What is a CEO worth? Don't look to peers: peer group comparisons skew the board's determination of a CEO's intrinsic value. A new performance metric is required--and we have conceptualized what that should be.

AuthorElson, Charles M.
PositionCEO COMPENSATION

THE CONTROVERSY over executive pay in the United States seems unending. Pay has escalated dramatically over the past two decades, significantly outpacing shareholder returns in most years. Two explanations for this phenomenon have typically been proffered. The first relates to poor board function. Management-dominated, passive boards have failed to negotiate effectively with management over pay, leading to rapidly growing pay packages unrelated to performance rendered. The second explanation claims that higher pay is simply the natural consequence of a highly competitive market for scarce executive talent.

While there is some validity to both opinions, we believe an alternative explanation exists which may accommodate both disparate viewpoints and help lead to a resolution of the pay controversy.

It is true that boards have been lax in many instances in negotiating pay, leading to higher and higher pay on demand. It is also true that a marketplace for talent does exist that acts to escalate pay levels. But little attention has been paid historically to the mechanical process by which boards actually set pay. Typically, boards rely on data that show pay at comparable enterprises. It is this reliance that has in large part significantly and dramatically increased pay to the levels that have created popular and shareholder outrage. We will explain how this process has so acted, critique its application, and offer an alternative that we believe will improve its mechanics and ultimate results.

Any understanding starts here

Understanding the internal mechanism of the pay process used by most boards is critical to any attempt to solve the compensation controversy. Typically, boards engage compensation consultants who aid in the structuring of the pay package to be negotiated with the executive concerned. These consultants, advising the board's compensation committee, are asked to put the package into some perspective vis-a-vis the overall competitive job market. They construct a framework of comparative metrics based on levels of pay at companies deemed similar--as selected by the compensation committee and consultants, often with varying degrees of input by management. The executive's proposed compensation is based on this comparison. Generally, each board will choose to create a package that is in the 50th, 75th, or 90th percentile of their target peer group. Targeting levels below the 50th percentile is rarely, if ever, done.

But why these levels? It is because any other action would place the board in an uncomfortable and disadvantageous position. In the current construct, pay below the 50th percentile does not simply send a message of...

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