Ranking companies by the CEO’s salary can prove costly

Pay increases for top chief executives, especially in a time of austerity, are invariably controversial, as Aer Lingus chief executive Christoph Mueller and Bank of Ireland chief executive Richie Boucher recently discovered. Are ostensibly outsized pay packages necessary to keep the best talent at a company? Or is this just a convenient argument to justify inflated corporate salaries?

The role of chief executive has certainly gained in prestige over the last three decades, especially in the US, where Messrs Mueller and Boucher’s 2013 pay packages (€1.52 million and €843,000 respectively) are dwarfed by those of their corporate brethren.

According to the American Federation of Labor and Congress of Industrial Organisations, the average S&P500 chief executive took home $11.7 million (€8.5 million) last year. The chief executive-to-worker ratio in terms of pay has multiplied from less than 50:1 in 1983 to 331:1 in 2013, it says.

The cult of the superstar chief executive took hold during that time, especially during the booming 1990s, with defenders of executive compensation packages pointing to the potentially incalculable influence exerted by such visionaries as the late Steve Jobs at Apple or Amazon's Jeff Bezos. Both Jobs and Bezos founded their companies and studies show that companies headed by their founders tend to outperform substantially. Given their connection to their firms, they are unlikely to be tempted by attractive pay packages on offer from competitors.

Mobile talent?
In fact, while companies say big bucks are needed to attract the top talent in a global marketplace, data suggest corporate executives are not a particularly mobile bunch. According to the UK-based High Pay Centre, out of 489 Fortune 500 companies analysed, only four chief executives were poached while chief executive of another company in a foreign country.

In the US, Japan, Latin America and Eastern Europe, not one chief executive was appointed from outside the company’s home country. Four out of five appointments were internal promotions. Only 6.5 per cent were poached from a separate company.

Excessive pay may even lead to company underperformance. One study found that highly paid CEOs tend to be sensitive to notions of fairness and respond by overpaying company employees.

If the CEO is overpaid by 64 per cent, the researchers estimated, executives in the same company are likely to be overpaid by 26 per cent, with further overpayments trickling down the organisation.

Not all highly paid CEOs are so generous, of course. Former Hewlett Packard boss Mark Hurd reportedly took home more than $72 million in his last two years at the helm of the company, while simultaneously cutting pay and employee numbers. Internal surveys at the time indicated that nearly two-thirds of HP employees were willing to leave if they got an offer from another company.

Ironically, CEO generosity doesn’t cure staff alienation. The abovementioned study found employees are inclined to leave if they perceive that the chief executive is very overpaid – even if they are themselves overpaid relative to other firms.

Importance overstated
There is another, more profound argument against such large pay packages, however; their importance is overstated. The lionisation of superstar chief executives in recent decades has led to the "fervent, though erroneous, belief that the quality of the CEO is the primary determinant of firm performance", writes Prof Rakesh Khurana, author of Searching for a Corporate Savior: The Irrational Quest for Charismatic CEOs. Most studies confirm Khurana's contention that the chief executive's impact is modest, with company performance far more reliant on what industry it's in, economic conditions in general and the company's own internal culture.

This idea is not shared by many investors or the wider business press. Complex corporate developments tend to be reduced to catchy but simplistic narratives.

Mueller, for example, may deserve his increased pay packet, but the argument that his actions saved the company and tripled the share price needs to be considered in a broader economic context.

In late 2011, for example, Aer Lingus’s share price had halved, and was back near the lows recorded when Mueller took over in September 2009.

Since then, shares are up 150 per cent. Great, but so is the Stoxx Europe TMI Airlines Index. The Iseq, too, has almost doubled over the same period. Just as Mueller was not to blame for the Europe-wide woes of 2011, he should not be eulogised for a share price rebound that has mirrored that seen in airlines throughout Europe.

Market reaction
Still, many investors tend to buy into the idea that a company's fortunes are inextricably linked to its CEO. A report which looked at the short-term and long-term share price performance of 314 companies that named new chief executives between 2004 and 2009 found expectations were not always fulfilled. Of companies that saw a first-day share price rise, just over half, 55 per cent, went on to record long-term gains – less than the 59 per cent rise recorded among companies whose share price declined on the day of the announcement.

As for stocks that popped 5 per cent or more upon the announcement, only 40 per cent sustained the rise. Of the stocks that experienced first-day declines of at least 5 per cent, 79 per cent went on to record long-term gains. The authors of the report said the results indicated investors’ “imperfect understanding of the highly specific challenges facing companies” and their “unrealistic expectation that new leaders will act as saviours”.

Storytelling
The problem, cautions behavioural finance author and Nobel economics winner Daniel Kahneman, is that we tend to engage in storytelling, associating the success of the firm with the quality of its chief executive and ignoring all the other factors that influence performance.

In Thinking, Fast and Slow, he asks readers to consider two similar firms headed by chief executives of differing abilities. How often, he asks, will you find that the firm with the stronger one is the more successful? A "very generous" estimate would see the stronger one leading the stronger firm in just 60 per cent of cases, he says. The odds are improved, although it is "hardly grist for the hero worship of CEOs we so often witness".

Such "hero worship" can be found in popular business books like Built to Last, which looks to draw operational morals from examining extremely successful businesses. However, the gap in corporate profitability and stock returns between the best and worst firms studied in the book "shrank to almost nothing" over the following years, says Kahneman.

Similarly, a 20-year study of Fortune’s most-admired companies found those with the worst ratings went on to earn much higher returns than the most admired firms.

Kahneman suggests investors not look for simple causal explanations for these turnarounds, which are unlikely to have been triggered by complacency or renewed determination or whatever explanation commentators like to come up with. The gap must shrink, he says, “because the original gap was due in good part to luck, which contributed both to the success of the top firms and to the lagging performance of the rest”.

Ultimately, the chief executive is important, but nowhere near as crucial as is widely believed, and even the very best executives cannot perform miraculous turnarounds. Warren Buffett puts it well: "When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact."