If American corporations want to regain their global leadership, visionary boards should be drastically reviewing the way they are appointing and compensating their top leaders, while leading a major cultural change and reskilling all workers.
Back in 1965, CEOs earned 21 times more than the average worker; by 2023, this ratio had escalated to 290 times. The situation is even worse for 100 out of the S&P 500 corporations, where in 2022 this ratio was 603 times. As a result, real (inflation-adjusted) CEO compensation in large firms increased by 878% from 1978 to 2022, while real worker compensation rose by 4.5% during this period.
As the following two graphs show, between 1938 and 1970 it was workers who increased their pay in constant terms; from 1970 on, it was large-firm CEOs who increased their real income more than 900%.
View this interactive chart on Fortune.com
View this interactive chart on Fortune.com
Strikingly, before 1970, large firms’ real value grew at its highest rate of 6.1% per year, yet their CEO pay growth was 0.1% per year. In stark contrast, after 1970 the growth in large firms’ real value declined to 5.2% per year, while their real CEO pay increased by 4.6% per year (921% total through 2022). Clearly, increased pay has not been driving performance up.
What changed starting in 1970 is the result of three negative forces: the increased visibility of executive compensation, the resulting growing participation of search firms with contingent percentage fees, and the most powerful force: an unconscious, MRI-verified, dysfunctional automatic response of our brains to increased pay visibility in workers, executives, and directors.
In 1970 Forbes magazine published the Forbes 800 scorecard of the highest-paid CEOs. Higher-paid CEOs became apparent to the public and other chief executives, who suddenly felt unfairly paid. Directors listened. Compensation consultants saw their fees multiply from then on. Most companies wanted to be in the top compensation quartile, a mathematical impossibility precipitating an unstoppable upwards spiral. And when the SEC made CEO pay instantly observable at www.sec.gov, the explosion of CEO real compensation became exorbitant for the following eight years, with an incredible 27.6% yearly growth rate for the top 50 CEOs.
At the same time, executive search firms were having their best time ever. However, two perverse incentives pervasive in the profession further inflated executives’ compensation and reduced economic growth compared to the 1938 to 1970 period: Contingent fees generated an excessive hiring of outsiders (up to 10 times larger than economically justified for CEO searches of American largest corporations) and a reduction in talent development, which reduced S&P 1500 real value growth by a full percentage point per year, while inflating executives’ compensation both to retain leaders as well as to pay a premium to attract external ones. Percentage fees boosted compensation even further, favoring the more expensive external candidates (typically male) rather than the most competent ones.
To fix the pay gap between the C-Suite and workers, we propose four initiatives:
Hire and select CEOs with a greater focus on values and potential
In 2024, 44% of new S&P 1500 CEOs were hired externally. This is ridiculous. Does this mean that almost half of the largest American companies, many of which have tens of thousands of employees, didn’t find just one qualified internal successor? What have they been doing?
Furthermore, 21% of new CEOs had prior CEO experience and the average age of incoming CEOs rose to 55.7 years, even though new CEOs tend to deliver stronger performance.
Rather than promoting excessive external hiring of executives, and particularly mature CEOs, from other companies (further inflating compensation with each switch and degrading talent development), companies should be placing a much larger focus on potential when selecting their leaders, and especially their CEOs. Potential should trump experience and even current competence, because even if someone today has the perfect competency for their current job, what got them here won’t even allow them to stay here if they do not have the potential to continue growing, changing, learning, and self-reinventing.
Drastically change compensation perspectives and practices
The strongest source of motivation is internal and not external, though external incentives can help if properly aligned with internal motivators. However, external motivators are tricky. Financial incentives trigger one of the most primitive parts of the brain, the nucleus accumbens, which is associated with our “wild side.” Scientists call this region the “pleasure center” because it is linked with the “high” that results from drugs, sex, and gambling. To avoid documented destruction of firm value, companies should make sure that financial incentives are not exaggerated and are properly aligned to build lasting greatness.
In addition, the impact of compensation systems for achieving outstanding levels of lasting greatness appears to be quite limited. When Jim Collins was asked how important executive compensation and incentive decisions were for building a great company, he concluded, after more than 100 analyses, that his research could find no pattern. His conclusion strongly reinforces the argument that decisions about whom to pay in the first place are much more important than how much or how.
Build a collaborative culture
We also need to shift from individual to collective incentives, since in today’s knowledge economy value comes from collectively creating and seamlessly sharing information.
Corporations should learn from the best professional service firms, where we find two basic compensation systems: The prevalent one (particularly in the U.S.) is eat-what-you-kill, in which people’s pay directly reflects the business they generate and the work they produce for clients. The second model is the lockstep, in which people’s pay is unrelated to their personal contribution and instead varies according to some preestablished formula related to years of service, years as a partner, or participation in local, regional, or even global profits.
While most professional service firms follow an eat-what-you-kill system, in nearly every sector there are a few locksteps which tend to have the best reputation, the highest profitability, and the nicest culture. Why? Because, as illustrated by Egon Zehnder in his Harvard Business Review article on “A Simpler Way to Pay,” the best professional is assigned to each client’s need and professionals collaborate, sharing information seamlessly. This increases value to the client (and therefore prices) and productivity, all of which explains why lockstep firms tend to have the greater reputation, climate, and profitability. Even smart private equity firms are realizing the power of treating all employees equitably, as illustrated by Pete Stavros, KKR’s global co-head of private equity; Pete founded Ownership Works to implement systems to treat all employees as owners, including stock pay, at KKR’s acquisitions.
While shifting to collective incentives, top leaders should be focusing on culture as a filter for hiring while mastering compassionate coaching. These hiring and coaching practices demand extraordinary discipline. But they help visionary leaders create a culture of unconditional love that perpetuates itself and binds their team together into a whole much bigger than the sum of its parts.
Urgently commit to reskilling the American workforce
As Raffaella Sadun and her coauthors write in their award-winning HBR article on “Reskilling in the Age of AI,” as the pace of technological change continues to increase, millions of workers may need to be not just upskilled but reskilled—a profoundly complex societal challenge that will sometimes require workers to both acquire new skills and change occupations entirely. Companies have a critical role to play in addressing this challenge, but to date few have taken it seriously. However, they will need to do it if they want to not only adapt dynamically to the rapidly evolving new era of automation and AI, but even to survive and prosper.
America could learn from Singapore, which succeeded by investing large portions of its public budget in education, a strong civil service, and the development of great leaders, proactively moving its economy away from basic manufacturing to higher value, technology-based manufacturing, then to knowledge-based R&D sectors. This has allowed Singapore (which constantly watches the Gini coefficient to avoid excessive inequality) help its workers not only stay competitive and grow the economy but also live better. While the USA’s average real wage for production and non-supervisory workers has increased at a mere 0.1% per year since 1978—far less than real GDP’s 2.5% growth—Singapore’s wages have matched its extraordinary yearly real GDP growth of 4.8% for decades.
* * *
The pay gap between the C-suite and workers needs to be fixed. Unless the current dysfunctional response to pay visibility is rapidly corrected, the perceived unfairness will create increased political violence, populism, and social unrest. American corporations will lose the global battle, employees will continue losing purchasing power, organizations will turn into increasingly miserable places (the U.S. last year fell to its lowest ever rank in happiness), and society will grow increasingly divided.
However, visionary boards and leaders have a way to revert this trend by hiring and developing great ethical leaders with a stronger focus on potential, changing compensation practices, and developing a unique winning culture where proud employees will feel fully appreciated, rewarded, supported, encouraged, engaged, and developed.
Claudio Fernández-Aráoz is a frequent lecturer at Harvard Business School, a former partner and member of the global executive committee of Egon Zehnder, and the author of It’s Not the How or the What but the Who. Greg Nagel is a finance professor at Middle Tennessee State University who previously worked 20 years at General Motors and on its joint venture with Toyota.
The opinions expressed in Fortune.com commentary pieces are solely the views of their authors and do not necessarily reflect the opinions and beliefs of Fortune.
This story was originally featured on Fortune.com
Recent Comments