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Executive compensation: How much is the right amount?

June 5, 2015
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What is the value of a CEO?

Almost everyone believes they are paid what they deserve unless they think they are under paid. In 40 years of compensation work, I never recall anyone saying they were paid too much. Some people will admit they are paid well, but to say it is too much is another issue. 

A number of years ago, Max DePree, CEO of Herman Miller, made a statement that the CEO of an organization should not be paid more than 20 times the rate paid to the average worker in a company. At the time he was taking a very bold position. Today he would probably be laughed at as being out of touch with reality. 

A recent article in USA Today quoted data that indicated the average CEO is paid 373 times more than the average worker in the company. In other words, they make in one hour what is takes the worker more than two months at seven days a week to make. The study was based on data collected by the AFL-CIO, undoubtedly tracking “big time” organizations.

But what is the reality for most organizations?

It is clearly less than the numbers quoted for the sensational news article. Even so, if the average worker is paid $15 per hour and the CEO is paid 40 times that amount, the CEO is making roughly $1.25 million dollars. Is that the right balance?

Most CEOs in small to medium-sized organizations are likely not making that kind of money. The critical factors are the size of the organization and the components of the compensation plan.

How do people get paid? It is generally two ways: an hourly rate, with a special allowance if you work beyond 40 hours a week, or a fixed salary and sometimes a bonus on top of that. The hourly paid people may also get some special allowances such as piece work or a bonus of some sort.

Executives typically get salary, bonus and a component that is related in some form to the increased value of the organization. It may be a stock-ownership award, or an option to purchase stock at some future date at a fixed price. In a private company, the ownership may translate into actual distribution of cash in relationship to the number of shares they own.

The distribution of earnings or value increase in shares owned may actually be several times larger than the base salary or the bonus paid out. It may be arranged in such a way that it repeats every year in larger amounts.

The plans or methodologies are quite variable and are designed generally to align the pay of the executive with the value owners receive, based on results of company performance. That is the expectation, but it is not always the way it works. Some plans pay out a tremendous amount in spite of poor performance. That is something for which the board of directors has to take responsibility.

But how much is the right amount?

The basic question that should be asked is how much should we pay the CEO or other executives for poor, good or outstanding performance? Like any business decision it should be controlled first by what the organization can afford. The next question should focus on the value the executive can or does bring to the organization. Another consideration may be concern about losing the person, or whether the company is recruiting the right person with the necessary, proven skills.

This then becomes a market-driven decision, similar to getting the right quarterback in the NFL. When multiple organizations are willing to pay a high price, it drives up the price even more.

With such decisions, it has to be recognized that the decision is not made in a vacuum. Such decisions often have a number of repercussions, seen and unseen. Some you live with, others become more important than losing a perceived critical employee.

After years of dealing with such matters, I’ve reached one conclusion. It may not be 100 percent correct in all situations, but I strongly believe when you look at the importance of internal equity and external equity, getting the internal balance right always has better long-term outcomes.  

Mr. DePree may not have had the exact ratio right, but he seems to have the right concept. Aligning pay with workers and looking at other key executives, as well as demonstrated performance over time, builds a team. No one feels there is a disproportionate “recognition” of an individual when the payouts make reasonable sense. 

Furthermore, other studies show when there is a teamwork culture, there is employee engagement. That doesn’t only apply to lower-level staff but to all staff. When there is engagement, the organization’s performance drastically outshines that of organizations where people think of it as just a place get a paycheck.

Executive compensation is about long-term performance. So, when you start to design an executive comp plan, you have to look at the big picture and what it looks like over time. If pay is the only arrow in your quiver to attract and retain the “right” person, you had best add a few more arrows.

You want to make sure the alignment of the players ties in with the strategic plan and know that there are a number of ways to achieve each objective. Make sure your comp plan can be as flexible as the business environment in which you operate. Each component of the plan plays a notable role. Getting the right notes in proper balance can build a pretty fantastic song, which can be sung many times.

Ardon L. Schambers is president and principal of P3HR Consulting & Services. 

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