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Rewarding the Top Dog
The media, institutional investors, and even government officials all seem to have an opinion about CEO compensation, often criticizing how and how much top executives are paid. But do CEOs really dictate their own paycheck, and is their pay as overinflated and far removed from company performance as critics imply? Not at all, according to HBS professor Jay W. Lorsch, whose 1998 working paper, "Compensating Corporate CEOs: A Process View," examines the procedures and forces that drive CEO pay packages. Lorsch found that CEOs do not dictate their own salary, that a number of internal and external factors have an impact on their pay, and that, in fact, today's CEO compensation packages are tied very closely to company performance.Lorsch began his study by looking at the proxy statements of 72 companies representing four categories: sustained performers, growth companies, turnaround companies, and low-performing companies. But in order to focus on how compensation decisions are made, he garnered most of his data from interviews with the compensation committee chairs from fifty of the sample's boards.
The interview results clearly showed the compensation committees to be in the driver's seat when making decisions about the amount and form of their CEO's pay package. While the committees would certainly take a CEO's input on his or her compensation under advisement, Lorsch contends that their comments indicate that they are the ultimate actors in its formulation.
The interviews also revealed that compensation committees face a number of pressures to keep top executives' pay at a certain level. Not the least of these, says Lorsch, are surveys performed by compensation consultants. These surveys provide data on the pay of CEOs from similar companies and can be an inflationary influence if a committee feels pressured to raise its own top executive's pay in order to keep up with the competition.
In addition, the sample companies favored the inclusion of stock options in CEO pay packages as an effective but inexpensive way to link their CEO's pay to company performance. "The evidence suggests that in contrast with what the critics have been charging, the compensation committees are doing quite a responsible job," Lorsch concludes.
Getting a Grip on Sustainability
There are as many interpretations of sustainability - the ability of an enterprise to ensure that environmental resources are replenished for future generations - as there are people discussing the issue. But with increased pressure on businesses to consider the costs of their actions to society and the environment along with the corporate bottom line, a clearer definition is needed. In his working paper, "Sustainability and the Firm," HBS associate professor Forest L. Reinhardt draws on the economics and accounting literature in developing a two-part test for sustainability that makes sense from an economic standpoint and that can be applied at the level of the firm.
Reinhardt writes that for a company to be sustainable, it must have a strategy or development path that maintains an undiminished level of net assets. He argues that if the prices in the firm's accounting systems are the correct ones, the injunction to maintain net assets is exactly equivalent to the familiar business imperative of creating value. "A firm that delivers cash to shareholders only by selling off assets is not sustainable," he says, "and neither is a firm that creates accounting profits only by liquidating natural capital stocks." Measures of a company's sustainability must consider not only the costs for capital, labor, and traded goods but also social costs like the effect of air pollution on health or even the value people derive from the continued survival of an endangered species. At the same time, managers are never evaluated solely on their ability to manage social costs. They also must create value when their inputs and outputs are valued at prevailing market prices: otherwise they cannot stay in business. "Realistic assessments of a country's or firm's sustainability need to consider its economic performance as well as its environmental performance," Reinhardt writes. "By this definition, sustainability is intimately linked to the fundamental preoccupations of business managers: productivity, investment, and profit."
Building on this logic, Reinhardt asserts that managers concerned about sustainability should support the development of governmental regulations that will clearly define and equalize both private and social costs. In addition, he urges firms to take a hard look at their own operations and develop measures for pollution control and natural resource preservation as well as for profits and investment.
Alumni may request copies of HBS working papers by calling 617-495-6852.
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