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What should CEOs earn?

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Jake VanKersen: Are CEOs overpaid?

Usually, when we talk about this subject, it’s in terms of the ratio between what a CEO is paid and what employees make. And hey, listen, while that conversation is one worth having, Morningstar recently looked at it from a different perspective: Is CEO pay appropriate relative to the value they create for the companies they lead?

Simply put, are CEOs worth what they make?

Now, it’s probably not helpful to do an apples-to-apples comparison between, well, something like Apple and Union Pacific. Instead, it’s better to look at CEO pay across sectors.

Joshua Aguilar: We found that industries with higher predictability allowed compensation mechanisms to work as intended. More volatile sectors, however, need better compensation mechanisms to better align CEO and investor outcomes. For example, defensive sectors’ CEO compensation generally offered great return for shareholders. In comparison, energy sectors CEOs were paid higher but failed to create any shareholder value during the most recent bull market. That’s because of the widespread use of relative total shareholder return when crafting CEO compensation plans.

The problem with relative TSR is that it measures performance primarily against a self-selected group of peers. So, not only is the deck stacked but relative TSR has allowed management teams to double dip and benefit both when oil rises and falls.

VanKersen: One of the companies in the energy sector, Chesapeake Energy, is worth focusing on for a minute. The company filed for Chapter 11 bankruptcy protection on June 28, 2020. In the process of looking over their books, then-CEO Doug Lawler discovered that his predecessor had the company paying for things like $110 million for two parking garages, a wine collection in a cave behind a utility closet, and an NBA season-ticket package to the Oklahoma City Thunder, among other things. And although most of this shocking behavior didn’t occur under his watch, things weren’t much better for shareholders under Lawler. Economic value created was a negative 2.4% over the most recent 10-year period prior to Lawler’s retirement, and the stock price fell nearly 44% in 2018.

Yet, Lawler himself was given a raise that included a $1.25 million cash retention bonus.

With all that, you might be wondering why we just don’t focus on setting a CEO pay in relation to the employees of the company.

Aguilar: CEO pay ratios may certainly be important in the conversation relating to fairness and equity. However, there are several reasons we think the CEO pay ratio is suboptimal for investors.

First, the SEC gives companies wide latitude in how they compute this metric, which, at best, translates to less than ideal peer-to-peer comparisons.

Second, geography makes this metric less useful for investors. Companies with a large contingent of workers from developing nations are more likely to have a high CEO pay ratio.

Third, it’s hard to compare the CEO pay ratio across industries. For instance, manufacturing firms tend to have higher pay ratios than, say, professional services firms.

We think compensation committees should consider using legal instruments, like a rabbi trust, which operates like an M&A earnout. CEOs would earn performance credits when they meet certain milestones. However, these credits wouldn’t be taxable until payments accrue to CEOs, since they’d still be subject to forfeiture by claims of the company’s shareholders.

VanKersen: By tying CEO compensation to value creation, it can make it so that if shareholders suffer, so do CEOs.

Kristoffer Inton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.