CRF Blog

Neither rigged nor fair

by David De La Torre

The Economist argues that executive pay is Neither rigged nor fair.

Critics claim that executive compensation is essentially a rigged game, in which boards packed with insiders parcel out rewards to their friends. Defenders argue that the market is setting pay, as firms strive to keep hold of talented executives in a competitive world. The truth lies somewhere in between. Compensation is not the work of a cartel, but it is light years from being an ideal market.

The notion that the market is efficient at setting executive pay rests on three arguments. The first is that competitive pressures are at work. Inside the firm, the “tournament theory” of pay holds that big awards high up a company are worthwhile because they motivate ambitious middle managers to take risks and put in the hours in order to climb the greasy pole to the top. And outside the firm, there are observable prices for the labour of senior executives, thanks largely to disclosures by listed firms. For example, the median pay level of an S&P 500 chief executive in 2015 was $10.4m, according to Equilar, a research firm, a rise of 1% over the 2014 figure. (In practice, executives do not benchmark themselves against pan-industry figures but against their peers.)

These sorts of pay packages seem outrageous to many, especially when compared with wages elsewhere in the economy. Peter Drucker, the doyen of management theorists, reckoned that exceeding a 20–1 multiple of pay within a firm between executives and the average worker was bad for morale. Mr Drucker was worrying about the gap back in the 1980s, when the economy-wide difference between CEOs of big American firms and average workers was in the 40–1 range. How quaint that seems: depending on how you count things, the multiple now is somewhere between 140–1 and 335–1.

Even those who defend the market view of pay often say that these multiples may be too high from a social or ethical perspective. But their argument is that, from an economic perspective, they make sense. Pay is not set in isolation. Just like other parts of the labour market, what others pay sets an external market price. “You can argue that CEOs of public firms are in some senses underpaid,” says Mr Kaplan, who points out that a senior partner at a blue-chip law firm or consultancy could earn several million dollars a year with none of the scrutiny, more job security and far fewer people to manage. Overpaid or underpaid, executives certainly know what the going rate is. [more]