Comparison ShoppingThe real reason CEO compensation got out of hand.

By Ray FismanPosted Monday, May 11, 2009, at 6:08 PM ET

Last fall, with headlines of million-dollar Wall Street bonuses
appearing amid the worst economic crisis in a generation, I attended a
lecture on corporate ethics by the CEO of one of America's most
venerable corporations. This captain of American industry was critical
of the compensation committees and formulas that generated these
outsize payouts and felt that in his own case, he didn't deserve more
than $10 million, regardless of what the committee came up with.

It
is truly a statement of the times we live in that a self-imposed $10
million pay cap is a sign of modesty and virtue. Half a century ago,
the median pay of top executives in U.S. companies was 30 times an
average worker's salary; by 2005, the ratio was nearly 110. How did we get here?

The popular (and populist) perception is that of America's CEOs
greedily rubbing their hands together as they approve their own
paychecks, and there certainly has been some of that. Others argue that in most cases CEOs are richly compensated because they're so good at what they do.

Several
recent studies stake out a middle ground, assuming that CEOs are
neither villains nor business masterminds. These studies argue that the
seemingly innocuous practice of benchmarking pay against other
companies' CEOs may be to blame, because the list of comparable
executives is often formed selectively to include highly paid peers and
to omit lower-paid ones. Though this opportunistic selection of peers
may result in only a small bump to CEO pay in any particular year, over
time, the rising tide of peer pay may well account for much of the
increase in corner-office salaries that we've seen in recent decades.

If
bosses set the salaries of their workers, who decides what the bosses
earn? In a modern corporation, the task of setting the CEO's pay falls
to the board of directors, typically a subgroup of board members on its
compensation committee. A CEO's pay is partly a reward for leading the
company and partly an inducement to keep him from leaving for greener
pastures.

How much is enough? It makes sense to see what competing firms—the
ones that might try to lure your CEO away from his current job—are
spending to reward and retain their leaders. That's where the
peer-group comparison comes in. But who is the "right" peer? You
probably want to pick someone running a company in the same industry,
of similar size, of comparable profitability, and with similar
experience (similar tenure at the firm and so on). Depending on your
industry, however, there might still be dozens of CEOs who meet these
criteria—how do you decide who makes your list of comparables?

Compensation committees use their discretion, and that has led to claims of abuse by committees with too-cozy (or just plain incestuous)
relations with the CEO. (Compensation consultants, often brought in to
help figure out the "right" pay, have also been accused of currying favor with executives
in the hope of securing other, more lucrative business from the
company.) To shed more light on what had been a less-than-transparent
process, the Securities and Exchange Commission mandated in 2006 that
companies had to make their peer lists public.

For more information on WHy CEO Pay Got Out of Hand.

Posted by Dan Walter

Performensation: Equity Compensation for High Performance Companies.