Are CEO salaries justified?

While corporates have an image for poaching top staff from rivals with huge financial enticements, research seems to show the opposite is true. Many CEOs are long-standing one-company people whose loyalty is eventually rewarded with the top job.

By James Johnston, a lecturer in economics at Paisley Business School. Tenure, Promotion and Executive Renumeration was published in the May edition of Applied Economics.

Media hyperbole and political points-scoring often obscure the important concerns that lie behind the issue of CEO pay.

High-profile scandals, such as the Robert Maxwell pensions affair, have highlighted the importance of companies putting adequate safeguards in place.

The absence of a link between executive rewards and company performance may indicate that internal controls on managerial discretion leave something to be desired. Trade and industry secretary Patricia Hewitt echoed public anger at the seemingly relentless rise in directors' pay last November when she said: "All too often directors are lavishly rewarded for lacklustre or even poor performances."

Quite apart from the spectacle of unjustified enrichment, there is also the worry that badly designed CEO remuneration packages may damage profits, shareholder returns and jobs.

Union leaders have been particularly vocal in their criticism of the juxtaposition of inflation-busting pay rises for directors and the more modest settlements for their members. Responding to an Incomes Data Services survey on executive pay, TUC general secretary John Monks said last October: "Executives' pay rises show no sign of letting up. We need to see some boardroom restraint especially in such uncertain economic times."

It is possible that if worker discontent on this issue is not addressed satisfactorily, it may eventually dent worker morale, lower productivity and sour industrial relations.

When defending high levels of executive pay, the most commonly heard justification is that they are needed to attract, motivate and retain the best executives for Britain's leading companies. Underlying this view is a belief that CEOs are highly-mobile, market-responsive workers who will quit one job and move to another as soon as it is financially beneficial.

Yet it is difficult to find good evidence on the extent of mobility among top executives. Recent research from Paisley Business School suggests most CEOs had not been lured from rival companies but had risen through the ranks, often after a long-term employment relationship.

On reflection, there are good reasons for believing companies may prefer to promote internal candidates:

- Long tenure may be a sign that a bond of mutual trust and respect has been forged between the CEO and firm.

- Successful bonding may stimulate the acquisition of productivity-enhancing, company-specific skills. Executives are more likely to expend effort on non-transferable expertise if they expect the employment relationship to last.

- CEOs who underperform will quickly come under pressure from investors to leave the company. That a CEO has held his or her job for some time is in itself an indication of some success.

- Elevating an internal candidate to the post of CEO is less risky because the selection committee may already have high-quality information on important personal traits such as honesty, loyalty and motivation. It would not be surprising if companies were even willing to pay a premium to avoid the risks connected with hiring a newcomer to such a pivotal post.

- Firms filling top-level posts from outside may find this damages the motivation and commitment of failed internal applicants.

However, there are circumstances where an outside applicant will be favoured. If there is to be a shake-up at the top of a failing company, shareholders may demand a new person be hired. Whether a company will promote from within or hire from outside will be the outcome of a delicate balancing act and depend upon the business and the executive.

Paisley Business School constructed a sample drawn from Britain's largest companies (ranked in terms of turnover), examined annual accounts for 1995/96, and gleaned detailed information on factors such as CEO work histories (including job and company tenure) and remuneration. After excluding companies where the information was incomplete, we were able to analyse some 220 of Britain's industrial giants.

Support for the belief that CEOs and firms often enjoy a long-term employment relationship became clear when we found that only 21 per cent of CEOs had company tenure of less than three years. In contrast, some 60 per cent of CEOs had been with their current employer for more than six years. The typical CEO had worked for the same company for 11.3 years, with the longest-serving individual boasting 48 years of company service.

Among the numerous examples of these highly-durable employment relationships is Lord Browne at BP. He joined BP in 1966, became an executive director in 1991, and CEO in 1995. His case is the rule rather than the exception.

Despite half of the individuals sampled having been a CEO for less than three years, we were careful not to jump to the conclusion that tenure as CEO is typically short - the flipside of this is that half of our CEOs had been in the job for more than three years. One quarter of those studied stayed more than six years.

It is also important to remember many of the CEOs with job tenure of less than three years will be offered new deals. The often prolonged nature of CEO tenure was clearly evident in the results of our study. Additionally, we found that average CEO remuneration tends to rise with CEO tenure. The empirical evidence clearly rejects the argument that short-tenure CEOs will earn more as they have had to be poached from rivals. Rather, high pay levels appear to reflect efforts to retain successful appointments.

So is it better in theory to appoint from within or hire from outside when filling the post of CEO? Most of our CEOs (59 per cent) had been promoted internally, and the average basic salary for this group was some £558,339, compared to £475,462 for those recruited externally.

In conclusion, much of the public debate on executive remuneration focuses on the need to pay high salaries to attract, motivate and retain the best executives. Yet most of the CEOs in our sample had not been recruited from other firms but had been promoted internally, often after a long-term employment relationship.

Taking account of the work history of CEOs may help us to better understand their current remuneration levels. The common perception that a CEO's contract is typically a short, but highly-rewarded one, is not borne out by the data. Many top executives enjoy long company tenure, and those who achieve the top job through internal promotion appear to do particularly well in terms of financial rewards.