CEO pay and the Lake Wobegone effect

2009

The excesses of executive pay that we have seen over the past few years were driven as much by shareholder expectation as by the need to protect and retain top talent, a new study has suggested.

In what has been termed "The Lake Wobegone effect" after the books by humorist Garrison Keillor, academics Scott Schaefer and Rachel M Hayes have argued that firms fell into a vicious cycle where they had to be pay their CEOs over the odds or risk seeing their share price plummet.

Nevertheless, the Obama administration's moves to artificially cap CEO pay may not be the answer to the problem, suggest the professors from the University of Utah's David Eccles School of Business.

In Keillor's fictional hometown of Lake Wobegon, all children are 'above average'. Schaefer and Hayes argue that something similar happened in the business world in relation to CEO pay over the past few years.

In essence, corporations had to pay ever-higher salaries to convince investors their CEO was above average, while investors expected to see these high salaries to give themselves something to believe (and therefore invest) in.

No organisation wanted to admit to having a CEO who was below average, and therefore no firm allowed its CEO pay package to lag behind market expectations.

In the study published in The Journal of Financial Economics, the two suggest companies had clear incentives to keep even bargain-basement CEOs highly rewarded simply to maintain stock prices, and remarkably this was even the case when investors recognised the CEO was being paid over the odds.

"Everyone knows that in well-functioning labor markets, better performers earn higher salaries," Schaefer pointed out.

So if a firm hired a CEO and paid a low salary of, say, $1 million a year, investors might simply conclude he or she wasn't great CEO material and downgrade the firm's stock.

But if the firm decided to pay its bargain-basement CEO as if he or she was a superstar, investors were more likely to conclude a superstar was leading the organisation and therefore push the share price higher.

"The Lake Wobegon idea as applied to CEOs seems to presume that investors aren't very smart," pointed out Schaefer.

"You can imagine investors being fooled once or twice, but over time you'd think they'd catch on as highly touted and well-paid CEOs consistently fail to deliver," he added.

Yet this was not always the case because, intriguingly, the Lake Wobegon effect could still hold true even when shareholders saw through it.

"Our research shows that the Lake Wobegon effect can drive up pay even if investors are super smart about it. The key is investors' expectations," said Schaefer

With shareholders likely to jump to the conclusion that, whatever the actual performance, any CEO being paid "only" $1 million must be truly unqualified, a firm might simply be better off overpaying its manager, even if investors were not fooled.

To determine that the Lake Wobegon effect could occur and in an attempt to analyse under what conditions, Schaefer and Hayes used game theory to create a mathematical model of what a firm wanted, what a manager wanted and what investors wanted.

Then they analysed various strategies players might use to achieve their goals and compare the likely outcome to the Lake Wobegon effect.

Another implication of this vicious cycle was that effect it had on CEOs' attitudes to risk-taking, argued Schaefer.

"Pay packages have gotten so high that the repercussions of getting fired are minimal because these guys are so wealthy. They're not afraid of taking risks," he said.

Nevertheless, artificial caps on CEO pay are unlikely to be the answer and might simply cause an exodus of CEO talent to consultancy work, Shaefer predicted.

At insurance giant AIG, for example, while there has been much public anger over vast pay-outs to people who have by their actions destroyed a lot of wealth, restricting pay was also simply preventing those who had been brought in to clear up the mess from being rewarded for their efforts, he pointed out.

The solution, rather, should be to tie pay to long-run value-creation in firms by lengthening the vesting periods for CEO stock and stock-option grants, Shaefer argued.

This would ensure that the CEO's path to wealth was through the creation of sustainable, long-run value for shareholders.

Schaefer and Hayes' research adds another twist to the increasingly febrile debate over executive pay on both sides of the Atlantic and, crucially, what sort of executive pay model will be right for the global economy once we are through the current slump.

Consultancy Watson Wyatt in December argued we are likely to see a wholesale re-evaluation of senior level pay and how to reward performance, both good and bad, and was in fact already happening even before the downturn hit.

Yet firms may also need to be careful not to throw the baby out with the bathwater, as the consultancy also argued in February last year that there was a growing body of evidence suggesting that, rather than incentives leading to a culture of greed and stagnation, in fact there was a clear link between financial incentives at the top and high-performing organisations.