Book Review: The CEO Pay Machine

When you laugh out loud as you read a book on a train, people may want to know what you are reading. They aren’t expecting you to say, “Oh, a great new book on executive compensation.” I wasn’t expecting to be chuckling myself, or to be so entertained by former CEO and board member Steve Clifford’s, “The CEO Pay Machine: How it Trashes America and How to Stop It.” But I was, and I begin the review this way because wit and wisdom are closely linked qualities.

The wit makes for pleasant reading, but the wisdom of the content is key, and clearly both spring from a sharp mind, filled with curiosity and reluctant to accept “that’s the way it is done” as an answer. Clifford was CEO for 14 year of communications company King Broadcasting, but it is the time he has spent on compensation committees that edifies the most.  Much writing on pay focuses on the amount paid; this book focuses on the whys and hows. It was inspired by the questions Clifford asked as a compensation committee member, and the answers he received.

After introducing his story, and walking through an imaginary fairy tale of setting pay, he devotes two chapters to explaining why this book merits a read by the broader citizenry.  One of these framing chapters is titled, “how the pay machine harms companies and shareholders” and the other is “how the CEO pay machine curtails economic growth and weakens democracy.” Both are quite compelling and crucial.

In subsequent description of the pay machine, Clifford takes apart all the components with a fresh eye. He is skeptical, for example, of the mantra of pay for performance. He notes that bonuses that don’t change behavior are a waste of money, and that many that do change behavior may change it for the worse. “All pay-for-performance systems cause more harm than good,” he writes. “They generate perverse incentives, undeserved and often absurdly high bonuses, and damage the companies that use them.” He offers concrete examples of ways CEOs can influence the setting of goals and targets as well as their achievements. “All of us, CEO’s included, would like to receive a bonus for fogging a mirror. Heads I win, tails I win. CEOs can often negotiate this happy result. “

He is similarly suspicious of peer groups and of “best practices.” As he notes, the evolution of pay includes many suggested adoptions of innovative governance-friendly ideas. But he points out that in order for a practice to become broadly adopted, “The practice must work to increase CEO pay. As a class, CEOs were able to veto any practice that diminished their compensation, so by this Darwinian selection, the Pay Machine evolved to relentlessly push the numbers into the stratosphere.”

He also speaks with great insight about the role of directors. “It’s impractical, if not impossible,” he notes, “for board members committed to being supportive players on the team to transform themselves into hard-nosed negotiators.”

A fascinating section of the book is an in-depth dive at pay of four highest paid executives at the time he was working on the book: Charif Souki of Cheniere Energy; David Zaslav of Discovery Communications; John Hammergren of McKesson (in the news again this week) and Stephen Hemsley of Unitedhealth Group.

Clifford takes apart the suppositions underlying much of compensation today, which he describes as delusions. The “importance delusion” overestimates the power of a particular individual on a company. Clifford believes that “CEO skills are largely company and industry specific.” Thus he disputes the pay-defender point that CEO compensation is analogous to that of super-star athletes. “A CEO changing companies,” writes Clifford, “is almost like an athlete who switches sports.”

Likewise Clifford questions whether bonuses truly motivate executives to do their very best work. As he does throughout the book, Clifford sites academic studies. In this case, “A meta-analysis of 128 studies of human behavior demonstrated that large monetary incentives tend to decrease motivation and performance.”

But as also seen throughout the book, it is his analogies that are the most powerful. He identifies “the performance delusion” as that corporate boards can effectively measure and reward CEO performance. Here he notes, “I could observe an evening of roulette and conclude that the best gamblers were rewarded for their performance. How do I know they were the best gamblers? Easy. They won the most money.”  This is essentially what some compensation consultants do in defending a link between pay and performance.

The “alignment delusion” is that “stock options and measurable bonus goals align the interests of the CEOs and shareholders. Clifford notes as many others have noted before him, “A shareholder pays for his stock and bears downside risk.”

The book concludes with suggestions for reforming the system. Clifford proposes higher salaries, elimination of cash bonuses, and half or more of compensation over long-term vesting. The awards he envision would not vest in their entirety until the CEO leaves or retires, and even then only if the shareholders have benefitted over the time the CEO was in office. In addition, a luxury tax would be included on every dollar over $6 million.

I think these are some fine ideas though I am skeptical that they will ever be enacted. Still, as Clifford writes, “Long accepted theories and practices can’t be replaced by outrage. They can be replaced only by better theories and practices.” A certain level of outrage, however, is a necessary if not sufficient to move this topic forward. Clifford has done a great favor by writing the book that may inspire a nuanced and sophisticated outrage among shareholders and citizens across the country. Everyone should read it.