As the pay gap between the average American worker and chief executive officers of public companies becomes larger, people are questioning what’s behind this disparity and what drives the pay of CEOs. According to the AFL-CIO, a federation of labor organizations, for instance, the salary of a typical S&P 500 company CEO in 2014 was 373 times the salary of an average rank-and-file worker. In actual figures, average CEO pacakge was more than $22.6 million in 2014, according to Equilar, which researches executive compensation. Certainly, there is a big disparity between CEO pay and the pay of other workers in corporate America, but is there any reason this disparity exists?

An Incentive for Performance

One major justification put forth by corporations about what’s behind gargantuan CEO pay levels is that they have to pay big in order to attract the right candidates who will impact the company’s performance. That way, the company’s shareholders get a better return on their investment. Companies that come up with this justification say that by awarding a big part of an executive’s compensation in the form of stock grants, they are providing an incentive for him or her to run the company well and personally benefit, as well as reward shareholders.

The Superstar Theory

Another factor that companies cite for excessive pay is that some CEOs are indispensable and almost inextricable from the companies they lead. For instance, Steve Jobs will forever be linked to Apple, Inc. (AAPL) as the man who led the company as it introduced many of its major innovations and established it as a major force in the market. Similarly, investors tend to associate General Electric Co. (GE) with Jack Welch.

Board Influence

The pay of public company CEOs is normally set by a compensation committee formed of members of its board of directors. And that’s another reason behind skyrocketing CEO pay levels, since these directors, though seemingly independent, tend to be nominated for their directorship by company CEOs. Therefore, the members of these compensation committees tend to be the cronies of the CEOs whose pay they set. Naturally enough, they tend to go along with high CEO pay levels as they enjoy the benefits of their own director positions.

Use of Peer Groups for Comparison

The use of peer groups to determine CEO pay has also been cited as a factor for burgeoning CEO pay. The people setting CEO pay are supposed to look to companies in a similar market and of a similar size to set CEO pay in their own company. In practice, however, many company directors tend to look at bigger and more flourishing companies that tend to pay their CEOs more as an aspirational yardstick to set pay.

Are High CEO Pay Levels Justified?

In a capitalistic system, it is justified that CEOs should be paid for superior performance. However, not all CEOs are superstars and a lot of the time CEOs do not add much long-term value. Instead, they have an incentive to focus more on short-term measures that drive up a company’s stock price during their tenure. This leads to excessive risk-taking by companies. Of course, there is the occasional exceptional CEO for whom a case could be made for an exceptional premium, but that doesn’t justify the sky-high pay levels of every run-of-the-mill CEO.

And while CEOs should be paid a significantly higher salary than rank-and-file employees for running companies, the questions are how high should the differential be and is there any justification for today’s extreme differential.

The Bottom Line

CEOs are at the helm of public companies and the role needs to be adequately rewarded so as to attract suitable candidates who will steer their companies well. While that’s not at issue, what has become controversial is the exorbitant levels of pay that CEOs command. Companies have come up with a number of reasons for the pay differential between CEOs and other workers, but they sometimes seem to be specious, as a CEO’s pay is often set by their boards of directors who have every incentive to please them. And the use of peer groups to set pay is more aspirational than based on a comparison of apples to apples.

 

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