$2m club: Are they worth it?

Chief executive pay is out of whack with what the rest of us earn. Some of the big pay is justified and quite a lot of it is not. Chief executive pay and the link to performance is actually more about weak governance than anything else.

Firms with strong governance pay their chief executives mostly for performance. Firms with weak governance pay their chief executives mostly for luck. And executives have too much influence over pay.

Some truths to high pay

There are some truths to why chief executives earn a lot more.

One is to attract the best for the job. The other is to compensate them for the risk and responsibility of the job.

Attracting capable chief executives is a big a job. But global comparisons are often fraught with risk. In the United States, chief executives typically earn three times more than their European counterparts but usually run smaller and less complex businesses. Air NZ recently nabbed its new chief executive from the US Walmart business despite offering a much smaller pay packet.

As the experience of the global financial crisis showed, some of the highest-paid chief executives wrecked the financial system and caused massive damage to the real economy, and lost real people’s savings and jobs.

Chief executives take on a lot of risk and responsibility. They do not always have control over everything in the business but have to take responsibility.

Like sport stars, if you strike out early for whatever reason, you may never be a chief executive again.

So there is a tendency for chief executives to try to earn as much as possible while in that position, as it may not last.

But the level of pay is much higher than it needs to be

There is a myth of business heroes earning their dues through extraordinary merit.

Chief executives are important but their success depends on myriad factors.

Academic literature suggests the chief executive effect is negligible.

A study of 1500 of the largest US firms between 1993 and 2012 found that the chief executive effect was negligible in these companies. Financial performance could be better explained by random luck or chance than the qualities of a great leader.

In a study of Britain’s top 350 biggest firms between 2003 and 2014, these companies increased their value (returns on investment/capital) by only 1 per cent, yet executive pay over the same period increased by 80 per cent, most of it described as performance-related.

It is hard to argue that when a chief executive earns many millions, that they would make less of an effort or be less effective if they were paid 50 per cent more or 50 per cent less.

The link between performance of a business and what can be attributed to a chief executive is notoriously difficult.

Instead of a true reflection of performance, chief executive pay is increasingly set through an incestuous and self-referencing process. Boards and chief executives look to executive pay consultants to set pay, who go round and round chasing their tail pushing up executive pay more and more because the ‘‘market’’ says so. No-one wants to pay or have below average chief executive pay, which suggests they have a below average chief executive.

In a local example, Fonterra’s previous chief executive had an enormous pay packet, but left behind a road crash. The new chief executive is on a much smaller package, yet is tasked with cleaning up the mess.

Arguably, the latter deserves greater compensation. Only time will tell but already the new chief executive is putting in place a much more sensible strategy than the previous, more highly paid chief executive.

How to fix it

There is little link between what chief executives get paid and their performance.

They should be compensated for results. The way to do it is simple. Give them a small base salary and a big performance linked component, which is linked to clearly set targets and are attributable.

This needs strong governance and activist investors.