s track record is a function of a number of variables, among which their own performance may or may not rank highly. Google was not phenomenally successful simply because it had a highly effective CEO. To a degree it was the right product in the right place at the right time. The CEO did not write the code that made Google successful and I doubt he had the idea to monetize searches via keyword sponsorship that led to the exponential increase in Google’s share price. Even if he did, is there another industry in which one good idea can turn out to be worth trillions of dollars?

Another issue is that very successful executives normally accumulate significant wealth. Picture if you will an incumbent executive with a successful company that has $10m in the bank and an annual salary of $1m. Studies have shown that moving job is one of the most stressful experiences a human being can encounter. How much more stressful is it when thousands of shareholders and staff are banking on you to do a better job than their last (presumably failed) chief executive could? How much would the aforementioned homo executivus (to coin a phrase) need to be paid to leave the comfort of his successful job with Company A to take on the potentially poisoned chalice of Company B? With ten mill in the bank a better option for your health would be to simply retire. The premium is not going to be another $100,000 a year, I can tell you that. It could be multiples (to account for the risk that he may not last a year and suffers irreparable harm to his reputation).

One reason, not mentioned in the article, that executive pay has been on the rise for several decades is that it has become more common for Boards to seek an external candidate moving laterally than an internal one moving upwards (precisely because an internal candidate naturally lacks the track record of chief executive success). For the company, the perceived reduction in risk from an exec with a track record is significant, and thus worth paying a premium for. For the candidate, the degree of risk involved in a lateral move is magnitudes higher than in an upwards one. Hence the pay required for someone to move companies would be expected to be magnitudes higher, and it is.

Thus executive compensation is a vicious spiral more reflective of the needs of the executive than their worth. In other words, it is a seller’s market. Can the recent spate of shareholder rebellions and executive defenestrations reverse the flow? Not likely.