Are CEOs rewarded for luck?

Jim Manzi has an article up at The Atlantic Business where he talks about a recent article about how CEOs don’t matter as much as the conventional wisdom thinks in The Atlantic Magazine. Jim argues that the research presented isn’t impressive, and describes the article at TAS as an “argument that is presented against CEOs [that] is really an argument against markets setting prices.”

He writes this characteristically sharp paragraph:

There’s just no way out of the problem that what makes companies do well or badly is very, very complicated, and therefore isolating the impact of any one variable by lining up some descriptors for a few hundred companies and looking for patterns is like trying to grab liquid mercury. The only way to really isolate the causal impact of CEOs on performance would be to randomly change a subset of them while holding others out as controls, which of course will never happen. Even if we could do this, we would still have an almost insurmountable generalization problem: How would this vary by industry? Are some CEOs only good at turnarounds, independent of industry? Are CEOs secularly more valuable in some time periods than others? And so on.

To start, there are really two different questions here. One is “how much do CEOs matter?” The other is “How competitively set are CEO’s compensation packages?” The first is probably a fair amount. CEOs get final calls on mergers and acquisitions, and nothing can destroy a good company than a M&A gone bad. Since to study this part of it, you’d have to not only analyze what has happened but also what has not happened, what was prevented from happening, you are going to have a lot of problems right away.

The other question is more interesting. Our gut reaction should be that CEOs are overpaid compared to their productivity. One reason is that they are signals a company sends to the financial markets. It may be perfectly ok, or even pretty cool, if when someone compliments you on your jacket to say “oh this? I thrifted it. $10!” It is less cool if a board says to the bond market “Oh this CEO? We got him for cheap.” There’s always an incentive to bid over the average salary, and as such that should move market prices up.

There’s another argument where the CEO can appoint the people who compensate and monitor him. This has a long history of some really sharp research inside finance and business research, and I’m surprised The Atlantic author went to sociology for paper citations. Michael Weisbach’s Outside Directors and CEO Turnover (1988) is a good place to start, where he finds, quite conclusively in my opinion, that outsider-dominated boards do a better job of governance than insider dominated boards. This kicks off a whole wave of research in this vein.

But what about the specific point Jim brings up above? Can we isolate one variable and see how CEOs are compensated when it varies? Ask and ye shall receive! Are CEOs Rewarded for Luck? The Ones Without Principals are:

ABSTRACT: The contracting view of CEO pay assumes that pay is used by shareholders to solve an agency problem. Simple models of the contracting view predict that pay should not be tied to luck, where luck is deŽned as observable shocks to performance beyond the CEO’s control. Using several measures of luck, we Žfind that CEO pay in fact responds as much to a lucky dollar as to a general dollar. A skimming model, where the CEO has captured the pay-setting process, is consistent with this fact. Because some complications to the contracting view could also generate pay for luck, we test for skimming directly by examining the effect of governance. Consistent with skimming, we fiŽnd that better governed fiŽrms pay their CEO less for luck….

PAPER: Simple models of the contracting view generate one important prediction. Shareholders will not reward CEOs for observable luck. By luck, we mean changes in Žperformance that are beyond the CEO’s control…

This paper starts by examining whether or not CEOs are in fact paid for luck using three measures of luck. First, we perform a case study of the oil industry where large movements in oil prices tend to affect Žfirm performance on a regular basis. Second, we use changes in industry-speciŽc exchange rate for firŽrms in the traded goods sector. Third, we use year-to-year differences in mean industry performance to proxy for the overall economic fortune of a sector. For all three measures, we Žfind that CEO pay responds signiŽcantly to luck. In fact, we fiŽnd that CEO pay is as sensitive to a lucky dollar as to a general dollar. Moreover, these results hold as well for discretionary components of pay—salary and bonus—as they do for options grants.

These results are inconsistent with a simple contracting view. Motivated by practitioners such as Crystal [1991], we propose an alternative, skimming, which can explain these results [Bertrand and Mullainathan 2000a]. The skimming view also begins with the separation of ownership and control, but it argues that this separation allows CEOs to gain effective control of the pay-setting process itself.

I love this paper. This paper looks at things that are random to CEO performance – oil prices for the oil industry, currency exchange-rates for exporters, and mean performance of an industry. The question is how much they should be compensated for luck, for things they have no control over. They shouldn’t. At all.

The important thing for this analysis, to answer Jim’s question, is whether or not the variable we are looking at is independent of the CEO’s performance. CEOs for oil companies don’t set oil prices. However when oil prices go up, they get paid more. And before you move to make a ‘human capital’ argument – that oil company CEOs are worth more when oil prices are high – there’s an asymmetry there. Oil company CEOs’ salaries do not go down the same way when oil prices drop. (The paper digs into this obvious criticism if you want to click through to the pdf above.)

The same goes for export industries who have profits tied heavily to exchange-rates. Exporters don’t set exchange-rates. Trust me, hedge funds across the US are trying to use complicated mechanisms to get a 5 basis point edge on exchange-rate movements; the CEO of an export company doesn’t have an edge here. Same effect. Even if you find the third measure, mean performance as proxy a little squishy (I can see that, though I’d disagree), the first two strike me as very reasonable ‘instruments’ for analyzing CEO performance.

And of course, the closer we look there the more it looks like CEOs are capable of skimming quite well from the people who have entrusted them to lead their company. Even more so if their monitors are chosen by the CEOs. It’s not an indictment, but it does go with our initial intuitions about how CEOs can capture the companies and boards they are supposed to be monitored by.

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3 Responses to Are CEOs rewarded for luck?

  1. Jim Manzi says:

    Thanks for the compliment.

    The answer to the question that titles your post is also simple: Yes. (assuming you mean, “in part”). Of course, all of us are rewarded, at least in part, for luck. I think that the conclusion that CEOs should not be does not follow from this, however. You’d have to ask (I think) “Would a company that attempted to remove luck entirely as a driver of CEO comp be worht more than one that does not?”. And I think the only way to really answer this, in practice, is also with market pricing.


  2. anne says:

    I think CEOs are more than figureheads for a corporation – I think they truly do lead the company in so many different ways – their tone, how they treat employees, how they invest and allocate resources – companies don’t move with the tide – they are definitely led by the CEO.

    Whether or not they deserve the kind of compensation they’re getting these days – that’s a different story.

    In their book, Pay without Performance, Lucien Bebchuk and Jesse Fried say that “in 1991, the average large-company CEO received approximately 140 times the pay of the average worker; in 2003, the ratio was about 500:1.”

    And what have we gotten from this significant increase in our investment in corporate leaders?

    An economy in ruins. Financial sector in a shambles – propped up heavily by the government. The Big Three struggling to stay alive. Airline industry on the verge of collapse, with some organizations in the throes of serious labor issues. Newspaper industry about to shut down.

    And what else do we see?

    -John Thain entering a company that was bleeding money like blood from an artery (a $15 billion loss in one quarter alone!) – focusing his attention on the million dollar renovation of his office as he rammed through federally funded bonuses to highly compensated execs.

    -American Airline employees launching a public campaign to inform the public of the CEO’s outrageous salary – and asking the public to vote against bonuses for top execs at American (which recorded a net loss of more than $2 billion in 2008.) (You can see the campaign here:

    -GM’s leader riding off into the sunset with a $20 million retirement package – though in more than a decade in the C-Suite (COO, CFO and CEO), Rick Wagoner led his company only into bankruptcy. (Though I’ve heard that his retirement package is being held up as a result of the federal bailout.)

    So I don’t even think you can say that CEOs are rewarded for luck. They’re just excessively rewarded – no matter what.

    Certainly, CEOs should be highly rewarded for their work – especially when the organization grows and succeeds. But it seems that paying these boys astronomical incomes that are completely divorced from performance is a waste of money.

  3. Chris says:

    CEOs get final calls on mergers and acquisitions, and nothing can destroy a good company than a M&A gone bad. Since to study this part of it, you’d have to not only analyze what has happened but also what has not happened, what was prevented from happening, you are going to have a lot of problems right away.

    The fact that the CEOs’ decisions matter does not mean that the CEOs matter. If the alternative CEO you would have had would have made the same decision, then the CEO you did have didn’t change anything relative to the CEO you didn’t have. Since you often don’t even know who the alternative CEO *is*, this is hard to estimate.

    Binary decisions (approving or disapproving a subordinate’s plan) mean that there’s *at least* a 50% chance that the alternative CEO would have made the same call, and that’s if the right choice isn’t objectively obvious to anyone with a MBA. If MBAs are actually worth something (to the company that hires one, that is), some business decisions *will* have a right choice that any merely competent CEO will make the same way as a high-paid superstar, and therefore the superstar isn’t making a difference on those either. (Or, in other words, you don’t have to pay $100 million to find a guy who can tie his own shoes.)

    On top of that even the high-paid ones screw up sometimes (perhaps just as often as the ones fresh out of business school), so it’s not at all clear that they have any positive value, let alone one commensurate with their cost.

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