In his NYT op-ed from several weeks ago, Joe Stiglitz reveals his misunderstanding of incentive pay. He argues, “So C.E.O.’s must be given stock options to induce them to work hard. I find this puzzling: If a firm pays someone $10 million to run a company, he should give his all to ensure its success.” Stiglitz mistakenly assumes CEOs are paid to work hard (or in some other similar fashion) and then asks whether paying them more could possibly induce them to work any harder when they are surely already working as hard as they possibly can.
Stiglitz doesn’t realize that companies don’t pay CEOs for what they can do; they pay them for what they are willing to do. Companies pay CEOs to compel them to take the risks necessary to commercialize innovations that significantly improve their company’s product offerings relative to competitors. Stiglitz should read a brief summary of the book Leadership on the Line to understand the risks faced by leaders who demand change.
A CEO’s primary objective is to maximize the value of his career by remaining CEO for as long as possible. Taking strategic risks and failing put once-in-a-lifetime CEO careers in jeopardy. An undiversified CEO is logically more reluctant to bear potential career-ending risks than diversified investors. If given the opportunity, a CEO can easily become satisfied with satisfactory underperformance, which is difficult for investors to identify on their own. While it’s true, competitors’ innovations often compel change, companies pay CEO for more than reactive change; they pay for proactive change. The differential pay for success must be large enough to compel CEOs to find and take prudent risks proactively. Society, namely customers, are better served by this incentive structure.
The problem is compounded by the growing value of success more broadly. To attract top talent, CEO pay must be competitive with the pay for other similarly talented endeavors, which has risen. As the average pay rises, CEO should logically grow more risk-averse making a compelling differential for proactive success even larger.
University of Chicago’s Steve Kaplan, provides evidence supporting this view. His research shows that CEO pay has risen comparably with other high paid professions; that the value of CEO pay relative to the value of success to investors has remained comparable; and that boards have exerted more control over CEOs as evidenced by the shortened tenure of CEOs.