O.R./Analytics at Work Blog

executive pay

Looking through some archived issues of the INTERFACES journal, I found myself drawn to a series of papers published in Dec. 2013 regarding executive pay structure -- the financial compensation received by executives in the form of salary, bonuses, and stock options.

A quick glance at each title left me with the impression that these papers would cast the culture of executive pay in a negative light, so I read through a few of them to see if that first impression would ring true.

“The Ombudsman: Evidence and Executive Compensation—Like Trains Passing in the Night? An Introduction to “Are Top Executives Paid Enough?”

by Jeffrey Pfeffer

Pfeffer’s short introductory paper starts with a lofty note on the determinants of executive pay. He writes in the first few lines that “many of the premises that guide executive compensation decisions have little evidence supporting them.”  I find myself wondering if that claim is true. If there is no evidence supporting exec compensation decisions, then how are they made?

My own research led me to discover a wide range of factors that go into an executive’s pay: company growth, personal performance, political factors, level of responsibility, social factors, and so on. In short, there are nearly an infinite number of considerations at play, so any problems with exec pay may never truly be “solved” as a mathematical optimization problem might be. I see from the start that Pfeffer believes in change, and I don’t think I have the knowledge yet to form my own opinion. So I read on.

Just a few lines later, Pfeffer prefaces the findings by he and the authors of the other papers in this series by saying that “sensible evidence-based suggestions for reforming executive pay have little chance of being implemented; they will face vigorous opposition from the various interests so well served by the present arrangements.”  Not withholding a slight pessimism by the author, I’m interested in finding outhowpeople are trying to implement change in the executive pay system.

Pfeffer goes on to say that there is more than enough “theory and data” to “know what to do regarding executive pay” (meaning that there are, in his opinion, clear regulations and changes that need to be made) but there are just “few incentives” and “no sanctions for failing to do so.” I realize at this point that like most research topics, I must suspend the belief of practicality and focus on the backbone of the issues. 

“The Ombudsman: Are Top Executives Paid Enough? An Evidence-Based Review”

by Philippe Jacquart, J. Scott Armstrong

I’m excited to get into the real heart of the issue with this paper. The introduction opens with a haymaker: “In 2008, Fortune 500 CEOs were paid 185 times more than the average worker.” This fact doesn’t make me instantly believe that executives are overpaid, but it certainly makes itsoundlike CEOs are overpaid.

Early on, I get some answers to my initial questions of how exec pay is determined: “Board of directors set the compensation of their top executives,” the authors write. In my opinion, any regulations or changes should therefore be directed towards the board of executives and not the CEO.

The authors then present a review of a study claiming that interviewers werelesslikely to hire overweight candidates than those of a normal weight. The point I infer from the reference to this study is that the hiring process of executives is flawed and imperfect. However, I see hiring bias as a problem for any hiring situation and I don’t yet see the tie between the inherently flawed hiring process and executives salary.

The next big question presented in this paper: “Does Higher Pay Lead Firms to Hire More Effective Executives?” Before reading the section, I’m assuming the answer that will be offered in this one-sided paper is a stern NO.

“One argument for high executive compensation is that firms must compete for the best managers by offering higher pay,” the authors write. Also, they reference studies claiming that intelligence is the best predictor of job performance, but HR professionals identified conscientiousness as a better predictor than intelligence 82 percent of the time.

More references and arguments are stated claiming that experts have little actual ability to accurately predict job performance. The unreliability of hiring a CEO seems to be the main method of attack in this paper.

In defense of CEOs, I find unreliability to be a problem in any hiring situation. Sure, not every CEO that is hired will do an outstanding job and lead their company to make billions of dollars, but this is the case for any position in a company.

The authors argue that “Incentive plans can be detrimental to the interests of shareholders when the plans focus on short-term performance at the expense of long-term profitability.”  In this way, they are saying that offering large incentives to executives undermines their ability to effectively perform their duties at the same level as those who are not privy to such high stakes. However, clearly incentivizing work will never go away, so if there are problems found with the current structure then some light reforms should be made. Executives, Jacquart and Armstrong write, are so preoccupied with profits under many incentive systems that they fail to place adequate emphasis on other aspects of their job, such as the handling of shareholders and investors.

Moreover, Jacquart and Armstrong make some deeper ties to the evils of incentives – saying that over-emphasis on profits can lead to the deterioration of the morality of many executives, including tempting executives “to engage in fraudulent behavior.”

To conclude this paper, the authors provide their four possible solutions to curb mal-aligned executive pay, listed below:

  1. “Use evidence-based procedures for the selection and compensation of top executives”
  2. “Reduce executive pay”
  3. “Eliminate incentive payments for executives”
  4. “Improve corporate governance by giving stockholders more control over the hiring, retention, and compensation of top executives”

After reading those four proposed solutions, I fully understand why Pfeffer stated in his paper that many of the reforms on executive pay have little chance of being implemented.

However, I don’t believe reforms won’t happen because the “powers that be” would never let it happen. I believe that many of these solutions will never happen because they just don’t make sense, specifically an all-out reduction  of executive pay and eliminating incentive payments for execs.

Neither of these two articles believe that executive pay in its current state is justifiable – both seem to connote the idea that actions need to be taken to curb the excesses of executive pay. And although I have little pretext to comment on the validity of the claims this collection of papers make, I do believe myself to be keen enough to understand that there is always another side to the story – in this case, that other side is that in which the current state of executive pay is certainly justifiable.

Here are some reasons that executive pay may be justified in its current state:

  1. It’s not that the value of executives is skyrocketing compared to the average workers, but that the value of the average worker has diminished significantly in the last 20 years due to improved functionality of IT and automated tasks. If mindless tasks are being completed much easier, then unfortunately it could make sense to decrease pay or keep pay the same for workers.
  2. When you consider executive pay as being a fixed fraction of the overall production and value of a company, it makes sense for executive pay to be skyrocketing. Why? Because companies are so much bigger today, and they make so much more money on average than they used to. Therefore, bigger companies on average means bigger compensation packages for execs.
  3. The CEO has endless responsibilities and stresses. Normally, a worker has someone above them (a boss) to whom they can take difficult problems. However, a CEO has nobody in most cases to whom they can rely on in difficult times. A CEO must make all of the most strenuous decisions and because of that they face all of the responsibility of the consequences stemming from those actions. It is said that many CEOs age twice as fast, and that’s probably because they have so much riding on their successes/failures. And in the current day, CEOs are facing so much MORE responsibilities than they used to – hence a higher pay.
  4. A CEO never gets a day off, whereas an average worker can shirk his/her duties at 5pm every weekday and on the weekends. An executive is constantly working, constantly thinking, and constantly worrying about the next moves for the company. When you consider that fact, many people don’t even WANT to be CEOs. Therefore, executives must be paid much more when the risks become higher as they have. That’s the nature of supply and demand.
  5. In the event of failure, a CEO is the one who gets all the blame. Shareholders always need someone to blame when a company isn’t doing well, and it is always the CEO. In reality, CEOs do have an incredible amount of control over the direction of a company, but they encounter so many uncontrollable factors that influence day-to-day operations. Therefore, if an executive is going to put his head on the line for his job, then the pay should reflect that.

In conclusion, there is really no right or wrong answer because it depends on the individual situation of the company and the executive. Of course, any unfair benefits and corruption should be eliminated from the executive pay systems across America (if they do exist), but it’s much easier said than done. 

CITATIONS

  1. Jeffrey Pfeffer (2013) The Ombudsman: Evidence and Executive Compensation—Like Trains Passing in the Night? An Introduction to “Are Top Executives Paid Enough?”. Interfaces 43(6):578-579. http://dx.doi.org/10.1287/inte.2013.0704
  2. Philippe Jacquart, J. Scott Armstrong (2013) The Ombudsman: Are Top Executives Paid Enough? An Evidence-Based Review. Interfaces 43(6):580-589. http://dx.doi.org/10.1287/inte.2013.0705
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