Drucker and Executive Compensation – Are CEOs Paid Too Much?

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Robert W. Swaim
06/09/2011

The gap between the CEOs and front line workers has increased by over 1000% since 1965. In this week’s Drucker Files, Dr. Robert W. Swaim asks whether CEO’s are really worth what they’re paid.

"If one can get fired for poor performance, one must also be able to "get rich" for extraordinary performance." - Peter F. Drucker

Drucker once described the role of CEO as an impossible job. Let’s begin with some of Drucker’s earlier comments on executive compensation and then explore what is happening in CEO compensation today.

Drucker expanded on his above quote in The Practice (1954) in his discussion of compensation as a reward and incentive and that they should be directly tied to the achievement of objectives. He also felt that compensation systems should not be so rigid as to exclude special rewards for "performance over and above the call of duty."

Here he added that "the reward for such contributions should be rare, like the Congressional Medal of Honor or the Victoria Cross. But it should also be as conspicuous and as great."

Drucker built on this concept of rewards for performance in Managing for Results (1964) by stating, "If a company is to obtain the needed contributions, it must reward those who make them. The spirit of a company is made, in the last analysis, by the people it chooses for senior positions." He did not go on to expand on his views on executive compensation in Managing for Results and avoided the topic all together in The Effective Executive in both his earlier 1967 and updated 2006 version.

A Dangerous Illusion

Drucker dealt with the topic of executive compensation in more detail in Management (1973) in his discussion of Executive Compensation and Economic Inequality. He went to considerable length in his discussion to cite that the inequality of incomes between the person on the "top" and the blue collar in the factory was much lower than what Americans actually perceived.

Here he commented that numerous surveys suggested that an "income ratio of 1 to 10 or 12 ("big boss" to the factory worker) would be considered "about right." In fact, he stated that "relative to the incomes of manual and clerical workers, after tax executive compensation, and especially the income of men at the very top, has been going down steadily for fifty years or more." He then added, "The facts of increasing income equality in U.S. society are quite clear. Yet the popular impression is one of rapidly increasing inequity. This is illusion; but it is a dangerous illusion." He attributed this illusion to "the widely publicized enormous pre-tax incomes of a few men at the top of a few giant corporations, and the – equally widely publicized – "extras" of executive compensation, e.g. stock options."

He somewhat rationalized this by calling this "make-believe money" with its function being status rather than income. Admitting however, that this illusion did socially and psychologically create harm and destroyed mutual trust between groups, his suggestion to deal with this was to get companies to commit to a maximum range of after-tax compensation of the 1 to 10 ratio. He also felt that part of the company’s social responsibility was to work for tax reform and to eliminate "tax gimmicks" a concept that is still in the news today in the U.S.

Returning to his earlier views he continued by stating, "There should, I would argue, be room, however, for an occasional exception: the rare, "once-in-a-lifetime," very big, "special bonus" for someone who has made an extraordinary contribution." He also felt that compensation should be in the form of money that allowed the executive to pay for what additional "hidden" benefits or perquisites the company was providing. Once again, we will see how this is being handled since Drucker initially addressed this issue.

"There is a strong case for adequate incentives for performing executives. And compensation in money is far preferable to hidden compensation such as perquisites." Peter F. Drucker

Drucker also was somewhat critical of other benefits that were provided to executives such as retirement benefits, extra compensation, bonuses, and stock options, particularly if the objective was to tie the person (known today as "golden handcuffs") to the organization. He argued that these benefits actually related to "past employment" and the individual should be entitled to them even if they leave the company. If not, he suggested that rather than forfeit these benefits, the individual would remain with the organization even if performing poorly and unmotivated.

Overpaid Executives: The Greed Effect

"Few people- and probably no one outside the executive suite – sees much reason for these very large executive compensations. There is little correlation between them and company performance." Peter F. Drucker, The Frontiers of Management (1986).

It took Drucker over a decade to finally address the issue of overpaid executives in his book, The Frontiers of Management (1986) when he described the "Greed Effect." Perhaps it was the decade of the "go-go" 1980s and the big bucks being made by the "wheelers and dealers" on Wall Street that finally got to him? (Sound familiar?)

Although he tended to still present a case that compensation between management and employees, when inflation and taxes were taken into account were not that dramatically out of balance, he did acknowledge the growing concern in the country with excessive executive compensation. He did down play this to a certain extent by saying this was attributed to "a very few top corporate executives."

Perhaps recognizing the futility in attempting to describe this as a non-issue he clarified his position - or capitulated - by stating, "But perhaps the real issue is not aggregate "executive compensation." It is the compensation of a tiny group – no more than one thousand people – at the top of a very small number of giant companies. Statistically this group is totally insignificant, to be sure. But its members are highly visible. And they offend the sense of justice of many, indeed of the majority of management people themselves."

Drucker’s Solutions

Drucker did suggest a number of possible solutions to the "Greed Effect." These included:

1. Establish a Visible Link – Drucker suggested perhaps there should be a link between executive compensation and employee welfare and their employment security. This he felt would prevent what he considered employees resent the most – top people getting big increases in the very year in which a company slashes blue-collar and clerical payrolls. He also felt this created a possible drawback in that it would reward top management for keeping employment but would increase operating costs.

2. Limitation on Total After Tax Compensation – Here Drucker suggested a "voluntary" limitation on the total after-tax compensation package paid to the chief executive officer – to a preset multiple of the after-tax total compensation package of the lower level employees. He felt that if the multiple were set at 20, it would affect approximately 500 executives in the U.S. and at 15 perhaps it would affect one-thousand executives. At the 20 multiple he forecasted executive compensation would be limited to $850,000 and at the 15 multiple the limit would be $650,000. Keep in mind this was over twenty-five years ago.

3. Charitable Contributions – Some argued that executive compensation actually designated the cultural rank of the executive in the organization and was a "badge" rather than "real money." Drucker countered this argument by suggesting that if this was the case, then the excess compensation over the designated multiple limit paid to the executive should be donated in his name to a charitable organization of his choosing.

4. Other Recommendation – Although not a Drucker recommendation, an additional solution that was discussed was setting a limit on the amount of executive compensation a company could deduct for tax purposes.

Drucker admitted that perhaps there were other ways to balance executive compensation with performance and at the same time maintain an equitable relationship between top-management compensation and that of the other employees.

He concluded by saying, "And some answers will be worked out within the next few years – unions and politicians will see to it." Were they?

Wage Gaps & Bailouts

According to the Economic Policy Institute, "Pay packages for average CEOs were 262 times higher than the average worker’s pay in 2005, up from 71 times in 1989 and 24 times in 1965.

"In 2007, CEOs in the S&P 500, averaged $10.5 million annually, 344 times the pay of typical American workers. This was a drop in ratio from the year 2000, when they averaged 525 times the average pay.

But to answer whether Drucker’s earlier insight into whether excessive executive compensation issue has been addressed, the economic turmoil of 2008 provides some interesting perspectives.

The Troubled Asset Relief Program, commonly referred to as TARP, was a program of the United States government to purchase $700 billion of assets and equity from potentially failing large financial institutions to strengthen the financial sector and supposedly to prevent the economy of the world from collapsing.

It was signed into law by U.S. President George W. Bush on October 3, 2008 and was a component of the government's measures in 2008 to address the subprime mortgage crisis. Included in the legislation were limits on executive compensation for firms that participated in the program as set forth below:

1. Limits on executive compensation:

TARP sets some new limits on the compensation of the five highest-paid executives at companies that elected to participate significantly in TARP. The Act treated companies that participated through the auction process differently from those that participated through direct sale (that is, without a bidding process).

a. Companies who sold more than $300 million in assets through an auction process were prohibited from signing new "golden parachute" contracts (employment contracts that provide for large payments upon termination) with any future executives. It also placed a $500,000 limit on annual tax deductions for payment of each executive, as well as a deduction limit on severance benefits for any golden parachutes already in place.

b. Companies in which the Treasury acquired equity because of direct purchases had to meet tougher standards that were to be established by the Treasury. These standards would require the companies to eliminate compensation structures that encouraged "unnecessary and excessive" risk-taking by executives, provide for claw-back (forced repayment of bonuses in the event of a post-payment determination that the bonuses were paid on the basis of false data) of bonuses already paid to senior executives based on financial statements later proven to be inaccurate, and prohibit payment of previously established golden parachutes.

The Auto Bailouts

In September, 2008 the Big Three (Chrysler, Ford and General Motors), asked for $50 billion to pay for health care expenses and avoid bankruptcy and ensuing layoffs, and Congress worked out a $25 billion loan. By December, President Bush had agreed to an emergency bailout of $17.4 billion to be distributed by the next administration (Obama) in January and February.

In early 2009, the prospect of avoiding bankruptcy by General Motors and Chrysler became nearly impossible as new financial information about the scale of the 2008 losses came in.

Ultimately, poor management and business practices forced Chrysler and General Motors into bankruptcy. Chrysler filed for chapter 11 bankruptcy protection on May 1, 2009 followed by General Motors a month later.

Enter the Pay Czar

In 2009 Ken Feinberg was appointed by the U.S. Department of the Treasury to manage compensation issues for companies receiving federal bailout money and became known as the Obama administration’s "pay czar." After taking this position, he announced that seven companies receiving "exceptional" amounts of taxpayer aid would have the annual salaries for their 25 top executives slashed by an average of around 90 percent from 2008 levels.

President Obama praised the move to cut executive pay by his pay czar saying, "This is America. We don't disparage wealth. We don't begrudge anybody for doing well. We believe in success. But it does offend our values when executives of big financial firms that are struggling pay themselves huge bonuses even as they rely on extraordinary assistance to stay afloat."

Saying that Feinberg has taken "an important step forward today," the president said, "That more work needs to be done, and called on Congress to pass legislation giving shareholders a voice in executive pay packages." The cuts applied to executives of AIG, Citigroup, Bank of America, General Motors, Chrysler, GMAC and Chrysler Financial, which still owe a considerable sum of taxpayer dollars.

Overall, the total compensation for the 25 executives, including yearly bonuses and retirement pay, were cut by an average of around 50 percent. Additionally, any of the 175 executives who wanted more than $25,000 in special perks -- such as private planes, limos, company cars or country club memberships would have to receive government permission first. Combined, the executives’ firms received almost $300 billion in taxpayer dollars, more than the gross domestic product of South Africa or Portugal.

Responding to criticism that curbing pay might cause an exodus of top talent and in fact hurt the companies and American taxpayers, Feinberg said "it's a big concern" but that his "primary obligation here is to make sure under the law that the taxpayers get their money back that was lent to these companies." This did prove to be effective as in order to avoid these executive compensation restrictions, most TARP participating firms paid back the government as soon as possible.

Feinberg had also said, "He hoped other companies will follow in the same footsteps but that it's not the government's place to impose any laws on executive compensation. I'm hoping that, using these seven companies as a template or as a model, that other companies will voluntarily see the wisdom of the way we've structured compensation -- less cash, more long-term stock tied to the financial future of these seven companies. Hopefully others will see the wisdom of this and follow suit voluntarily." But he added, "This is a unique situation involving these seven companies who are, in effect, owned by the taxpayer. I do not think it wise or prudent to expand the jurisdiction of what I'm doing now."

SEC Adopts Shareholder "Say-on-Pay" Rules

Shareholders of U.S. publicly listed companies now have an opportunity to be heard on executive compensation through advisory votes, under a new rule adopted by U.S. securities regulators in April 2011. The "say-on-pay" rules, approved in a 3-2 vote by the Securities and Exchange Commission, implements a provision in the Dodd-Frank Wall Street reform law, another one of Obama’s desires as previously noted.

It is designed to give shareholders greater input over executive compensation after many investors expressed outrage during the financial crisis at lavish pay practices. The "say-on-pay" votes are non-binding, although companies generally want to avoid the embarrassment of a "no" vote. Shareholders would also get a chance to vote on "golden parachute" compensation arrangements in connection with a merger or acquisition, and companies would be required to make additional disclosures about such compensation arrangements.

Dodd-Frank legislation for the first time made "say on pay" votes mandatory in 2011. As the proxy season began shareholders had voted against several pay plans, indicating that they do care and that they are discerning enough to be able to tell the difference between a pay plan that may be excessive and one that has a material negative impact on shareholder value.

It is interesting to note that no votes on pay did not come from a small group of activists. At Beazer, for example, almost 15 percent of the stock was held by Fidelity and 81 percent is held by institutions. Shuffle has more than 87 percent institutional holdings. It appears, based on these early examples that ownership may be as important a predictor of a no vote as the pay-performance link. These investors who care most and best understand the impact on shareholder value of excessive compensation are the same number-crunchers who make the buy-sell-hold decisions. It should be noted that the majority the shares of public companies are owned by institutions, not the infamous little old lady from Pasadena that inherited the shares when her husband passed away.

Perhaps, excessive compensation is starting to be put to a real market test by institutional shareholders?

Putting Compensation into Perspective

Of course, all of this needs to be put within a greater context of compensation and performance. Perhaps the story of a young baseball player helps illuminate the disparities best. On April 22, 2011, the American League baseball team, the Milwaukee Brewers signed All-Star outfielder Ryan Braun to a five-year $105 million contract extension through the 2020 baseball season.

The deal also included a mutual option for one additional year worth up to $20 million (obviously conspicuous and great). Braun is one of the better baseball players in the league having hit 128 home runs in his first four years as a player, the eighth-most in Major League Baseball history. On the other hand, even though Braun has been a star, his team has yet to win the coveted World Series during his tenure as a player with them (organizational performance).

Perhaps another important question is then, should a CEO of a major corporation be paid only half that of a twenty-something year old baseball player who theoretically works only 162 days a year?

Where are the compensation czars of sports?

Editor's Note: For further reading, including a detailed analysis of CEO compensation packages and the role of corporate governance, please contact the author by e-mail.

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