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Business school experts: High CEO pay hurts American companies, stockholders

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AP

In 2013, CEOs of S&P 500 companies earned, on average, 204 times the salary of rank-and-file employees. Some stockholders are upset. Should they be?

The need for high executive salaries and generous incentives continues to be debated. By and large, economists conclude from their studies that high remuneration for top executives is beneficial, while organizational psychologists conclude that it is harmful. 

Based on our reading of the evidence, CEOs in the U.S. are currently paid more than ten times what is needed in salary alone.

Some commentators attribute this disagreement to a different political outlook, as economists tend to be more conservative than academics in organizational behavior and related disciplines.

But who is right? 

Executive compensation poses a complex problem, and expert opinions provide little help to answer such questions. As in other complex fields, such as medicine and engineering, experiments are necessary for identifying causal effects. Experiments are the gold standard for science.

Our paper, “Are Top Executives Paid Enough?” which appeared in a recent issue of the journal, Interfaces, provides the first review of experimental evidence on the issue of executive pay.

Organizational psychologists commonly use experimentation, while economists seldom do. We believe this explains why they have reached different conclusions.

Our review of experimental evidence led to four key findings:

1. The argument that higher salaries enable firms to hire the best candidates is undermined by the prevalence of poor recruiting practices. Indeed, executive recruiters are seldom aware of evidence-based procedures for selecting managers. Instead, executives are typically selected based on their performance in unstructured interviews, which are prone to biases from irrelevant characteristics such as—but not limited to—age, gender, looks, voice, weight, height, and race.

2. There is no evidence that higher pay produces better executive performance. Instead, there is evidence that higher compensation undermines the intrinsic motivation of executives, inhibits their learning, leads them to ignore some stakeholders, and discourages them from considering the long-term effects of their decisions.

3. It is impossible to devise incentive schemes that relate executives’ actions to the performance of the firm. Incentive systems in organizations can only work when an employee has full control over the outcomes, as with highly repetitive tasks that require little thinking or learning. This, of course, is not the case for top executives.

4. Incentives are likely to encourage unethical behavior. Stock options became infamous when the public discovered that grant dates of CEO options were being manipulated to increase the personal benefits of CEOs at the expense of the firms’ owners.

How confident can we be in these findings? Although our results are based on numerous studies, it is possible that we could have been biased in our selection of studies. To check this, we contacted many researchers asking them to send us experimental studies that challenged our conclusions. We did not receive any.

Could we have misinterpreted the studies we reviewed? To address this, we sent our papers to all authors whose experiments we had cited, asking them to confirm whether we had properly interpreted their findings. Most responded, and the vast majority of them agreed with our interpretation of their work. When they made suggestions, we made changes.

In sum, there is no controversy. High executive pay and performance incentives are detrimental to firms. In light of the evidence that high executive pay and incentives are harmful, firms should consider taking action.

Lowering executive pay and eliminating incentives are obvious steps. In the roughly 300 firms that make up the Mondragon Cooperative in Spain, CEOs do not receive incentive payments, and their compensation cannot exceed 11 times that of the lowest paid workers. 

They have no trouble finding top executives. As it happens, firms in the Mondragon Cooperative are more profitable than traditional firms offering similar products in Spain. 

Cooperatives in other countries typically pay even less to their top executives. Some U.S. firms have also implemented limits on executive pay. For example, the maximum ratio between CEO versus average worker pay at Whole Foods is set at 19:1. Their CEO, John Mackey notes that this is similar to the typical ratio of 24:1 in U.S. firms in 1964.

Based on our reading of the evidence, CEOs in the U.S. are currently paid more than ten times what is needed in salary alone.

One way to better align the interests of owners and executives would be to invite sealed bids for top positions from a variety of applicants, including those currently working in the firm. 

The invitation would ask applicants to state what they could do for the firm along with evidence to support their claims; what remuneration they would require; and what bonus they would expect to receive if they were to quit or be fired. 

If such a request for bids seems strange, consider the actions you would take as a homeowner seeking to hire contractors to do major renovations on your house.

After obtaining bids, selection committees should employ evidence-based procedures. For example, they should remove irrelevant material, including demographic information, from the bids before they are evaluated. This calls for the use Meehl’s Rule, based on seven decades of experimental research: Make the hiring decisions before meeting the candidates. 

Leading candidates would be evaluated by independent assessment centers for such abilities as to learn, run effective meetings, analyze data, listen to others, write and present persuasive reports, understand economics, create change within an organization, and develop strategic plans.

Organizations, including cooperatives, orchestras, and professional sports teams, have used some of the above evidence-based methods. The book, turned movie, "Moneyball," shows how this was applied to baseball. Many sports teams have adopted the "Moneyball" approach. Those who resist win fewer games.

Stockholders have good reasons to be upset with the current executive remuneration system. These decisions should follow the evidence, not the folklore.

J. Scott Armstrong is an author, forecasting and marketing expert, and a professor of Marketing at the Wharton School of the University of Pennsylvania. 

Philippe Jacquart, is Assistant Professor of Leadership, EMLYON Business School.