The Pay-for-Performance Fallacy
It's infuriating when CEOs reap big bonuses for lackluster results. But get over it: Bad executives eventually wind up overboard.
By Jeffrey Pfeffer

(Business 2.0) – NEARLY EVERY DAY, it seems, some commentator or another is carrying on about the disconnect between CEO pay and company performance. These "experts" are baffled as to why corporate scandals, executive prison terms, and accounting reforms have yet to remedy the situation. Well, having served as a board member at several companies where I helped set executive salaries and incentives, I'm going to let you in on a little secret: The correlation between CEO pay and performance is never going to get stronger. Let me tell you why, and why you shouldn't lose sleep over it.

Boards of directors determine CEO compensation the way sports teams make offers to athletes. First they commission surveys to figure out how much CEOs at comparable companies are making; then they rank their man or woman against the competition. Sounds reasonable, but in reality boards are less likely than George Steinbrenner to criticize players. One reason, of course, is that board members are often handpicked by the very CEOs they're evaluating. But even shareholder-appointed directors can be less than objective. That's because, as hired guns, board members are charged with governing their companies, which means that any compensation adjustment implying that their CEO is doing less than a stellar job is tantamount to admitting the board's own failure. Organizational behavior theorists call it the "above average" effect: Employees usually act on the belief that their own performance is superior to the mean.

Large bonuses tied to financial goals, such as sales and earnings targets, don't really solve the problem. Of course, when a company is on track to sail past milestones, performance-based payouts are anticipated and deserved. But when things aren't going well, everyone knows it long before bonus season. In those cases, executives inevitably start to complain that without lower, attainable targets they'll find it more and more difficult to come to work in the morning. Thus, even when performance is poor, pay stays high. That's not necessarily a bad thing. As Dave Morthland, former head of human resources at Willamette Industries (now a unit of Weyerhaeuser), points out, tough times are precisely when you want the best people you can find, and the best people don't come cheap.

Which is why a weak link between CEO pay and performance doesn't bother me, and why employees and investors—and those disgruntled commentators—should stop making such a big deal about it. Financial targets and share prices reflect many factors, including past actions, industry health, and macroeconomic shifts. Why make or break a CEO's pay based on outcomes that are in some ways out of his or her control? Should the Yankees, for instance, have cut manager Joe Torre's salary after last year's pennant loss to the Red Sox? Such a reaction could have cost the team a talented executive. Not that incentives don't have their place. One of the smartest views on pay for performance that I ever heard was from George Zimmer, CEO of the Men's Wearhouse, who gives employees a small bonus for meeting inventory-loss targets. Zimmer says financial incentives should be large enough to confer recognition and celebrate accomplishments, but not so large that they distort behavior.

Luckily, there's another mechanism by which companies ensure over the long term that CEOs earn their keep. As Jeff Miller, a partner at Redpoint Ventures who has served on several corporate boards, told me, "If you think your CEO is doing a good job, pay him accordingly. If not, get a new one." A recent study by Booz Allen Hamilton, in fact, shows an increasing rate of CEO dismissals in both Europe and the United States. Pay and performance can be out of whack for a while, but eventually CEOs who don't perform will see their compensation fall in line. Sometimes all the way down to zero.