Let's set the CEO's salary fairly, like this ...


The Problem

King III says that the CEO's salary should be set fairly' and 'responsibly'. King IV agrees with this and adds that it should be set 'fairly' and 'responsibly' in the context of overall employee remuneration. Also, that total remuneration should be 'transparent' and that remuneration practices need to be ethically sound.

Despite the existing requirement in King III to set CEO salary levels fairly and responsibly, history shows that this has seldom been the case. This is due largely to the 'ratchet effect', sometimes referred to as 'chasing the upper quartile'. The word 'ratchet' means to force something up or down. For example, to force something such as prices to rise or fall in level or intensity by deliberately applying pressure in successive and irreversible stages. Here is what it means in the context of executive salary levels:

The South African and International labour markets produce an array of professional salary surveys that cover executive positions and facilitate benchmarking. More to the point, however, is the fact that salary benchmarking data for CEOs, COOs and CFOs is readily available from company annual reports.

As this data is in the public domain, CEOs have full view of the salary levels of their peers. This is a most unusual situation as precise benchmarking data is typically not divulged to job holders. This unique set of circumstances creates a situation whereby the highest paid CEO in the peer group becomes the benchmark for other members of the group. Pressure is created in the system through the desire to pay the CEO above the average for the peer group. This sustained pressure gives rise to the ratchet effect whereby overall salary levels for specific groups of executives rise exponentially and far exceed the average market movements for executives.

Thanks to this unrelenting application of the ratchet effect, CEO salary levels have over many years risen way above those of their direct reports. While this practice does meet the goal of achieving external competitiveness, it clearly turns a blind eye to utilising the balancing criteria of internal equity. The current gap between CEO remuneration levels and those of their direct reports cannot (in the majority of cases) reasonably be defended on the basis of the actual differences in the value they add.

The gap between CEO salaries and their direct reports will get bigger every year if the ratchet effect remains in play. If it is not checked, the gap will become indefensible. This should not be happening under good corporate governance and it is therefore prudent to introduce some checks and balances.

The Solution

To achieve a 'fair' and 'responsible' remuneration level, two distinct criteria need to be met: the CEO's remuneration level needs to be externally competitive and needs to be internally equitable. It is incorrect to focus on only one of these criteria, at the expense of the other. However, this is essentially what has happened in the case of CEO (and other) salary levels.

In order to apply the principle of internal equity, we could bring into play salary data covering the CEO's direct reports and use this data as a primary reference point. Technically, the challenge is to come up with salary differentials between the CEO and his/her direct reports that fit the size of the company. Once agreed, the differentials will become targets to be achieved over a set period. To illustrate, the targeted differentials, using mid-points for their respective scales, could look like this: CEO 20% above COO, 40% above CFO and 60% above the average for all prescribed officers, excluding the COO and CFO.

If it is suspected that the ratchet effect has also unduly accelerated market rates for the company's CFO and COO positions, these would need to be discounted as well to arrive at an acceptable base for calculating the differentials. Plans would also then need to be put into place to bring these salary levels into line with those of the other prescribed officers.

All of this will require a culture change to one less tolerant of extreme inequality, a culture similar to that in Germany, Holland, Sweden and Japan but unlike the current cultures in the UK and US. South Africa has one of the largest wage gaps between CEOs and workers in the world and reinstatement of internal equity as a criterion for determining executive salaries will go a long way towards closing this gap. This will advance 'responsible capitalism' in South Africa and broaden faith in a market-driven economy.

Article produced by John Mansfield of Remuneration Management Services.

contact John at john@rms.co.za