CEO Incentives—It’s Not How Much

You Pay, But How

by 
Michael C. Jensen

 and 
 Kevin J. Murphy
From the Magazine (May–June 1990)

The arrival of spring means yet another round in the national debate over executive
compensation. Soon the business press will trumpet answers to the questions it asks
every year: Who were the highest paid CEOs? How many executives made more than
a million dollars? Who received the biggest raises? Political figures, union leaders,
and consumer activists will issue now-familiar denunciations of executive salaries
and urge that directors curb top-level pay in the interests of social equity and
statesmanship.

The critics have it wrong. There are serious problems with CEO compensation, but
“excessive” pay is not the biggest issue. The relentless focus on how much CEOs are
paid diverts public attention from the real problem—how CEOs are paid. In most
publicly held companies, the compensation of top executives is virtually independent
of performance. On average, corporate America pays its most important leaders like
bureaucrats. Is it any wonder then that so many CEOs act like bureaucrats rather
than the value-maximizing entrepreneurs companies need to enhance their standing
in world markets?

We recently completed an in-depth statistical analysis of executive compensation.

Our study incorporates data on thousands of CEOs spanning five decades. The base
sample consists of information on salaries and bonuses for 2,505 CEOs in 1,400
publicly held companies from 1974 through 1988. We also collected data on stock
options and stock ownership for CEOs of the 430 largest publicly held companies in
1988. In addition, we drew on compensation data for executives at more than 700
public companies for the period 1934 through 1938.

Our analysis leads us to conclusions that are at odds with the prevailing wisdom on
CEO compensation.

Despite the headlines, top executives are not receiving record salaries and
bonuses. Salaries and bonuses have increased over the last 15 years, but CEO pay
levels are just now catching up to where they were 50 years ago. During the period
1934 through 1938, for example, the average salary and bonus for CEOs of leading
companies on the New York Stock Exchange was $882,000 (in 1988 dollars). For the
period 1982 through 1988, the average salary and bonus for CEOs of comparable
companies was $843,000.

Annual changes in executive compensation do not reflect changes in corporate

performance. Our statistical analysis posed a simple but important question: For
every $1,000 change in the market value of a company, how much does the wealth of
that company’s CEO change? The answer varied widely across our 1,400-company
sample. But for the median CEO in the 250 largest companies, a $1,000 change in
corporate value corresponds to a change of just 6.7 cents in salary and bonus over
two years. Accounting for all monetary sources of CEO incentives—salary and bonus,
stock options, shares owned, and the changing likelihood of dismissal—a $1,000
change in corporate value corresponds to a change in CEO compensation of
just $2.59.

Compensation for CEOs is no more variable than compensation for hourly and
salaried employees. On average, CEOs receive about 50% of their base pay in the
form of bonuses. Yet these “bonuses” don’t generate big fluctuations in CEO
compensation. A comparison of annual inflation-adjusted pay changes for CEOs
from 1975 through 1988 and pay changes for 20,000 randomly selected hourly and
salaried workers shows remarkably similar distributions. Moreover, a much lower
percentage of CEOs took real pay cuts over this period than did production workers.

With respect to pay for performance, CEO compensation is getting worse rather
than better. The most powerful link between shareholder wealth and executive
wealth is direct stock ownership by the CEO. Yet CEO stock ownership for large
public companies (measured as a percentage of total shares outstanding) was ten
times greater in the 1930s than in the 1980s. Even over the last 15 years, CEO
holdings as a percentage of corporate value have declined.

Compensation policy is one of the most important factors in an organization’s

success. Not only does it shape how top executives behave but it also helps determine
what kinds of executives an organization attracts. This is what makes the vocal
protests over CEO pay so damaging. By aiming their protests at
compensation levels, uninvited but influential guests at the managerial bargaining
table (the business press, labor unions, political figures) intimidate board members
and constrain the types of contracts that are written between managers and
shareholders. As a result of public pressure, directors become reluctant to reward
CEOs with substantial (and therefore highly visible) financial gains for superior
performance. Naturally, they also become reluctant to impose meaningful financial
penalties for poor performance. The long-term effect of this risk-averse orientation is
to erode the relation between pay and performance and entrench bureaucratic
compensation systems.

Are we arguing that CEOs are underpaid? If by this we mean “Would average levels
of CEO pay be higher if the relation between pay and performance were stronger?”
the answer is yes. More aggressive pay-for-performance systems (and a higher
probability of dismissal for poor performance) would produce sharply lower
compensation for less talented managers. Over time, these managers would be
replaced by more able and more highly motivated executives who would, on average,
perform better and earn higher levels of pay. Existing managers would have greater
incentives to find creative ways to enhance corporate performance, and their pay
would rise as well.

These increases in compensation—driven by improved business performance—would

not represent a transfer of wealth from shareholders to executives. Rather, they
would reward managers for the increased success fostered by greater risk taking,
effort, and ability. Paying CEOs “better” would eventually mean paying the average
CEO more. Because the stakes are so high, the potential increase in corporate
performance and the potential gains to shareholders are great.

How Compensation Measures Up

Shareholders rely on CEOs to adopt policies that maximize the value of their shares.
Like other human beings, however, CEOs tend to engage in activities that increase
their own well-being. One of the most critical roles of the board of directors is to
create incentives that make it in the CEO’s best interest to do what’s in the
shareholders’ best interests. Conceptually this is not a difficult challenge. Some
combination of three basic policies will create the right monetary incentives for CEOs
to maximize the value of their companies:

1. Boards can require that CEOs become substantial owners of company stock.

2. Salaries, bonuses, and stock options can be structured so as to provide big rewards
for superior performance and big penalties for poor performance.

3. The threat of dismissal for poor performance can be made real.

Unfortunately, as our study documents, the realities of executive compensation are at

odds with these principles. Our statistical analysis departs from most studies of
executive compensation. Unlike the annual surveys in the business press, for
example, we do not focus on this year’s levels of cash compensation or cash
compensation plus stock options exercised. Instead, we apply regression analysis to
15 years’ worth of data and estimate how changes in corporate performance affect
CEO compensation and wealth over all relevant dimensions.

We ask the following questions: How does a change in performance affect current
cash compensation, defined as changes in salary and bonus over two years? What is
the “wealth effect” (the present value) of those changes in salary and bonus? How
does a change in corporate performance affect the likelihood of the CEO being
dismissed, and what is the financial impact of this new dismissal probability? Finally,
how does a change in corporate performance affect the value of CEO stock options
and shares, whether or not the CEO exercised the options or sold the shares? (For a
discussion of our methodology, see the insert, “How We Estimate Pay for
Performance.”)

How We Estimate Pay for Performance

Our analysis draws primarily on two sources of data: annual executive compensation
surveys published in Forbes ...

The table “The Weak State of Pay for Performance” provides a detailed review of our
main findings for a subsample of CEOs in the 250 largest publicly held companies.
Together, these CEOs run enterprises that generate revenues in excess of $2.2 trillion
and employ more than 14 million people. The results are both striking and troubling.
A $1,000 change in corporate market value (defined as share price appreciation plus
dividends) corresponds to a two-year change in CEO salary and bonus of less than a
dime; the long-term effects of that change add less than 45 cents to the CEO’s wealth.
A $1,000 change in corporate value translates into an estimated median change of a
nickel in CEO wealth by affecting dismissal prospects. At the median, stock options
add another 58 cents worth of incentives. Finally, the value of shares owned by the
median CEO changes by 66 cents for every $1,000 increase in corporate value. All
told, for the median executive in this sub-sample, a $1,000 change in corporate
performance translates into a $2.59 change in CEO wealth. The table also reports
estimates for CEOs at the lower and upper bounds of the middle two quartiles of the
sample.

The Weak State of Pay for Performance Note: The median individual components do
not add to the median total change in CEO wealth since sums of medians do not in
general equal the median of sums.

This degree of pay-for-performance sensitivity for cash compensation does not create
adequate incentives for executives to maximize corporate value. Consider a corporate
leader whose creative strategic plan increases a company’s market value by $100
million. Based on our study, the median CEO can expect a two-year increase in salary
and bonus of $6,700—hardly a meaningful reward for such outstanding
performance. His lifetime wealth would increase by $260,000—less than 4% of the
present value of the median CEO’s shareholdings and remaining lifetime salary and
bonus payments.1
Or consider instead a CEO who makes a wasteful investment—new aircraft for the
executive fleet, say, or a spanking addition to the headquarters building—that
benefits him but diminishes the market value of the company by $10 million. The
total wealth of this CEO, if he is representative of our sample, will decline by
only $25,900 as a result of this misguided investment—not much of a disincentive
for someone who earns on average $20,000 per week.

One way to explore the realities of CEO compensation is to compare current practices
with the three principles that we outlined earlier. Let’s address them one at a time.

CEOs should own substantial amounts of company stock. The most powerful link
between shareholder wealth and executive wealth is direct ownership of shares by
the CEO. Most commentators look at CEO stock ownership from one of two
perspectives—the dollar value of the CEO’s holdings or the value of his shares as a
percentage of his annual cash compensation. But when trying to understand the
incentive consequences of stock ownership, neither of these measures counts for
much. What really matters is the percentage of the company’s outstanding shares
the CEO owns. By controlling a meaningful percentage of total corporate equity,
senior managers experience a direct and powerful “feedback effect” from changes in
market value.

Think again about the CEO adding jets to the corporate fleet. The stock-related
“feedback effect” of this value-destroying investment—about $6,600—is small
because this executive is typical of our sample, in which the median CEO controls
only .066% of the company’s outstanding shares. Moreover, this wealth loss (about
two days’ pay for the average CEO in a top-250 company) is the same whether the
stock-holdings represent a big or small fraction of the CEO’s total wealth.

But what if this CEO held shares in the company comparable to, say, Warren
Buffett’s stake in the Berkshire Hathaway conglomerate? Buffett controls, directly
and indirectly, about 45% of Berkshire Hathaway’s equity. Under these
circumstances, the stock-related feedback effect of a $10 million decline in market
value is nearly $4.5 million—a much more powerful incentive to resist wasteful
spending.

Moreover, these differences in CEO compensation are associated with substantial

differences in corporate performance. From 1970 through 1988, the average annual
compound stock return on the 25 companies with the best CEO incentives (out of the
largest 250 companies examined in our survey) was 14.5%, more than one-third
higher than the average return on the 25 companies with the worst CEO incentives.
A $100 investment in the top 25 companies in 1970 would have grown to $1,310 by
1988, as compared with $702 for a similar investment in the bottom 25 companies.
The 25 CEOs of Large Companies with the Best Incentives Note: Sample consists of
CEOs in the 250 largest companies, ranked by 1988 sales.
The 25 CEOs of Large Companies with the Worst Incentives Note: Sample consists of
CEOs in the 250 largest companies, ranked by 1988 sales.

As a percentage of total corporate value, CEO share ownership has never been very
high. The median CEO of one of the nation’s 250 largest public companies owns
shares worth just over $2.4 million—again, less than 0.07% of the company’s market
value. Also, 9 out of 10 CEOs own less than 1% of their company’s stock, while fewer
than 1 in 20 owns more than 5% of the company’s outstanding shares.

It is unreasonable to expect all public-company CEOs to own as large a percentage of

their company’s equity as Warren Buffett’s share of Berkshire Hathaway. Still, the
basic lesson holds. The larger the share of company stock controlled by the CEO and
senior management, the more substantial the linkage between shareholder wealth
and executive wealth. A few companies have taken steps to increase the share of
corporate equity owned by senior management. Employees of Morgan Stanley now
own 55% of the firm’s outstanding equity. Companies such as FMC and Holiday have
used leveraged recapitalizations to reduce the amount of outstanding equity by
repurchasing public shares, and thus allow their managers to control a bigger
percentage of the company. After FMC adopted its recapitalization plan, for example,
employee ownership increased from 12% to 40% of outstanding equity. These
recapitalizations allow managers to own a bigger share of their company’s equity
without necessarily increasing their dollar investment.

Truly giant companies like IBM, General Motors, or General Electric will never be
able to grant their senior executives a meaningful share of outstanding equity. These
and other giant companies should understand that this limitation on executive
incentives is a real cost associated with bigness.

Cash compensation should be structured to provide big rewards for outstanding

performance and meaningful penalties for poor performance. A two-year cash
reward of less than 7 cents for each $1,000 increase in corporate value (or,
conversely, a two-year penalty of less than 7 cents for each $1,000 decline in
corporate value) does not create effective managerial incentives to maximize value.
In most large companies, cash compensation for CEOs is treated like an entitlement
program.

There are some notable exceptions to this entitlement pattern. The cash
compensation of Walt Disney CEO Michael Eisner, whose pay has generated such
attention in recent years, is more than ten times more sensitive to corporate
performance than the median CEO in our sample. Yet the small number of CEOs for
whom cash compensation changes in any meaningful way in response to corporate
performance shows how far corporate America must travel if pay is to become an
effective incentive.

Creating better incentives for CEOs almost necessarily means increasing the financial
risk CEOs face. In this respect, cash compensation has certain advantages over stock
and stock options. Stock-based incentives subject CEOs to vagaries of the stock
market that are clearly beyond their control. Compensation contracts based on
company performance relative to comparable companies could provide sound
incentives while insulating the CEO from factors such as the October 1987 crash.
Although there is some evidence that directors make implicit adjustments for market
trends when they set CEO pay, we are surprised that compensation plans based
explicitly on relative performance are so rare.2

The generally weak link between cash compensation and corporate performance
would be less troubling if CEOs owned a large percentage of corporate equity. In fact,
it would make sense for CEOs with big chunks of equity to have their cash
compensation less sensitive to performance than CEOs with small stockholdings.
(For example, Warren Buffett’s two-year cash compensation changes by only a penny
for every $1,000 increase in market value.) In some cases, it might even make sense
for pay to go up in bad years to serve as a financial “shock absorber” for losses the
CEO is taking in the stock market. Yet our statistical analysis found no correlation
between CEO stock ownership and pay-for-performance sensitivity in cash
compensation. In other words, boards of directors ignore CEO stock ownership when
structuring incentive compensation plans. We find this result surprising—and
symptomatic of the ills afflicting compensation policy.

Make real the threat of dismissal. The prospect of being fired as a result of poor
performance can provide powerful monetary and nonmonetary incentives for CEOs
to maximize company value. Because much of an executive’s “human capital” (and
thus his or her value in the job market) is specific to the company, CEOs who are
fired from their jobs are unlikely to find new jobs that pay as well. In addition, the
public humiliation associated with a high-visibility dismissal should cause managers
to carefully weigh the consequences of taking actions that increase the probability of
being dismissed.
Here too, however, the evidence is clear: the CEO position is not a very risky job.
Sports fans are accustomed to baseball managers being fired after one losing season.
Few CEOs experience a similar fate after years of underperformance. There are many
reasons why we would expect CEOs to be treated differently from baseball managers.
CEOs have greater organization-specific capital; it is harder for an outsider to come
in and run a giant company than it is for a new manager to take over a ball club.
There are differences in the lag between input and output. The measure of a baseball
manager’s success is the team’s won-lost record this year; the measure of a corporate
manager is the company’s long-term competitiveness and value. For these and other
reasons, it is not surprising that turnover rates are lower for CEOs than for baseball
managers. It is surprising that the magnitude of the discrepancy is so large.

On average, CEOs in our base sample (2,505 executives) hold their jobs for more
than ten years before stepping down, and most give up their title (but not their seat
on the board) only after reaching normal retirement age. Two recent studies,
spanning 20 years and more than 500 management changes, found only 20 cases
where CEOs left their jobs because of poor performance.3 To be sure, directors have
little to gain from publicly announcing that a CEO is leaving because of failure—
many underperforming CEOs leave amidst face-saving explanations and even public
congratulations. But this culture of politeness does not explain why so few
underperforming CEOs leave in the first place. University of Rochester’s Michael
Weisbach found that CEOs of companies that rank in the bottom 10% of the
performance distribution (measured by stock returns) are roughly twice as likely to
leave their jobs as CEOs whose companies rank in the top 10% of the performance
distribution. Yet the differences that Weisbach quantifies—a 3% chance of getting
fired for top performers versus a 6% chance of getting fired for laggards—are unlikely
to have meaningful motivational consequences for CEOs.

Our own research confirms these and other findings. CEOs of large public companies
are only slightly more likely to step down after very poor performance (which we
define as company earnings 50% below market averages for two consecutive years)
than after average performance. For the entire 1,400-company sample, our analysis
estimates that the poor-performing CEOs are roughly 6% more likely to leave their
jobs than CEOs of companies with average returns. Even assuming that a dismissed
CEO never works again, the personal wealth consequences of this increased
likelihood of dismissal amounts to just 5 cents for every $1,000 loss of shareholder
value.

With respect to pay for performance, there’s no denying that the results of our study
tell a bleak story. Then again, perhaps corporate directors are providing CEOs with
substantial rewards and penalties based on performance, but they are measuring
performance with metrics other than long-run stock market value. We tested this
possibility and reached the same conclusion as in our original analysis. Whatever the
metric, CEO compensation is independent of business performance.

For example, we tested whether companies rewarded CEOs on the basis of sales
growth or accounting profits rather than on direct changes in shareholder wealth. We
found that while more of the variation in CEO pay could be explained by changes in
accounting profits than stock market value, the pay-for-performance sensitivity was
economically just as insignificant as in our original model. Sales growth had little
explanatory power once we controlled for accounting profits. 4
Of course, incentives based on other measures will be captured by our methodology
only to the extent that they ultimately correlate with changes in shareholder wealth.
But if they don’t—that is, if directors are rewarding CEOs based on variables other
than those that affect corporate market value—why use such measures in the first
place?

Moreover, if directors varied CEO compensation substantially from year to year

based on performance measures not observable to us, this policy would show up as
high raw variability in CEO compensation. But over the past 15 years, compensation
for CEOs has been about as variable as cash compensation for a random sample of
hourly and salaried workers—dramatic evidence of compensation’s modest role in
generating executive incentives.5 “Common Variability: CEO and Worker Wages”
compares the distribution of annual raises and pay cuts of our CEO sample with
national data on hourly and salaried workers from 1975 through 1986. A larger
percentage of workers took real pay cuts at some time over this period than did
CEOs. Overall, the standard deviation of annual changes in CEO pay was only slightly
greater than for hourly and salaried employees (32.7% versus 29.7%).

Common Variability: CEO and Worker Wages

Looking Backward: Pay for Performance in the

1930s
CEO compensation policies look especially unsatisfactory when compared with the
situation 50 years ago. All told, CEO compensation in the 1980s was lower, less
variable, and less sensitive to corporate performance than in the 1930s. To compare
the current situation with the past, we constructed a longitudinal sample of
executives from the 1930s using data collected by the Works Projects Administration.
The WPA data, covering fiscal years 1934 through 1938, include salary and bonus for
the highest paid executive (whom we designate as the CEO) in 748 large U.S.
corporations in a wide range of industries. Nearly 400 of the WPA sample companies
were listed on the New York Stock Exchange, and market values for these companies
are available on the CRSP Monthly Stock Returns Tape. In order to compare similar
companies over the two time periods, we restricted our analysis to companies in the
top 25% of the NYSE, ranked by market value. WPA compensation data are available
for 60% of this top quartile group (averaging 112 companies per year), while data for
more recent times are available for 90% of the top quartile companies (averaging 345
companies per year).

The results are striking. Measured in 1988 constant dollars, CEOs in top quartile
public companies earned an average salary and bonus of $882,000 in the 1930s—
more than the 1982 through 1988 average of $843,000 and significantly more than
the 1974 through 1981 average of $642,000. Over this same time period, there has
been a tripling (after inflation) of the market value of top quartile companies—
from $1.7 billion in the 1930s to $5.9 billion in 1982 through 1988. Coupled with the
decline in salaries, the ratio of CEO pay to total company value has fallen
significantly—from 0.11% in the 1930s to 0.03% in the 1980s. Compensation was
more variable in the 1930s as well. The average standard deviation of the annual pay
changes—the best statistical measure of the year-to-year variability of compensation
—was $504,000 in the 1930s compared with $263,500 in the 1980s.

The incentives generated by CEO stock ownership have also declined substantially
over the past 50 years. To test this trend, we reviewed stock ownership data for CEOs
in the 120 largest companies (ranked by market value) in 1938, 1974, and 1988.
“Whatever Happened to CEO Stock Ownership?” reports our findings. The
percentage of outstanding shares owned by CEOs (including shares held by family
members) in the top 120 companies fell by a factor of nearly ten from 1938 to 1988.
The trend is unmistakable: as a percentage of total market value, CEO stock
ownership has declined substantially over the last 50 years and is continuing to fall.
Whatever Happened to CEO Stock Ownership? Note: Median stock ownership for
CEOs in largest 120 companies, ranked by market value. Data were obtained from
proxy statements and include not only shares held directly but also shares held by
family members and related trusts.

The Costs of Disclosure

Why don’t boards of directors link pay more closely to performance? Commentators
offer many explanations, but nearly every analysis we’ve seen overlooks one powerful
ingredient—the costs imposed by making executive salaries public. Government
disclosure rules ensure that executive pay remains a visible and controversial topic.
The benefits of disclosure are obvious; it provides safeguards against “looting” by
managers in collusion with “captive” directors. The costs of disclosure are less well
appreciated but may well exceed the benefits.

Managerial labor contracts are not a private matter between employers and
employees. Third parties play an important role in the contracting process, and
strong political forces operate inside and outside companies to shape executive pay.
Moreover, authority over compensation decisions rests not with the shareholders but
with compensation committees generally composed of outside directors. These
committees are elected by shareholders but are not perfect agents for them. Public
disclosure of “what the boss makes” gives ammunition to outside constituencies with
their own special-interest agendas. Compensation committees typically react to the
agitation over pay levels by capping—explicitly or implicitly—the amount of money
the CEO earns.

How often do shareholder activists or union leaders denounce a corporate board

for underpaying the CEO? Not very often—and that’s precisely the problem. Most
critics of executive pay want it both ways. They want companies to link pay to
performance, yet they also want to limit compensation to arbitrary amounts or some
fuzzy sense of “what’s fair.” That won’t work. Imposing a ceiling on salaries for
outstanding performers inevitably means creating a floor for poor performers. Over
time, by cutting off the upper and lower tails of the distribution, the entire pay-for-
performance relation erodes. When mediocre outfielders earn a million dollars a
year, and New York law partners earn about the same, influential critics who
begrudge comparable salaries to the men and women running billion-dollar
enterprises help guarantee that these companies will attract mediocre leaders who
turn in mediocre performances.

Admittedly, it is difficult to document the effect of public disclosure on executive pay.

Yet there have been a few prominent examples. Bear, Stearns, the successful
investment bank, went public in 1985 and had to submit to disclosure requirements
for the first time. CEO Alan Greenberg’s $2.9 million salary and bonus was the
nation’s fourth highest that year, and his ranking drew attention to the firm’s
compensation system. Under private ownership, compensation of the firm’s
managing directors was set at a modest $150,000 base plus a bonus pool tied to
earnings—a tight link between pay and performance. Because the firm was so
profitable in 1986, the bonus pool swelled to $80 million, an average of $842,000 for
each of the firm’s 95 managing directors. A public outcry ensued. Six months after
going public, Bear, Stearns announced it was lowering the bonus pool from 40% to
25% of the firm’s adjusted pretax earnings in excess of $200 million. According to
one account, the firm’s business success had “yielded an embarrassment of riches for
top executives.”6

More recently, we interviewed the president of a subsidiary of a thriving publicly

traded conglomerate. This president is compensated with a straight fraction of his
subsidiary’s earnings above a minimum threshold, with no upper bound. Today he
makes roughly five times what he made before his operation was acquired by the
conglomerate, and corporate headquarters recognizes him as one of the company’s
outstanding executives. Why doesn’t he want to be an officer of the conglomerate?
For one, because his salary would have to be made public—a disclosure both he and
the CEO consider a needless invitation to internal and external criticism.

We are not arguing for the elimination of salary disclosure. (Indeed, without
disclosure we could not have conducted this study.) But it’s time compensation
committees stood up to outside criticism and stopped adopting policies that make
their companies’ incentive problem worse. The costs of negative publicity and
political criticism are less severe than the costs to shareholder wealth created by
misguided compensation systems.
Corporate Brain Drain
The level of pay has very little to do with whether or not CEOs have incentives to run
companies in the shareholders’ interests—incentives are a function of how pay,
whatever the level, changes in response to corporate performance. But the level of
pay does affect the quality of managers an organization can attract. Companies that
are willing to pay more will, in general, attract more highly talented individuals. So if
the critics insist on focusing on levels of executive pay, they should at least ask the
right question: Are current levels of CEO compensation high enough to attract the
best and brightest individuals to careers in corporate management? The answer is,
probably not.

Who can disagree with these propositions?

 It is good when our most talented men and women are attracted to the
organizations that produce the goods and deliver the services at the heart of
the economy.
 People evaluate alternative careers at least in part on the basis of lifetime
monetary rewards
 People prefer to make more money than less, and talented, self-confident
people prefer to be rewarded based on performance rather than independent
of it.
 If some organizations pay more on average and offer stronger pay-for-
performance systems than other organizations, talent will migrate to the
higher paying organizations.

These simple propositions are at the heart of a phenomenon that has inspired much
handwringing and despair over the last decade—the stream of talented, energetic,
articulate young professionals into business law, investment banking, and
consulting. Data on the career choices of Harvard Business School graduates
document the trend that troubles so many pundits. Ten years ago, nearly 55% of
newly graduated HBS students chose careers in the corporate sector, while less than
30% chose investment banking or consulting. By 1987, more than half of all HBS
graduates entered investment banking or consulting, while under 30% chose careers
in the corporate sector. Last year, just over one-third of all graduating HBS students
chose corporate careers, while nearly 40% chose careers in investment banking or
consulting. And Harvard Business School is not alone; we gathered data on other
highly rated MBA programs and found similar trends.

We don’t understand why commentators find this trend so mysterious. A highly

sensitive pay-for-performance system will cause high-quality people to self-select
into a company. Creative risk takers who perceive they will be in the upper tail of the
performance and pay distribution are more likely to join companies who pay for
performance. Low-ability and risk-averse candidates will be attracted to companies
with bureaucratic compensation systems that ignore performance.

Compensation systems in professions like investment banking and consulting are

heavily weighted toward the contributions made by individuals and the performance
of their work groups and companies. Compensation systems in the corporate world
are often independent of individual, group, or overall corporate performance.
Moreover, average levels of top-executive compensation on Wall Street or in
corporate law are considerably higher than in corporate America. Financially
speaking, if you are a bright, eager 26-year-old with enough confidence to want to be
paid based on your contribution, why would you choose a career at General Motors
or Procter & Gamble over Morgan Stanley or McKinsey & Company?

Most careers, including corporate management, require lifetime investments.

Individuals must choose their occupation long before their ultimate success or failure
becomes a reality. For potential CEOs, this means that individuals seeking careers in
corporate management must join their companies at an early age in entry-level jobs.
The CEOs in our sample spent an average of 16 years in their companies before
assuming the top job. Of course, many people who reach the highest ranks of the
corporate hierarchy could also expect to be successful in professional partnerships
such as law or investment banking, as proprietors of their own businesses, or as
CEOs of privately held companies. It is instructive, therefore, to compare levels of
CEO compensation with the compensation of similarly skilled individuals who have
reached leadership positions in other occupations.

The compensation of top-level partners in law firms is one relevant comparison.

These numbers are closely guarded secrets, but some idea of the rewards to top
partners can be gleaned from data on average partner income reported each year in a
widely read industry survey. The table “Salaries for Top Lawyers Are High…” reports
1988 estimated average incomes earned by partners in the highest paying corporate
law firms. These five firms paid their 438 partners average incomes ranging
from $1.35 million to nearly $1.6 million. Partners at the very top of these firms
earned substantially more. When comparing these results with corporate
compensation, the appropriate question to ask is “How many public companies paid
their top 67 or 177 executives average salaries of $1.6 million or $1.2 million in
1989?” The answer is, few or none. How surprising is it, then, that law school classes
are bulging with some of the country’s brightest students?

Salaries for Top Lawyers Are High… Source: The American Lawyer, July–August
1989, p. 34.
Compensation for the most successful corporate managers is also modest in
comparison with compensation for the most successful Wall Street players. Here too
it is difficult to get definitive numbers for a large sample of top executives. But the
most recent annual survey, as reported in the table “…So Are Salaries on Wall
Street,” documents the kinds of rewards available to top investment bankers. At
Gold-man, Sachs, for example, 18 partners earned more than $3 million in 1988, and
the average income for those partners was more than $9 million. Only nine public-
company CEOs had incomes in excess of $9 million in 1988 (mostly through
exercising stock options), and no public company paid its top 18 executives more
than $3 million each. The Wall Street surveys for 1989 are not yet available, but
consistent with high pay-for-performance systems, they will likely show sharp
declines in bonuses reflecting lower 1989 industry performance.

…So Are Salaries on Wall Street Source: Financial World, July 11, 1989. Average
earnings are based on Financial World’s lower bound earnings estimate, p. 32.

The compensation figures for law and investment banking look high because they
reflect only the most highly paid individuals in each occupation. Average levels of
compensation for lawyers or investment bankers may not be any higher than average
pay levels for executives. But that’s not the relevant comparison. The very best
lawyers or investment bankers can earn substantially more than the very best
corporate executives. Highly talented people who would succeed in any field are
likely to shun the corporate sector, where pay and performance are weakly related, in
favor of organizations where pay is more strongly related to performance—and the
prospect of big financial rewards more favorable.

Money Isn’t Everything

Some may object to our focus on monetary incentives as the central motivator of
CEO behavior. Are there not important nonmonetary rewards associated with
running a large organization? Benefits such as power, prestige, and public visibility
certainly do affect the level of monetary compensation necessary to attract highly
qualified people to the corporate sector. But unless nonmonetary rewards vary
positively with company value, they are no more effective than cash compensation in
motivating CEOs to act in the shareholders’ interests. Moreover, because
nonmonetary benefits tend to be a function of position or rank, it is difficult to vary
them from period to period based on performance.

Indeed, nonmonetary rewards typically motivate top managers to take actions

that reduce productivity and harm shareholders. Executives are invariably tempted
to acquire other companies and expand the diversity of the empire, even though
acquisitions often reduce shareholder wealth. As prominent members of their
community, CEOs face pressures to keep open uneconomic factories, to keep the
peace with labor unions despite the impact on competitiveness, and to satisfy intense
special-interest pressures.

Monetary compensation and stock ownership remain the most effective tools for
aligning executive and shareholder interests. Until directors recognize the
importance of incentives—and adopt compensation systems that truly link pay and
performance—large companies and their shareholders will continue to suffer from
poor performance.

A New Survey of Executive Compensation

Routinely misused and abused, surveys contribute to the common ills of corporate
compensation policy. Surveys that report average compensation across industries
help inflate salaries, as everyone tries to be above average (but not in front of the
pack). Surveys that relate pay to company sales encourage systems that tie
compensation to size and growth, not performance and value. Surveys that rank the
country’s highest paid executives stir public outrage, raise legislative eyebrows, and
provide emotional justification for increased demands in labor negotiations.

The basic problem with existing compensation surveys is that they focus exclusively
on how much CEOs are paid instead of how they are paid. Our focus on incentives
rather than levels leads naturally to a new and different kind of survey. Instead of
reporting who’s paid the most, our survey reports who’s paid the best—that is, whose
incentives are most closely aligned with the interests of their shareholders.

Our survey considers incentives from a variety of sources—including salary and

bonus, stock options, stock ownership, and the threat of getting fired for poor
performance. It includes only companies listed in the Forbes executive compensation
surveys for at least eight years from 1975 through 1989, since we require at least
seven years of pay change to estimate the relation between pay and performance. Our
methodology is described in the insert “How We Estimate Pay for Performance.”

Compensation surveys in the business press, such as those published

by Fortune and Business Week, are really about levels of pay and not about pay for
performance. Yet they often include an analysis or ranking of the appropriateness of
a particular CEO’s pay by relating it to company performance in some fashion. The
methods adopted by Fortune and Business Week share a common flaw. CEOs
earning low fixed salaries while delivering mediocre performance look like stars; on
the flip side, CEOs with genuinely strong pay-for-performance practices rank poorly.
For example, Business Week’s 1989 survey calculates the ratio of the change in
shareholder wealth to the CEO’s total compensation, both measured over three years.
Executives with the highest ratios are labeled the “CEOs Who Gave the Most for
Their Pay.” Low-ratio CEOs purportedly gave shareholders the least. Fortune’s 1989
compensation issue uses a regression model to estimate how compensation varies
with factors such as the CEO’s age and tenure, company size, location, industry, and
performance. Although the author cautions against taking the results too literally,
CEOs earning more than predicted are implicitly designated as “overpaid,” while
those earning less than predicted are “underpaid.”

Consider the case of Disney’s Michael Eisner. By all accounts, Mr. Eisner’s pay is
wedded to company performance—in addition to loads of stock options, he gets
2% of all profits above an annually increasing threshold. Shareholders have
prospered under Eisner, and few have complained that his compensation is
unreasonable in light of the $7 billion in shareholder wealth he has helped create
since joining the company in 1984. But Business Week ranks Eisner second on the
list of CEOs who gave their shareholders the least (right behind option-laden Lee
Iacocca, who over the past decade helped create $6 billion in wealth for Chrysler
shareholders), while Fortune flags Eisner as the nation’s third most overpaid CEO.
Surveys ranking Eisner and Iacocca low are clearly not measuring incentives. In
contrast, our survey ranks Eisner and Iacocca as the nation’s fourth and ninth
respectively “best paid” CEOs measured on the basis of pay-related wealth alone.

We estimated the pay-for-performance relation for each of the 430 companies for
which we have sufficient data. The results are summarized in the four nearby tables.
Three of the tables include results for the 250 largest companies ranked by 1988
sales. The 25 CEOs with the best and worst overall incentives, as reflected by the
relation between their total compensation (composed of all pay-related wealth
changes and the change in the value of stock owned), are summarized in the first two
tables. Castle & Cooke, whose current CEO is David Murdock, ranks first with a total
change in CEO wealth of $231.53 for every $1,000 change in shareholder wealth. His
stockholdings contribute $224.24 of this amount, while the change in all pay-related
wealth adds another $7.29.

With a few exceptions, it is clear that the best incentives are determined primarily by
large CEO stockholdings. Donald Marron of Paine Webber is such an exception, with
more than $55 of his total of $67 coming from changes in pay-related wealth. So too
are Philip Hawley of Carter Hawley Hale, Henry Schacht of Cummins Engine, and
Disney’s Eisner.

The 25 companies providing their CEOs with the worst total incentives are led by
Navistar International whose CEO James Cotting on average receives
a $1.41 increase in wealth for every $1,000 decrease in shareholder value. Carolina
Power & Light’s Sherwood Smith, Jr. receives a 16-cent increase for every $1,000
decrease in shareholder wealth. Other well-known corporations whose CEOs appear
on the worst-incentives list include Chevron, Johnson & Johnson, Eastman Kodak,
and IBM.
Although one has to recognize that there is statistical uncertainty surrounding our
estimates of pay-related wealth sensitivity, no CEO with substantial equity holdings
(measured as a fraction of the total outstanding equity) makes our list of low-
incentive CEOs. As we point out in the accompanying article, an important
disadvantage of corporate size is that it is extremely difficult for the CEO to hold a
substantial fraction of corporate equity.

The inverse relation between size and stockholdings (and therefore the negative
effect of size on incentives) is readily visible in the much higher sensitivities shown
for the top 25 CEOs in smaller companies, those ranking from 251 to 430 in 1988
sales. (See the table “The Best of the Rest: CEO Incentives in Smaller Companies.”)
Warren Buffett of Berkshire Hathaway leads this list with $446 per $1,000, followed
by William Swindells, Jr. of Williamette Industries, Joe Allbritton of Riggs National,
and Barron Hilton of Hilton Hotels. Again, the importance of large stockholdings is
clear.

The Best of the Rest: CEO Incentives in Smaller Companies Note: Sample consists of
CEOs in companies ranked 251 to 430 by 1988 sales.

Indeed, one problem with current compensation practices is that boards often
reward CEOs with substantial equity through stock options but then stand by to
watch CEOs undo the incentives by unloading their stockholdings. Boards seldom
provide contractual constraints or moral suasion that discourage the CEO from
selling such shares to invest in a diversified portfolio of assets. One of the ironies of
the situation is that the corporation itself often funds executive financial counseling
by consultants whose common mantra is “sell and diversify, sell and diversify.” While
this can be personally advantageous to executives, it is not optimal for shareholders
or society because it significantly reduces CEOs’ incentives to run their companies
efficiently.

Pay-related incentives are under the direct control of the compensation committee
and the board. The table “Best Paid CEOs of Large Companies” lists the 25
companies that reward their CEOs in a way that provides the best incentives from
pay-related wealth alone—changes in salary and bonus, long-term incentive plans,
dismissal likelihood, and stock options. Each of these estimates is given in the table,
along with the sum of the effects in the last column. The table makes clear that the
major contributors to pay-related incentives are stock options and the present value
of the change in salary and bonus.

Best Paid CEOs of Large Companies Note: Sample consists of CEOs in the 250 largest
companies, ranked by 1988 sales.

1. The median CEO in our sample holds stock worth $2.4 million. The average 1988
salary and bonus for the CEOs in our sample was roughly $1 million. At a real
interest rate of 3%, the present value of the salary and bonus for the next five years to
retirement (the average for the sample) is $4.6 million. Thus total lifetime wealth
from the company is $7 million.

2. See Robert Gibbons and Kevin J. Murphy, “Relative Performance Evaluation for
Chief Executive Officers,” Industrial and Labor Relations Review, February 1990, p.
30-S.
3. See Jerold B. Warner, Ross L. Watts, and Karen H. Wruck, “Stock Prices and Top
Management Changes,” Journal of Financial Economics, January–March 1988, p.
461; and Michael S. Weisbach, “Outside Directors and CEO Turnover,” Journal of
Financial Economics, January–March 1988, p. 431.

4. For more detail on these tests, see our article, “Performance Pay and Top-
Management Incentives,” Journal of Political Economy, April 1990.

5. Data on hourly and salaried workers come from the Michigan Panel Study on
Income Dynamics. The sample includes 21,895 workers aged 21 to 65 reporting
wages in consecutive periods. See Kenneth J. McLaughlin, “Rigid Wages?” University
of Rochester Working Paper, 1989.

6. Wall Street Journal, March 21, 1986.

A version of this article appeared in the May–June 1990 issue of Harvard Business

Review.