Inside the head of an overpaid CEO
By Jeffrey Pfeffer,
This piece is part of an On Leadership round table exploring the reasons behind the persistence and prevalence of outsized executive pay.
High CEO pay is like a zombie that will not die.
And it’s hard to understand why, considering most leadership advice and organizational theory would stop excessive pay packages dead in their tracks. They put too much emphasis on one person’s contribution, distort decisions, encourage excessive risk-taking, and damage morale at a time when the rest of the company is being forced to cut back.
Study after study also shows that high differentiation in pay between the CEO and lower-level staffers hurts organizational performance. And there is no shortage of outrage over CEOs who get rich whether their companies do well or not.
But social psychology helps to explain why so little has changed — and why not much is likely to, either. CEOs and directors are people, too, and succumb to a number of decision biases.
For one, when decisions are questioned (and decisions about CEO pay have certainly been under attack), the first thing people do is justify the choices which, after all, are part of their identity. This justification and rationalization of past decisions actually escalates one’s commitment to them. In the process of explaining their choices, leaders may not convince their opponents, but they will certainly further convince themselves.
Moreover, research shows that when under threat, leaders and the people who work for them retreat to what they know and do best, a process sometimes called the “threat rigidity” effect. External threats lead to internal rigidity and a resistance to change. Put these two processes together, and ironically, the very attacks on CEO pay are almost certainly reinforcing the status quo. No one wants to feel pushed around or pressured, powerful CEOs least of all.
CEOs and the boards of directors who set executive compensation are also hurt, perhaps unwittingly, by the powerful perches they occupy. These positions cause them to trust their own judgment more than empirical research.
And the research abounds. Yes, there are studies on the ineffectiveness of stock options, which seem to drive little more than risky behavior and the need to restate financial results. And yes, a meta-analysis of more than 200 studies finds no consistent relationship between CEO equity ownership and corporate performance. And scores of studies over the years demonstrated the weak connection between CEO pay and corporate performance.
But what makes anyone think CEOs, or for that matter the directors of their boards or their advisers, know or care about any of this? Recent studies show that power leads to — no big surprise — reduced reluctance to take advice. People in high-ranking positions know what they know, and many are remarkably unperturbed by any contrary evidence. Making matters worse, pay advisers are motivated to keep their clients happy, as compensation consultant Graef Crystal pointed out decades ago in his tell-all book In Search of Excess . It’s a dynamic that is still the same. That’s why pleas to use compensation practices backed up by good evidence fall largely on deaf ears.
Then there’s what I call the “above-average effect.” Studies have shown that people, under most circumstances, tend to believe they are better than their peers on virtually all positive traits. That’s one of the reasons performance appraisals are often so contentious: The people getting reviewed all think they are above average, even if this is a mathematical impossibility. The same goes for CEOs and the boards of directors who hire and pay them. If you have supposedly above-average boards deciding on the pay of assumed-to-be above-average CEOs, then it must be the case that all CEOs have to be paid above average, right?
Finally, social psychologists have shown repeatedly that where you stand on the distribution of pay, rather than the absolute amount you are paid, determines its meaning. In other words, $2 million might seem like a perfectly reasonable annual compensation until it is viewed against one’s peers who are making $12 million or $22 million. As a result, ironically, the more discussion and disclosure there is of CEO pay, the greater the pressures grow to keep pay high. Who wants to admit to others — and least of all to themselves — that they don’t “measure up” in the rankings?
Put all of these forces together and it’s no wonder most CEOs earn a lot. Add to it the fact that because reform attempts seldom begin with any understanding of the causal factors at play, these efforts are more likely to make things worse than better. When leaders come to see the measure of their worth not so much in what they earn but in what they actually do for the various stakeholders whose lives they affect, then things might be different. But judging from the current rhetoric, I would not hold my breath.
Jeffrey Pfeffer is the Thomas D. Dee II Professor of Organizational Behavior at Stanford University’s Graduate School of Business. His most recent book is Power: Why Some People Have It—And Others Don’t.
Full On Leadership round table on executive pay:
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