CEOs and Incentives: The Myth of ‘Pay-for-Performance’ : Compensation: Analyst’s studies find no relationship whatsoever between executive salary packages and company results.


Back in 1991, when the screaming about American executive pay reached its zenith, critics like me hammered away at two major problems:

First, we claimed, CEO and other senior executive pay was too high; second, we pointed out, pay was relatively insensitive to corporate performance.

Apparently deciding that solving both problems at once was too hard a job, the business community commenced working on the second problem: pay sensitivity. Injecting more performance factors into executive pay packages seemed a lot less painful than cutting pay itself.

Some companies tightened their bonus plans to make them swing more with profits. Other firms injected more risk into their CEOs’ stock option packages. And quite a few companies began to demand that top executives hold a goodly number of company shares, instead of cashing in their holdings so as to diversify their investment portfolios.


As such, they have broadened the definition of pay to include not only traditional elements such as base salary, bonus and stock options, but also the pool of company stock where the CEO is expected to park his or her wealth.

Today, the various combinations of pay packages and outright share holdings--what I will call the “risk quotients"--are more sensitive to shareholder return (that is, stock price appreciation plus reinvested dividends) than before. But senior executive pay packages are also higher than ever.

I recently analyzed the risk quotients (RQs) of the 350 CEOs who run Standard & Poor’s 500 index companies and who have held their jobs for three years or more. Not surprisingly, the CEO who tied with two others for the highest RQ was Bill Gates of Microsoft Corp. His pay package, ironically, is hardly sensitive to shareholder return performance; instead, he reached the top by owning billions of dollars worth of Microsoft stock.

Of the 350 CEOs in the study, the 21 who work in the Los Angeles area exemplify the full range of RQ in their pay.


Barron Hilton, CEO of Beverly Hills-based Hilton Hotels Corp., has a package more sensitive than that of all but 2% of the CEOs. On the other end of the spectrum, the package collected by John E. Bryson of Rosemead-based SCEcorp is less sensitive than that of all but 2% of the 350 executives. However, Bryson is squarely in the middle of the pack among CEOs of utility companies, which, because of their regulatory history, have been slow to link executive pay to company performance.

Fans of linking pay to performance argue that CEOs whose fortunes are tied more closely to those of their shareholders will be better motivated. And because they are motivated, the argument goes, corporate performance will be improved.

The argument is relatively similar to that made by advocates of capital punishment. They, too, believe that, with proper motivation, behavior can change. And they are convinced that the threat of capital punishment ultimately causes many would-be killers to drop their knives just before they would otherwise plunge them into their would-be victims’ backs.

But suppose awareness of the death penalty doesn’t really influence would-be killers? Or that the promise of more money--and the risk of getting less--don’t really motivate CEOs? In that case you’ll get a second argument--the central theme of which is vengeance.


The pay-for-performance fans will point to the fact that even if CEO behavior doesn’t change, the CEO will be severely punished if the stock price slumps. Therefore, they contend, shareholders will at least be able to reap some satisfaction, however perverse. Similarly, capital punishment supporters will tell you that even if execution may not deter killing, it makes them feel great to see the murderer fry--and the stronger the current the better.

Does greater pay-package sensitivity lead to better performance? Most likely not. I have performed many studies on the subject, and every one of them shows there to be no relationship between pay-package sensitivity and longer-term shareholder return.

For example, I recently looked at 72 CEOs of major companies, all of whom received stock option grants in 1987. At one end of the spectrum, I found a CEO who had received an option on a mere $14,000 in stock. At the other end was an executive who had received an option on $13.7 million in stock. (The average CEO received an option on $2 million in stock.)

Now, if money really motivates, wouldn’t it be reasonable to assume that between 1987 and 1994, the CEOs who received the bigger stock option grants would, by and large, have outperformed the CEOs who received the smaller option grants?


It would be reasonable to assume that. But the assumption turns out to be wrong.

There is no relationship whatsoever between the size of stock option grants and future performance. That being the case, most shareholders would just as soon keep options as small as possible--or, for that matter, eliminate them altogether.

Although the evidence strongly favors the theory that more sensitive CEO pay packages don’t improve performance, there is one thing they do improve, and that is the size of CEO pay packages. CEOs who are forced to take a lot of pay risk rightfully demand higher remuneration as a quid pro quo. And they get it.

Walt Disney Co.'s Michael D. Eisner is a case in point: He has one of the riskiest pay packages in the country; indeed, looking solely at traditional pay elements, his is the riskiest of all. But over the last several years, he also has earned more than any other major-company CEO.


In other countries, companies have sought a different balance between pay-package sensitivity and pay-package size. They have subjected their CEOs to hardly any pay risk related to performance. But they have also paid them much less than their U.S. counterparts are paid.

Two recent studies I conducted for the London Sunday Telegraph showed that even after matching for type of industry, size of company and five-year shareholder return, the CEOs of American companies earn over three times more than their British counterparts. And British CEOs earn significantly more than French or German CEOs--and a whole lot more than CEOs in Japan.

To be sure, the promise of more money can be quite motivational when a person is flipping hamburgers at McDonald’s and is more than willing to work harder and smarter so as to rise above the bare subsistence level.

But will the promise of more money motivate a CEO to perform better over the long term when that CEO is already working as hard as he or she can? When he or she is already working as smartly as possible? When he or she is 59 years old and not likely to be adept at learning whole new ways of thinking? And when he or she is already earning, say, $5 million a year?


The Japanese, French, Germans and British all say no. And all the studies I have done say the same thing.


Risky Business

“Pay for performance” has been the rallying cry of corporate boards in the 1990s. Yet there remains a wide variance between top executives’ earnings and wealth and their companies’ performance. Pay expert Graef Crystal has devised a measure called the Risk Quotient that ranks the performance sensitivity of an executive’s compensation package and share holdings. In his analysis of 350 top CEOs’ pay, an RQ of 99 means the executive’s package is more sensitive to performance than that of 99% of the CEOs in the study.



Company CEO Risk Quotient Hilton Hotels Barron Hilton 98 Walt Disney Michael D. Eisner 96 Fleetwood Enterprises John C. Crean 91 Times Mirror Robert F. Erburu 89 Amgen Gordon M. Binder 81 Mattel John W. Amerman 73 Northrop Grumman Kent Kresa 72 Kaufman & Broad Home Bruce Karatz 65 Lockheed Daniel M. Tellep 62 Rockwell International Donald R. Beall 61 Avery Dennison Charles D. Miller 59 Computer Sciences William Hoover 56 First Interstate Bancorp Edward M. Carson 50 Great Western Financial James F. Montgomery 37 Unocal Richard J. Stegemeier 35 Occidental Petroleum Ray R. Irani 34 Teledyne William P. Rutledge 31 National Education Corp. Jerome W. Cwiertnia 23 Fluor Leslie G. McCraw 21 Atlantic Richfield Lodwrick M. Cook 11 SCEcorp John E. Bryson 2


Most Risk-Sensitive Packages


Company CEO Risk Quotient Microsoft Bill Gates 100 Oracle Systems Lawrence J. Ellison 100 Seagram Edgar M. Bronfman 100 Nike Philip H. Knight 99 Gap Donald G. Fisher 99 Limited Leslie H. Wexner 99 Wm. Wrigley Jr. William Wrigley 99 CBS Laurence A. Tisch 99 McCaw Cellular Communications Craig O. McCaw 98 Hilton Hotels Barron Hilton 98

Least Risk-Sensitive Packages

Company CEO Risk Quotient Cigna Wilson H. Taylor 3 SCEcorp John E. Bryson 2 Public Service Enterprise Group E. James Ferland 2 Texas Utilities Jerry S. Farrington 2 Consolidated Edison Eugene R. McGrath 1 American Electric Power E. Linn Draper Jr. 1 Commonwealth Edison James J. O’Connor 1 BellSouth John L. Clendenin 1 Salomon Robert E. Denham 1 AMR Robert L. Crandall 0

Note: Crystal analyzed the pay and stockholdings of all 350 U.S. chief executives who run the companies in Standard & Poor’s 500 index and have held their jobs for three years or more.