Executive Pay: Is “I’ll Have What He’s Having” Really the Best Approach?

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Anyone who’s ever watched When Harry Met Sally will remember the line “I’ll have what she’s having” as the perfect punchline to that memorably obscene deli scene. As a justification for CEO pay, though, the “I’ll have what she (or, more often, he) is having” approach is a lot less hilarious in its effects, contributing to the ratcheting up of CEO pay regardless of CEO performance.

A new study funded by the Investor Responsibility Research Center Institute shows that “peer group compensation benchmarking,” an approach that’s become the de facto standard for how executive pay is determined, perversely rewards mediocre CEOs for the performance (and the sky-high) pay of a few CEO superstars. “A formulaic reliance on peer grouping,” the study warns, “will lead to spiraling executive compensation.”

The idea behind “peer group” benchmarking is simple enough: When corporate boards attempt to determine what’s appropriate to pay a company’s CEO, they look to see what other companies pay their CEOs – and thus reduce the temptation of the CEO to jump ship to head up another company willing to pay more.

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But the IRRCi study, prepared by Charles M. Elson and Craig K. Ferrere of the John L. Weinberg Center for Corporate Governance at the University of Delaware, argues that this approach is based on some dubious logic, and one big false assumption. Consider what we might call the “Lake Wobegon Paradox.” As longtime listeners to Garrison Keillor’s Prairie Home Companion know, Lake Wobegon is the mythical Minnesota town where “where all the women are strong, all the men are good looking, and all the children are above average.”

In the real world outside of the imaginary Lake Wobegon, it’s obviously impossible for all the kids to be above average. In the real world, it’s also impossible for all CEOs to be average or above average. By adopting the stance that CEOs should be paid what their “peers” are paid, the “peer benchmarking” approach puts pressure on boards to compensate below-average CEOs as if they were at least average. What’s more, since the average pay can be inflated by the gargantuan compensation packages of a few superstars, CEOs can end up being rewarded for the performance of other CEOs rather than their own performance, which may have been something less-than-super .

The study also pokes holes in the notion that CEOs unhappy with their pay packages can simply say “see ya” and head to a company with a more generous board. This approach, the study argues, essentially conjures up “a model of a competitive market for executives” that wouldn’t otherwise exist. In reality, CEO talent isn’t so readily transferable from firm to firm. As CEO of Apple, Steve Jobs was a visionary. Would he have done as well heading up a chain of grocery stores? Would people really wait in line for days to pick up some new and improved iEggs and iMilk?

The folk at the IRRCi offer what is apparently now considered a radical strategy for setting executive pay: boards should judge individual CEOs on their own merits and their own accomplishments. “[C]orporate boards need to de-emphasize peer grouping, and increase the emphasis on their company and executive accomplishments,” explains Jon Lukomnik, IRRCi executive director, in a statement. “Companies are better served when directors use discretion – both up and down – in setting compensation structures and levels.”

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Will the IRRCi study have any effect on the way execs get paid? It’s hard to tell, but it seems unlikely that most boards will be willing to hear its arguments. Instead of cutting back on too-high executive pay, some companies are simply trying to make it look as though they pay their executives less. As the Wall Street Journal recently reported, some companies are starting to disclose executive pay in their proxy statements in a way that minimizes their total compensation.

In filings with regulators, companies are required to disclose things like stocks and stock options granted to execs. But in their proxy statements, where they have more discretion, hundreds of firms report “realizable” or “realized” pay instead – that is, what the exec actually took home that year and ignoring the value of unvested options, pensions and the like, which of course are a major part of most executives’ compensation packages. As the Journal notes, this can make a big difference: General Electric’s proxy states that CEO Jeffrey Immelt took home “only” $7.82 million in taxable income; the more complete figures given to regulators put his total compensation at $21.6 million.

Nice pay, if you can get it.