Steven Clifford's new book describes what has caused CEO compensation to explode over the last four decades, how it damages companies, the economy, and our democracy, and what we can do about it.
When I received a copy of Steven Clifford's new book, The CEO Pay Machine, just a week or two before its release, I dropped everything else for a few days and rearranged my editorial calendar to make sure we covered it. (My editor's choice review was our first crack at it.) It's an extremely important book, one that very soberly addresses an issue he believes is hurting companies, ailing the U.S. economy, and could ultimately undermine our very democracy. The issue is skyrocketing CEO pay, and Clifford reminds businesspeople—acerbically and bluntly—of their own agency, even complicity, in it. More importantly, it begins a more rational discussion of steps businesspeople can take to reverse it—for the good of their own businesses and the country.
(A side note of interest today: Executive data firm Equilar and the AP released the results of their CEO pay study yesterday, and the tide continues to come in for CEOs, as "CEO pay climbed faster last year, up 8.5 percent." Executives in media took all the tops spots, including David Zaslav of Discovery Communications, one of the CEOS Mr. Clifford profiles in the book. On a positive note, it looks like "Say on Pay" provisions of Dodd-Frank may finally be having some effect on arresting the alarming increase in CEO compensation. Of course, the author of the article notes, "proposed legislation in Washington … could weaken 'Say on Pay.'")
Mr. Clifford was kind enough to respond to some questions I sent him earlier this month, and that exchange is below.
800-CEO-READ: The most common discussions we hear on the rise in CEO pay are about income inequality. And you address that, telling us that CEOs now make 300 to 700 times that of the average worker—a staggering increase from the 26 times it was at in 1978. But, beyond the question of basic fairness and income inequality, you make the case that it damages the companies that pay such exorbitant salaries, and the overall economy, as well. Can you explain why?
The tens of millions that a company wastes on CEO pay is a small fraction of the total cost. The effects on employee morale are much more costly. When the boss makes 300 to 700 times what you do, it is difficult to swallow that "employees are our most important asset" and' "There is no I in team." More costly is the short-term focus encouraged by the Pay Machine. This was a major cause of the 2008 banking crisis that cost companies trillions of dollars.
800-CEO-READ: Can you explain what PUPNUP is?
Steven Clifford: It is an acronym I coined, standing for Peers Used for Pay, Never Used for Performance. A CEO's target compensation is set by what his peers, CEOs of comparable companies are paid. The typical CEO works in Lake Woebegone and is targeted at the 75th percentile of the peer group. He can make two or three times this target if he surpasses his performance goals. But these goals never reference his peers. He never has to beat them, only meet some goal he negotiated with the compensation committee. (Forgive the use of the male pronoun, but 95 Percent of Fortune 500 CEOs are men.)
800-CEO-READ: You write that “CEO pay is as market-driven as were the salaries of Soviet commissars.” I think the idea that CEO pay is divorced from a free-market for their services would seem surprising to most. Most people seem more outraged (or at least similarly outraged) at the salaries of famous athletes as those that CEOs receive, but athletes clearly earn it. Wherever Lebron James goes, Finals appearances follow. Is that a fair comparison? Don’t you get what you pay for? If you don’t pay them what they want, couldn’t a CEO just proverbially, “take his services to South Beach,” a direct competitor, and “win a few championships” there?
Steven Clifford: Supply and demand determines compensation for athletes and movie stars, but not for CEOs. Teams and movie studios bid for athletes and movie stars in an auction market. Companies rarely bid for CEOs. Their compensation is determined by a rigged system.
NBA teams bid for LeBron James because his skills are portable. He would be a superstar on any team. CEO skills, which tend to be company and industry specific, are seldom portable. A successful CEO must fully understand a single company—its finances, products, personnel, culture, competitors, etc. Such knowledge and skills are best gained working within the company and not worth much at another company. Therefore, companies seldom bid against each other for CEOs. Internal promotions account for three quarters of large company CEOs (Fortune or S&P 500). Less than 2% of new CEOs were CEOs of another public company. A CEO jumping between large companies happens less than once a year. And when they jump they usually fail.
As far as getting what you pay for, most studies show that CEO pay and performance are uncorrelated or negatively correlated, meaning the more you pay the less you get.
800-CEO-READ: That’s a kind of apples-to-apples in comparison to earnings. But you also write that, “In 2014, the top twenty-five hedge fund managers made an average of $464 million. In total, these twenty-five made more money than the nation’s 158,000 kindergarten teachers.” But surely those hedge funds have added exponentially more to the growth of the economy and created many jobs with their investments, as well. Or is this simply another case of the American economy rewarding short-term profits (and thinking) over long-term growth?
Steven Clifford: Hedge funds are seldom patient, long-term strategic investors. To the extent that they are short-term traders they help the economy somewhat by making markets more efficient. They make millions because their customers are fools who believe one can beat the market while paying a two percent management fee plus 20 percent of the profits.
I offer no solution to the exploitation of fools because an effective one would bankrupt at least one quarter of all businesses in America.
800-CEO-READ: You mention how “colossal CEO pay harms American industry, curbs economic growth, and undermines democracy,” but how might it affect the average consumer? For instance, one of the four highest paid CEOs you cite is Stephen Hemsley of UnitedHealth Group, who made $102 million in 2013. Do you believe that could affect holders of UnitedHealth policies, as well?
Steven Clifford: If CEOs are wildly overpaid, the money has to come from shareholders, employees, or consumers, but I cannot even estimate what amounts came from whom.
800-CEO-READ: This is not even mentioning that the fact that they were backdating stock option for over a decade, and the broader effect that might have on the public. For instance, you tell us that the SEC believes UnitedHealth Group hid more than $1.5 billion in executive compensation, which effectively stole money directly from shareholders, including the California Public Employees’ Retirement System—which was the lead plaintiff is a suit against them.
Can you explain how CEO pay structuring affects stock buybacks, and how that, in turn, not only causes the companies they run to be overvalued in the short-term, but also erodes the corporate R&D they’ll need to innovate and succeed in the long-term? And what does that do to individual corporations and the collective economy over time?
Steven Clifford: The structure of CEO pay with its annual financial focus and its massive stock options discourages sound investments. Instead of investing for the future, companies buy back their own stock. This keeps the price high when executives cash in their options. From 2005 to 2014, stock buybacks by the S&P 500 totaled $3.7 trillion. This equaled over half of net income. It exceeded dividends to shareholders by 50%. This is $3.7 trillion that could have been invested in American industry. Instead they cut R&D by 50%. This is eating the seed corn. But the seed corn tastes quite good if you are making $30 million a year.
800-CEO-READ: You write that “Persistent growth, which has happened only in the last two centuries, demanded inclusive economies that benefit the broad populace rather than the controlling elite.” If secular stagnationists like Robert Gordon, author of The Rise and Fall of American Growth, are correct and we simply can’t expect economic growth of the kind we’ve been used to, what incentive do those at the top have in not expanding their share of (potentially) zero-sum wealth?
Steven Clifford: I am not an economist and should not opine on stagnation. I do note that historically plutocrats are rarely satiated with their share regardless of whether the economy is growing or stagnating.
800-CEO-READ: I wish I could say I was surprised to encounter Michael Jensen and Dean William Meckling's paper “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” which has had such a huge influence on American business since they first set it forth in 1976. I’ve encountered it occasionally over the years in my reading, most directly in Roger Marin’s book, Fixing the Game. Unfortunately, I don’t think most understand how drastically it has altered the business landscape. Can you explain that and how it has contributed to the explosion in CEO pay, and what other factors have compounded it?
When I was in business school in the late 60s we read cases that implied the stakeholder model. A company had many stakeholders other than shareholders, such as employees, customers, suppliers, financiers, communities, governmental agencies, political groups, and unions. The wise and far seeing CEO would consider the needs (and powers) of all.
In 1976, Jensen and Meckling published the seminal work you cited that introduced the shareholder value paradigm. Over the next 15 years this became corporate dogma. While the initial paper was based on sophisticated economics, the concept of shareholder value was simplified and misapplied to hold that nothing counts other than the stock price. This has been used to justify capitalism with the gloves off, corporate takeovers, debt fueled buyouts and subsequent layoffs, and insane CEO pay. Jensen himself later modified his views but the captains of industry were no longer listening.
If you'd like to find out what can be done, and what you can do, to stem the rising tide of CEO compensation, pick up a copy of The CEO Pay Machine today.
ABOUT THE AUTHOR:
Steven Clifford served as CEO for King Broadcasting Company for five years and National Mobile Television for nine years. He has been a director of thirteen companies and has chaired the compensation committee for both public and private companies. He holds a BA from Columbia University and an MBA from Harvard Business School.