The More You Pay, the Less You Get

By James Kwak

Schumpeter at The Economist pointed me to a paper by Richard Cazier and John McInnis on one of my favorite topics: CEO hiring. Cazier and McInnis first confirm, not surprisingly, that pay for new, externally-hired CEOs is positively related to the past performance of their previous firms. In particular, they measure EXCESS_COMP as the difference between actual first-year compensation and the compensation that you would predict just based on the characteristics of the hiring firm; EXCESS_COMP turns out to be positively associated with the CEOs’ prior firms’ stock returns. That makes sense, since you would think that people from successful companies would be able to command a higher price than people from less successful companies, and it isn’t obviously controversial, since you would think they would deserve it.

But what do the new firms get for this pay premium? It turns out that their future performance, measured in terms of return on assets and operating return on assets, is negatively associated with excess compensation based on prior performance.* In other words, people from successful companies don’t deserve the pay premium because the higher the premium they are able to command, the less well they are likely to do.

This should not be too surprising. The more of a superstar someone is at Company A, the more likely the board of Company B is to overlook all the things that make her a bad fit for Company B—like not having experience in the industry, or with the new company’s customer base, or having led Company A through a different phase of its lifecycle than Company B, or not having the skills that Company B needs at that point in time, or any number of other things. The more reasons for concern that Board B overlooks, the more likely the new hire is to do badly. In the end, you get something vaguely like the Peter Principle: the more successful Company A is, the more market power its CEO has, and the more likely she is to be overpaid to be CEO of a company she is not qualified to lead.

Last month I used Steve Jobs’s resignation as an opportunity to talk about the difference between founder and non-founder CEOs. Since then, Jobs’s death has led to reverential eulogies throughout the media and widespread celebration of Jobs as the greatest CEO of our time. Yet I would be surprised if Jobs ever thought of himself as a master of generic “management,” whose greatest skills were identifying and nurturing talent, bringing out the best in people, motivating employees, delegating wisely, and all the other blather associated with management-speak. He may have been good at some of those things (and famously bad at some others), but that’s not what made him great.

According to Cazier and McInnis, the argument in favor of external CEO hiring is that “society has accumulated an expansive body of knowledge regarding management disciplines which, if mastered by a CEO, enable him to effectively manage nearly any modern corporation.” Jobs did lead three different companies, but the idea that his success was due to abstract management ability—as opposed to, say, his vision for the iPod—seems ludicrous. Yet companies look less for people like Jobs than for people like, well, John Sculley. Or Meg Whitman, who turned a successful run managing a consumer-to-consumer Internet startup and a catastrophic campaign for California governor into a job as CEO of Hewlett-Packard.

* Cazier and McInnis use fitted excess compensation—the amount predicted by the CEOs’ prior firms’ past performance—rather than actual excess compensation as their explanatory variable. This troubles me slightly, but I can’t figure out which is more appropriate theoretically. At the very least, their specification does capture the extent to which hiring boards are swayed by the impressiveness of prior performance.

29 responses to “The More You Pay, the Less You Get

  1. The idea that his success was due to his vision for the iPod — as opposed to, say, his abstract management ability – seems ludicrous.

  2. I know that in American culture and maybe in human culture it is considered very bad taste to speak negatively of those who have died. Nonetheless, I can’t stop myself, as I feel the lie is worse.

    I want to applaud James Rainey of the LATimes (I’m guessing there were a very few others) for having the courage to say things as they should be said—that is accurately.
    http://www.latimes.com/entertainment/news/la-et-onthemedia-20111008,0,7256248.column

    Looking at FOXCONN alone and also looking at the unsolved mystery of how Steve Jobs received his liver transplant so quickly—see here— http://articles.cnn.com/2009-06-24/health/liver.transplant.priority.lists_1_organ-transplant-liver-transplant-united-network?_s=PM:HEALTH I think I can with 100% certainty say Steve Jobs was not, is not, and will NEVER be, a hero or a person to be emulated as a man/human being. As to Steve Jobs skills’ as a manager, I’ll let others more qualified on management skills debate.

    I have very mixed feelings on Steve Jobs. It’s really hard to argue with the results and achievements he has had, which can’t be brushed aside easily. Nonetheless, there was the problem of the i-Phone antenna, which I think Steve Jobs had to take full responsibility for as nothing is released to market without his final say. The cowardly act of trying to push off the i-Phone antenna fiasco on an employee by firing speaks of low character in my book. The man who was fired didn’t make the decision to release the product to the market too early, and any idiot who tried the i-Phone (including Jobs) would have known the antenna problem if he had given the phone a few test runs himself.

    Also there was the backdating of options scandal, which again had Steve Jobs inky fingers smeared all over it. Backdating of options is one of the most low-down, disrespectful, disdainful things a corporate executive (much less a CEO) can do to his shareholders. It shows Apple scored a big <bZERO in the corporate governance column. It’s really incomparable in its sliminess in regards to fiduciary responsibility to shareholders. It doesn’t speak much for Steve Jobs’ morals or ethics.
    http://www.businessweek.com/technology/ByteOfTheApple/blog/archives/2008/08/a_nice_tidy_end_to_the_options_backdating_scandal.html

    http://www.msnbc.msn.com/id/16373057/ns/business-financial_times/t/apple-falsified-files-steve-jobs-options/#.TmApnM22Anp

    http://arstechnica.com/apple/news/2006/10/7909.ars

    Also I see him as very similar to Lee Iacocca in his mastery of P.R. By that I mean when he was done at Ford, Iacocca had everyone believing he had written the original engineering blueprints for the Ford Mustang. Iacocca was more skilled at marketing than engineering. When Jobs takes all of the bows for the products such as Mac, I-Pod, mouse, the original scroll down menus, i-Pad etc, he may deserve a part of those bows for assembling a good engineering team and cajoling them to make a great product. But to say he was the “creator” of all those ideas is very misleading and discredits what I am sure was an outstanding TEAM of engineers.
    http://auto.howstuffworks.com/lee-iacocca.htm

    One last thing which strikes at least equally as bad as the others. The suicides at Foxconn. Anyone who believes a guy as anal retentive as Steve Jobs had “no idea” the situation at the Foxconn plants, I am afraid is a little more naive a person than the average. You cannot massage/encourage the media’s interpretation of you as detail oriented and then turn around and say “Oh, I didn’t know” or after 17 people kill themselves say something to the effect of (and I am paraphrasing here) “Oh, it’s really not that bad, the workers have a pool at the factory”. To say it strains believability (much less insults human intelligence) is an extreme understatement.
    http://www.wired.com/magazine/2011/02/ff_joelinchina/

    http://www.nytimes.com/2010/06/07/business/global/07suicide.html

    http://www.telegraph.co.uk/finance/china-business/7773011/A-look-inside-the-Foxconn-suicide-factory.html

  3. So there is room for a “Moneyball” type revolution in CEO hiring. If underqualified CEOs are being overpaid, then by inference, overqualified CEOs are being underpaid. Thus it should be possible to hire a great CEO “on the cheap” and outperform your competition who hires a poor CEO for a princely sum.

    And in an actual free, competitive market, that is exactly what should happen. I wonder if I will ever see one of those.

  4. I know this might seem completely unrelated to the main point of your post, but what really stood out to me was that you chose to use the pronoun, “she”, when referring to overpaid, under qualified CEO’s. Unless you had someone very specific in mind (ie. Meg Whitman), it wouldn’t offend me in the least, if you used “he” to describe this particular class of people.

  5. Daniel Greenwood

    The data are compatible with other hypotheses as well:

    –Past CEO performance measured by stock price is no predictor of future success, because stock price is largely unrelated to company performance. 2/3 of it, after all, is related to market wide movements that have little to do with the company, and much of the rest may be related to fads, bubbles and crashes and other chaotic movements in the company’s reputation rather than its performance, or to governmental support or market regulation that has more to do with the lobbying division and political currents than the CEO and is unlikely to be brought over to the new company.

    –Past CEO pay correlates with company performance not because CEOs cause company performance, but because CEOs of successful companies have a larger pot of money from which to seize a share. Successful companies cause CEOs, not the other way around.

    –CEOs succeed by inspiring other executives to compete in a tournament or lottery with a huge prize — work hard today for a chance to become a vastly overpaid CEO later. By hiring an outside CEO, the board makes clear that the tournament is an illusion and thereby destroys the very benefit of having an overpaid CEO in the first place.

    –CEO success, like stock picking performance, is largely a matter of luck, so past success does not predict future success. After all, CEOs rarely design the product and can only indirectly inspire marketing or quality production. However, again like stock picking, there is a large group of CEOs who are actually value destroying: it is not hard for a leader to rapidly damage the company. So hiring a “good” CEO is much like hiring someone who has been “good” at winning craps. Chances are excellent that you are either paying for past luck that won’t be duplicated or falling for a scam artist.

    –Much CEO success in raising stock price results from short-term value extraction: mining reputation by cutting R&D or quality control expenses; creative accounting or mergers that allow reporting profits now and deferring expenses to later or hiding routine expenses in one time charges; financially driven transactions that, in the right market, can create the appearance of profits, such as increasing assumed rates of returns on pension funds; defaulting on implicit contracts with employees to cut expenses short term but with productivity and morale costs long term; and the like.

    CEOs of this sort are highly likely to have short term success followed by later, larger declines. However, they will only be hired away from their former firm if the second half of the cycle hasn’t happened yet. Moreover, boards are most likely to look for an outside CEO when their own firm is suffering from the second half of the cycle already. Accordingly, the quick fix that the board is looking for is highly likely to make the problem worse — hiring a CEO who knows how to create short term appearance of success at long term cost to cure a company that is already suffering the long term problem is much like trying to cure a patient suffering from excessive blood drawing by hiring an expert blood drawer whose last patient seems to be doing well.

  6. “But what do the new firms get for this pay premium? It turns out that their future performance, measured in terms of return on assets and operating return on assets, is negatively associated with excess compensation based on prior performance.*”

    Well, so much for rational expectations. ;)

    Perhaps this phenomenon has a simple statistical explanation: regression to the mean. That is, the people doing the hiring are not taking the chance factor into account. I do not mean that the performance of CEOs is just luck. But chance is surely an element, and the performance of the top performers in one time period is likely to be less good in the next time period (or in the previous one), even if they stay in their current position. If we assume that the hiring committee has selected candidates from the cream of the crop, then, although the difference in performance between that group of candidates and other executives may be based on ability, the difference between two different candidates is due largely or wholly to chance. If you pay for those differences, you are paying too much.

  7. Mike Toomey is a big part of why Perry wins elections.

    http://www.texastribune.org/texas-politics/2012-presidential-election/in-perrys-texas-the-man-behind-the-curtain/

    Texas Lobbyist Mike Toomey is Force Behind Rick Perry

    by Ross Ramsey, Jay Root and Jim Rutenberg, The New York Times
    10/14/2011

    Behind every politician there are men and women working in the wings, operatives who can make calls, fix problems, raise money, punish enemies.

    In Rick Perry’s world, one man stands above them all: Mike Toomey.

  8. Relating more directly to Mr. Kwak’s post, I think if Mr. Kwak is not familiar with W. Edwards Deming, he should put it at the top of his priority list immediately. And by “familiar” I mean being able to spout off from memory Deming’s 14 points and other key thoughts “Seven Deadly Diseases” and “A Lesser Category of Obstacles”.
    http://www.amazon.com/New-Economics-Industry-Government-Education/dp/0262541165/ref=sr_1_3?s=books&ie=UTF8&qid=1318811190&sr=1-3
    Deming’s general philosophy of quality as defined by Japanese familiar with him (from I ashamedly admit, Wiki):
    Quality equals results of work efforts divided by total costs.
    Quality tends to increase and costs fall over time. However, when people and organizations focus primarily on costs, costs tend to rise and quality declines over time.

    Based on this definition it’s easy to see why America is losing. We have people in junk bond markets, people in credit default swaps, and those in the higher ranks of investment banking, who are adding nothing to the system, but subtracting extremely high costs with their salary and bonuses. And the negative externalities caused by credit default swaps and bundled loans sold as “securities”.

    And what causes the extreme unhappiness in America currently?? The extreme anger and extreme frustrations in America now, and even has a strong relationship to OWS demonstrations in the major cities??? Read about or even watch a video of W. Edwards Deming performing his “Red Bead Experiment” and it becomes amazingly easy to decipher America’s current situation.

    There are some who will say Deming’s ideas sound “early ’90s”. That Deming’s concepts are “antiquated”. And those same people who say Deming’s ideas are “antiquated” are part of the problem

  9. Past performance is not a predictor for future returns. Sounds familiar? This is the same observations found in investments, be it star analyst, fund mangers, or stocks. People are always looking for the magic bullet, in this case, the savior. While there are Steve Jobs and Warren Buffet and there will always be exceptions to the norm, most people are, well, normal. The compensation incentive schemes ignore ordinary hard work and rewards luck instead.

  10. I recall there was a study done many years ago that showed how stock performance was inversely correlated to the variance in pay levels between top executives. I would imagine that paying big bucks to bring in a perceived superstar without commensurate rises for his or her underlings would increase pay variance and may produce this effect. If memory serves I recall that this phenomenon also existed in companies that did not hire externally– or even hire at all. What wasn’t clear was the driving mechanism, whether it was overconfidence on the part of the star, or lack of cooperation from the rest of the executive team due to perceived inequity. Or maybe the offer had to be large to draw a name brand onto a sinking ship?

  11. @Moses

    Thanks for the links – it’s very very very sobering how far gone we are thanks to militarism…Which social engineering cult relegated Mr. Demming into a historical place of disrespectful oblivion at such speed? You have to ask if you want to figure out a way around them – we are at war, after all…

    Whenever a new industry is grown, such as organ transplants, so many dams are erected cutting off water to other life-supporting industries. New age *management* at the global non-USA corp that grew the organ transplant industry were upset recently with a USA born citizen quality control contractor with 20 years of experience who had the audacity to figure out a way to own a home in USA based on the *small private business* of providing as-needed quality control. When challenged as to why they were able to lay hold on all her private financial information and use it as a case for lowering the salary of quality control staff even more than 40%, HR promptly put together *proof* that she did not *LIKE* the corp and “good luck to you in the future, you’re going to need it”.

    Health care is the most vital industry to address in slowing down collateral damage to the human sepcies based on an *investor* class that is criminally predatory.

  12. peacnic: “In Rick Perry’s world, one man stands above them all: Mike Toomey.”

    Your point being that Rick Perry pays Mike Toomey too much money?

  13. Annie, Dr. Deming was simply a victim of the arrogance of post-war American business management, who mistook – or refused to see – that being the last country standing in a world devastated by war does not mean that your products are superior. Instead of concentrating on making the best possible products, American business instead concentrated on improving marketing, focusing on business methods that used styling and window dressing to induce consumers to replace more rapidly rather than repair and maintain. For a generation this worked, but after that the war-damaged economies rebuilt, and rebuilt better from the ground up, focusing on the next generation’s success rather than their own generation’s.
    In the 70s the attempts of American management – GM’s laughable misreading of the reasons behind Japan’s sucesses comes immediately to mind – were at least in the right direction if faltering owing to their need to focus on short term financials and not the massive cultural change that Deming methods require.
    Ford at least understood what was required and had the courage to undertake the cultural change needed. But it wasn’t really until the data-driven 6-sigma production methods of Silicon Valley spread across the country that Deming-think reached critical mass. His methods, though not identified as his, are pervasive in many of our remaining manufacturing firms. It’s unfortunate that during this time the American economy turned away from manufacturing into financial rent-seeking. If we had applied Deming’s methods to the working of the FIRE sector in the 80s, methinks we would have a radically fairer and more competitive economy.
    Soapbox off.

  14. @oregano – “For a generation this worked, but after that the war-damaged economies rebuilt, and rebuilt better from the ground up, focusing on the next generation’s success rather than their own generation’s.”

    And which countries would those be? Here’s the top 10 most polluted countries on earth released by World Health Organization:

    10. Kuwait
    9. Nigeria
    8. Iran
    7. UAE
    6. Egypt
    5. Saudi Arabia
    4. Senegal
    3. Pakistan
    2. Botswana
    1. Mongolia

    The rest of your analysis is also fraught with more *perception is reality* than reality and an utter waste of time to converse about especially when I gave a specific example of a new industry – human organ transplants – that is NOT the freekin’ puerile gizmology success story of Lalaland – there were HUGE wastes and loses with gizmos that never took off – stop acting like gizmologists are the saviors of the planet and had more than one flop – you don’t even have a video game to play *pretend*….

    It is absolutely fair to call 1% of citizens a *cult*. I think we have as much evidence as we had from *Jonestown* after Jim Jones cult with regards to *financial instruments*. A *demon* is a *demon* because he consistently chose the most diabolical methods available to get ahead.

    Get over yourselves…

    More misery for others = More $$$$ for ME ME ME

    They have MY financial records all along – do you have theirs? WTF is that – not demonization of the innocent?

  15. @annie, I was just responding to your question, “Which social engineering cult relegated Mr. Demming into a historical place of disrespectful oblivion at such speed?”. My point was that his ideas were eventually adopted by his home country. He’s in no way disrespected in manufacturing circles these days. I don’t think that gizmologists are the saviors of the planet, but treating workers as if they were worth something is, and was at the core of Deming’s methods. That and the primacy of the product’s benefit to the consumer. And yes, any tool, even one as powerful as Dr. Deming’s, can be misused by a technocracy, as China’s current ecological miseries and your top 10 list attest. I was making no points as to the desirability of any current sociopolitical system. As to the rest of your post, I admit, I have absolutely no idea what you’re talking about. I made the mistake of thinking that your question was a sincere request for information rather than a rhetorical launching pad. For that I apologize. But I wasn’t attacking you, and I’m somewhat perplexed as to why you would think that my comments were, or so devoid of value as to merit such derision.

  16. Okay, Oregano – you don’t know what I am talking about and you are not open-minded enough to consider that that is not my problem and/or a problem with me…

    Someone else gets it, a political pundit wrote, in part, “While much of the class warfare waged on the poor in recent decades has taken an economic form through stagnant or declining real wages for working people, tax cuts for the wealthy and the like, there has also been a psychological, even spiritual, component of class warfare as well. The right wing has sought not just to make poor people poorer, but to delegitimize the hopes, aspirations and even opinions of working people. Half a century ago, for example, labor unions were understood by many to be an important part of our political and economic system, helping ensure fair treatment for their members while contributing to the wealth and productivity of industry. Over the last quarter century or so, labor unions have been demonized as parasites dragging our economy down. Similarly, public institutions including schools, universities, libraries and social services used to be understood as playing a valuable role in expanding opportunities to all Americans ensuring that everybody who worked hard had a chance at a better life. Now these institutions are dismissed as socialism by an angry and aggressive right wing.”

    I did not hear one peep from Silicon Valley so I don’t get when *critical mass* was reached – you wrote, “But it wasn’t really until the data-driven 6-sigma production methods of Silicon Valley spread across the country that Deming-think reached critical mass.”

    So how could *critical mass* have been reached and STILL you don’t want a connection to the human being – your view, “I was making no points as to the desirability of any current sociopolitical system.”

    You like Demming’s organization of labor and manufacturing, but you still don’t like labor?

  17. Good GAWD, @Annie, you have COMPLETELY misinterpreted my comments. I was NOT making an anti-labor statement. Far from it, I think that the working class has been completely screwed over repeatedly. I fully agree with the pundit you cite. Deming actually attempted to give the worker more power over their jobs and the quality of the product, an approach directly opposite that of the “scientific” school of management that turned workers into not much more than mindless automatons to be considered liabilities, not assets. Again I’m confused. I’m only elaborating on Moses Herzog’s comments provided with his Deming video links and offering some of my own observances from my own industry, which is indeed high tech. If those observances are incorrect, I willingly stand ready to be enlightened. But please consider that we may just be talking past one another here.

  18. @oregano – we are in agreement about Labor, so let’s leave it at that…

    CEOs are *labor*, also, and it looks like the topic is about whether the more you pay for them, the more of a *mindless automaton* they’ll become :-)

    Anyone can be a CEO these days! But I guess there is still the requirement that you have to follow the *elite* ideology rulr book for cutting certain kinds of employees and not get creative about who gets axed. In general, they like the controlled addicts of one kind or another…easiest group to manage psychologically….

  19. David Greenwood
    “–CEOs succeed by inspiring other executives to compete in a tournament or lottery with a huge prize — work hard today for a chance to become a vastly overpaid CEO later. By hiring an outside CEO, the board makes clear that the tournament is an illusion and thereby destroys the very benefit of having an overpaid CEO in the first place. ”

    This is an excellent argument. It always seems odd to me, that we think both that good managers are good delegaters and we make the pay proportional to the size of the company. Both ideas can’t mke sense at the same time.

  20. Can’t see the actual model, don’t have free access to SSRN papers anymore. If the model fit is good (Rsquared, or other measure), then there’s a pretty good argument for using the predicted data. It may help control for changes to the CEO as they move from one job to the next (age, experience, etc.) More importantly, it shows that a decent statistical model an be used to quantify the value of a CEO better than the hiring committee, and thus the hiring committee is biased. (Otherwise, you might argue that the hiring committee did the best job possible – but clearly, a simple model can beat the hiring committee.)

    Many explanations for the relationship are possible. One big question is whether it’s an incentive problem or purely a selection problem. It’s possible that paying people TOO much causes them to contribute less…

  21. @oregano – link to explain the Jim Jones/Jonestown lessons-learned and what the story has in common with the 1% shenanigans….

    There is enough evidence to take the 1% *cult* to trial for crimes committed. The harder that embedded ideologue judges dig in against doing that, the worse it will get….

  22. Peter Principle

    “The more of a superstar someone is at Company A, the more likely the board of Company B is to overlook . . . things . . . like not having experience in the industry, or with the new company’s customer base, or having led Company A through a different phase of its lifecycle . . . or not having the skills that Company B needs at that point in time, or any number of other things.”

    Like the possibility that the CEO’s previous “success” was the product of sheer luck, or of economic or industry trends completely outside his/her control, or to complex group dynamics that can’t be attributed to any one person?

    I’m going to guess that this is a line of inquiry the Business Roundtable would prefer to head off.

  23. Hi!! James!! First, this blog is great for me to learn and know better about the crash of 2008 and support occupy wall street in the most informed way possible. This question is out of topic. I am really concerned about what is going on right now. A Senate panel is looking at the rising popularity of Exchange-Traded Funds (ETFs) in the financial markets.

    http://www.c-span.org/Events/Exchange-Traded-Funds-Scrutinized/10737424899/

    If anybody can enlighten me about what is going on! I would really appreciate it.

    Just by watching the entire hearing it smells like rotten chicken(wall street is going to foul us again?)

    Background! I am a stay at home mom eager to learn. I have a bachelor degree in Mathematics from the University of Texas at El Paso. I can understand some technicalities but try to explain it as simple as possible. PLEASE!!!

    Thanks in advance!!! Keep blogging and enlightening all the bloggers and commenters.

  24. lblankfien | Oct 19, 2011 09:53 AM ET
    Concentration of money has never been greater.
    FACT: 1200 people control 40% of the worlds wealth.
    Mix in the fact that some of them are sociopaths and kleptomaniacs and you have one big clusterphuc.
    If the Earth has 6 billion people this means that these 1200 people have control of more money than 2.4 billion people. Any questions?

  25. http://money.msn.com/investing/americas-highest-paid-ceos?cp-documentid=6866482

    McKesson in #1 – a megacorp devoted to spinning out the data enough to make sure healthcare is un-affordable for 40 million USA citizens…

  26. Steve Jobs just managed, finally, to learn how to price a product. It only took 30 years. If he had figured it out 25 years ago, microsoft would be a second rate company.

  27. The performance by a leader or anyone in the past couldn’t dictate future returns. Even those not performing well in the past can eventually become “the big man” in the future. Same goes with people in debt, there’s always the possibility of recovering and even make 6 figures. How do i get out of debt?

  28. Hi! i’m Re-twit you post: to my @asbaitrd twitter