All this talk about executive compensation reminded me of one of my favorite academic studies of CEO compensation. It was published in the late 1980's by my Stanford colleague Charles O'Reilly and two co-authors, one of whom -- Bud Crystal -- was a consultant who specialized in executive compensation.
They tracked 105 large firms and compared numerous predictors of how much the CEO was paid -- I am looking at the key tables in the article, and see these included number of employees, sales, return on equity, and assets. The interesting twist, however, was they hypothesized -- regardless of a firm's performance and size -- that the amount that outside directors on the compensation committee were paid on their own jobs would be a strong predictor of CEO pay. This is based on research on social comparison and anchoring -- the idea is that members of the compensation committee would use their own pay as a guide to help determine how much to pay the CEO -- and would be excessively swayed by this vivid information.
The results still amaze me: After controlling for traditional size and performance measures, the amount of money made outside directors, especially those on the compensation committee, had a huge effect on CEO pay. O'Reilly and his colleagues report that for every $100,000 that the average member of the compensation committee is paid, the CEO's pay goes up another $51,000 per year. Remember, these effects are independent of firm performance and size!
There are two lessons here. The first, as is well-documented, that there is little relationship between what CEOs get paid and firm performance, other -- less rational -- factors overwhelm it. See Pay Without Performance for the gory details. The second is that, if you want to make a lot of money, pick the richest and most highly paid people you can find to set your salary.
This is part of the problem that all those financial services CEO's now face. Obama's $400,000 salary is being bandied-about as the anchor, rather than the pay of the often stunningly wealthy people who have been sitting on their compensation committees for so long. Not only have their reputations suffered, the basic group dynamics and psychological principles they have to deal with are against them too -- they got merely well-to-do rather than fabulously wealthy people setting their pay now.
The reference to the article is:
O’Reilly, C.A. III, B.G. Main, & G.S. Crystal. 1988. CEO Compensation as Tournament and Social Comparison: A Tale of Two Theories. Administrative Science Quarterly. 33: 257-274.
P.S. Charles also has a more recent study that seems to show that the more a firm pays the people on the compensation committee, the more the CEO gets paid! I quote "On the average,for every $1,000 more in fees that is given to the chair of the compensation committee,the cash compensation of the CEO is $1,746 higher." How is that for a rate of return? Talk about pay for play, or I guess it is pay for pay. This is from: O’Reilly, C.A. III and B.G. Main. 2007. Setting the CEO's Pay: It's More Than Simple Economics. Organizational Dynamics. 36(1):1-22