« It’s very seldom that publishing compensation accomplishes much for the shareholders. No CEO looks at a proxy statement and comes away saying, ‘I should be paid less.' »
Warren Buffett made that contrarian argument earlier this year, at the annual meeting of Berkshire Hathaway, about the steady push for companies to disclose compensation in increasingly specific detail in the name of transparency.
It was an intriguing, counterintuitive point, but largely anecdotal.
Now, a study by three professors at the University of Cambridge may help prove Buffett’s assertion.
The study shows in devastating detail how compensation consultants – which use the increasingly available public data on compensation to advise boards on how much to pay chief executives – are helping to ratchet up the pay for the nation’s top executives.
Companies have long tried to « benchmark » the compensation of their executives to that of their peers.
But as the cottage industry of compensation consultancy has emerged – along with more detailed information about salaries and bonuses – the increase in compensation has not slowed. In fact, quite the opposite has happened.
« We consistently find evidence that supports the argument that compensation consultants are hired to justify higher CEO pay to the board, shareholders, and other stakeholders, » wrote the study’s authors, Jenny Chu, Jonathan Faasse and P. Raghavendra Rau.
In theory, the hiring of compensation consultants – and the publication of compensation plans publicly – should have curbed the rise in executive pay. The various headline-grabbing lists of compensation for chief executives are seemingly meant to shame boards – and the armada of consultants around them – to restrain their largesse.
But according to the study, it’s the other way around: Companies that hire compensation consultants for the first time « show a 7.5 per cent increase in CEO pay compared to other firms, and such companies where CEOs get a pay boost are less likely to turn over consultants the following year. »
One of the study’s authors cited the jump in pay for Michael Dell, founder and chief executive of Dell, after it hired a compensation consultant in 2011. (His pay quadrupled, though it may be hard to ascribe it solely to the consultant.) Similarly, the CEO of Public Storage’s pay multiplied after hiring a consultant.
Worse, allowing a chief executive to hire a compensation consultant instead of leaving the task to the company’s board, led to a 13 percent increase in pay, the study’s authors found.
Why in the world is a chief executive in charge of hiring a compensation consultant? That’s a good question, but it happens more than you would imagine.
The study, which examined more than 1,000 U.S. companies from 2006 to 2012, shows that compensation consultants have an increasing influence inside boardrooms.
In 2009, the Securities and Exchange Commission changed the rules concerning compensation consultants because they were worried about their influence and suspected them of conflicts. Many of the consultants, like Towers Watson, Mercer and Aon Hewitt, offered multiple services in addition to consulting on compensation. As a result, the SEC theorized that the disclosure of consulting fees might help prevent the consultants from trying to curry favor with management by helping to lift pay in the hope of receiving more contracts for other services.
But the study’s authors say they found « that the SEC rule change didn’t work as designed, because both company management and pay consultancies have found ways to circumvent the intent of the new rules. »
Indeed, a cottage industry of boutique compensation consultants sprang up in the wake of the new rule, in part because then the companies do not have to disclose consulting fees if the firm does not provide other services. Some Mercer partners left to start Compensation Advisory Partners, and Towers Watson « announced that it would partner with a newly created spinoff, Pay Governance LLC, » the authors wrote.
All of which brings us back to Buffett’s larger point about the disclosure of the compensation plans in the first place.
Is transparency a good thing? In most cases, it is hard to argue against the benefit it provides.
But when consultants and others use that transparency as a weapon in a compensation arms race, questions, even uncomfortable ones, must be raised.
Let’s be honest, compensation at the top level is rarely based on a true marketplace. Unless a rival company tries to poach a chief executive, it is hard to determine exactly what they should be paid.
Most employers seek to hire people at the lowest possible cost while still paying them enough to do the best job possible and keep them from leaving. It’s delicate balance. But most companies seek to maximize whatever money they devote toward compensation.
That is rarely how boards think about it. For them, the best chief executive makes the most money.
« How do you tell your shareholders you have a great CEO? » Rau said. « ‘For proof, we pay him peanuts.’ They never say they do that. »
So between the consultants and disclosure of all this information about compensation, the likelihood is that pay will rise at an ever greater pace.
« American shareholders are paying a significant price because they get to look at that proxy statement each year, » Buffett said.
He told a story about the time he ran Salomon Bros. « At Salomon, everyone was dissatisfied with their pay, and they got enormous amounts. They were disappointed because they looked at others, and it drove them crazy. »
Buffett’s business partner, Charlie Munger, chimed in: « I would say that envy is doing the country harm. »