Overpaying CEOs is a terrible way to motivate them

Under the “pay-for-performance” system that dominates board rooms, the goal is to align the chief executive with shareholders. How does pay-for-performance actually work? From Equilar data released this week, we know that the CEO of a typical public company receives only about 10% of his or her compensation in cash, and the balance in stock and equity-linked incentives. The massive shift towards equity pay produces both runaway CEO pay and stockholders who take the share of the pie that used to go to the employees.

An unintended consequence of pay-for-performance is we treat companies as if they are in the airline business, except the only person who matters is the pilot—not the grounds crew, nor the quality control tinkerers, nor the guys who wrangled the ore and fuel from the ground, forged the parts, tightened the bolts and soldered the frame.

And especially not those who are served the food in the cafeteria or cleaned the restroom late into the night. This segment of the workforce is now basically hidden, working for contractors who trade in lesser skilled labor where benefits and income security are sacrificed in the name of competitiveness.

Meanwhile, because pay-for-performance is so weighted in stock, it incentivizes senior managers to think more about the shareholders than their direct reports or the labor and talent on which the enterprise depends. In the 1970s, shareholders took out about 50% of a company’s profits, while the rest was reinvested in the productive capacity of the firm, including R&D to employee training and rewards. Today, the shareholder gets over 90% between dividends and share buybacks. Today, a 60% or greater weight on equity or equivalents is the norm in pay packages.

Boards are complicit. Increasingly, directors are paid like the CEO—in stock grants or rewarded with incentives tied to the stock price.

And what is the result of all this focus on the top of the food chain and shareholders?

Low employee engagement, as productivity gains that do nothing for the workers who produce them; Unions in decline, viewed as a drag on competitiveness and efficiency; Little investment in training; Levels of inequality in the US that are comparable to African countries, and are significantly higher than the norms in Europe; Communities fractured along lines of race, income, economic opportunity.

Meanwhile, this form of compensation is simply ineffective at motivating company leadership to make wise decisions. Among the reasons:

• Goals are very powerful–but not if they incentivize the wrong behavior. What are we paying people to do? What do the incentives reveal? Michael Dorff, corporate governance scholar and author of Indispensable and Other Myths, calls our attention to the unintended consequences of stock-based incentives, even in modest amounts, and reminds us that incentives are bad at rewarding complex tasks. They work for rote assignments and piecework but certainly not for jobs that rely on critical thinking skills, judgment, and EQ. The basic idea that financial incentives can help people work smarter is flawed. Monetizing or creating financial incentives to reward behaviors that require judgment, like the challenge of building a more diverse workforce, or even just honoring commitments, can have unintended consequences.
• Long-term rewards lose their power. Incentives are most effective when felt immediately. An executive can only influence stock over the very long haul. Examples in recent years, from Valeant to VW to Wells Fargo $WFC, illustrate how paying executives in stock drives short-term behavior to “make the number.”
• Internal pay equity is more important to the health of the enterprise than benchmarks across companies. Behind the notion of “felt fairness” is the observation that when too great a disparity exists between layers, the sense of teamwork, engagement, agency and creativity begins to shred. In 2009, Intel $INTC disclosed that the CEO’s pay stays within a range of 1.5 to 3 times that of the EVPs—at least at that point in time. Peter Drucker strongly believed the CEO should make no more than 20 times the “rank and file.” Ben and Jerry’s and Whole Foods, when still led by their founders, committed to multiples below that number. Paul Polman at Unilever hired a “global head of reward” and directed him to look at fairness from top to bottom.

We need a different approach. And it requires more than tinkering with the pay for performance system that got us here. What if we looked at the health of the enterprise and its many parts rather than the chief executive?

When we shift the lens away from the CEO and instead focus the company, new measures and metrics come into focus: employee engagement and retention, measures of productivity and customer service, and key risk factors buried in the supply chain.

Today, internal pay equity or fairness may seem like an antique idea, but it is designed to build a strong and resilient culture. Pay consultants like to benchmark the CEO against a “peer group” of other CEOs. This practice is the foundation of so-called quantum—the scale of pay—and is the root cause and justification for outsized pay packages. A smarter system links compensation internally against the people who matter most—the CEO’s own direct reports—and then down the food chain to workers and employees who create the goods and services and engage with customers. It works equally well to test and adjust the system from the bottom up.

Focusing on the employees who make up the enterprise may not resolve all of our questions about CEO pay, but it’s a useful place to start—a thought experiment that can restore some common sense and creativity to a system that has become formulaic and stale.

Judith Samuelson is a vice president at the Aspen Institute.