June 29, 2014
Superstar executives are brought on board by big companies to increase revenues, raise up shareholder returns and set companies on a path toward success. Since the late 1970s, we’ve seen an explosion in executive pay. CEO pay has risen 725% since 1978, whereas pay for the standard employee has only gone up around 10%. This has been looked at as an investment by most companies, placing trust in the ability of talented executive teams to make sure the company comes out ahead in the end. There are many examples of this strategy paying off, but according to new research, it appears that the opposite may be more true than anyone has realized before.
A new study shows that companies with the highest-paid CEOs tend to perform worse in the long run. The study, done by Michael J. Cooper of the University of Ugah, Huseyin Gulen of Purdue University and P. Raghavendra Rau of the University of Cambridge, finds that companies that pay CEOs in the top 10% earn negative abnormal returns over the next few years. In fact, the actual number is negative 8%. When dealing with the huge amount of capital some of the bigger companies have to throw around, a loss of 8% can tally up to a staggering amount.
But it doesn’t stop there.
Not only do the researchers find that overall company performance lags with increasing pay, but the longer an executive is in charge also has a big effect on diminishing returns. As the researchers say, the results prove true for both the highest-paid and lowest-paid executives, with contrasting performance leading to clashing results.
“We find that firms that lie in extreme excess compensation deciles exhibit striking differences in performance. In the year after the firms are classified into the lowest and highest excess-compensation deciles respectively, firms in the lowest decile earn insignificant industry — and momentum adjusted returns. In contrast, the firms in the highest decile earn significant negative abnormal returns. The performance worsens significantly over time,” the study says.
What does all of this research mean? It could mean that the large amounts of money corporations are throwing at CEOs and their executive teams are not worth it in the long run. It also runs counter-intuitive to some of the logic behind different compensation models, like performance and equity-based pay. The other alarming part of the results, the fact that the longer a CEO is in charge, the worse the company does, is also something businesses are going to need to take a long and hard look at.
The research clearly shows that the most handsomely rewarded of all CEOs tend to see the worst results. What exact seems to be the issue? The study points to one overarching theme: overconfidence. It’s not hard to imagine that one can become incredibly confident when raking in so much personal wealth, as it reinforces the idea that you are doing a good job. The researchers also indicate that actions taken by overconfident executives have long-term effects, which may not be obvious at the time decisions are being made.
“Higher-paid managers exhibit behavior consistent with overconfidence. Further, these overconfident CEOs invest more, engage in more mergers, and experience greater negative returns to the announcements of these mergers relative to other CEOs. Most importantly, we find that firms with highly-paid CEOs earn significantly lower returns when the CEO is also overconfident. We also find that firms managed by highly paid CEOs experience lower future operating performance,” the study said.
One example of overconfidence can be seen by taking a look at British Petroleum (BP) during the Deepwater Horizon oil spill. Under then-CEO Tony Hayward’s watch, BP took numerous shortcuts and cost-saving measures that ultimately ended up up dooming the company’s oil platform. Hayward’s overconfidence reared its head when he thought that a simple apology on behalf of BP would suffice, and then stage numerous efforts to try and place the cleanup and blame on someone else. Those actions alone cost him and BP any remaining respect they had in the public eye.
Another example is what has recently transpired with auto maker General Motors (GM) the past decade. Failure at the top of the company led to undisclosed product failures being put into the market place, resulting in several deaths. Current GM CEO Mary Barra has apologized for the oversight numerous times, even though she wasn’t at the company’s helm when the initial decisions were made. The overconfidence displayed by GM’s management in the early 2000s and the refusal to take the necessary steps is having a huge impact on the company now — almost 10 years after the fact.
CEOs can also create, within their own organization, a positive feedback loop that doesn’t always allow them to accurately gauge what’s going on. By surrounding themselves with allies, or “yes men,” CEOs can only get the responses employees or lower-ranking team members believe the leader wants to hear. Getting stuck in an endless loop of positive feedback can only reinforce the notion that CEOs are making good decisions, especially if no one is standing up and telling them otherwise. Done over the course of a few years, quite a bit of damage can be done with hardly any dissenting voices speaking up.
CEOs have the faith of shareholders and board members placed in their hands when they accept the job, but many can work to entrench themselves in the position rather than focus on the long-term health of the organization. The rise of equity-based pay models was meant to be a tool to curb such behavior, but in many cases hasn’t worked out with the best results. The idea was to have executive compensation tied to the company’s performance, and the logic can be sound. However, CEOs have been shown to make decisions that will please shareholders in the short term, but down the line be more damaging. An emphasis on short-term earnings may look good on paper, but as time marches on, returns can recede. This pay model can also breed resentment among lower-ranking employees, as most do not get to share in the company’s prosperity. When compensation is given in the form of stock options, hourly or salaried employees don’t see any tangible benefit to working harder or seeing a spike in stock prices.
Are there ways to hold CEOs more accountable for their actions, especially when their leadership leads to declining shares and company performance? Possibly, but don’t expect any new method to be welcomed with open arms. Speaking with Forbes, researcher Michael Cooper mentions that ‘claw-back’ provisions have been suggested, which would reduce compensation when companies don’t perform as well as expected. He says CEOs make a rather exorbitant amount, and many think that it’s simply too high.
“There is another school of thought that CEOs are just too highly paid, period,” Cooper said. “The U.S. is pretty egregious as far as the ratio between median pay and what the CEO makes.”
There are cases of CEOs actually putting their money where their mouth is, and taking a pay cut in the face of declining performance. Recently, Sony (SNE) CEO Kaz Hirai and a team of his executives returned roughly $10 million in bonuses. Following a disappointing fiscal year for Sony, Hirai took responsibility for the company’s failures and gave the money back.
Examples like the recent Sony decision are few and far between, and it’s hard to imagine that skyrocketing CEO pay will slow down in the near future. Despite the fact that what we see is undeniable and empirical evidence that the more a CEO is paid, and the longer they are in power, the worse a company performs overall. Executives can bust unions to cut costs, outsource talent and chase away skilled employees all to increase the bottom line, but over the long haul, choices like that can have a devastating effect on a company’s ability to stay competitive.
The study’s evidence is fairly clear, although the solutions are much more ambiguous. If businesses plan to take the results of this study seriously, and see what they can do to counteract the effects, big changes could be headed our way. But with the amount of money that’s being thrown around at the top, and with the only individuals in position make big decisions being the ones who will be effected, don’t expect much action.
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