Jacob Goldstein and Stacey Vanek Smith at NPR’s Planet Money did a podcast about why CEO pay exploded in the 1990’s. It’s an interesting story in itself, like a beautiful painting or football play.
But it’s the backstory we want. We’re interested in how big ideas manifest as small examples. Today we’ll dissect this twenty minute podcast and look for lessons to apply to our own lives and businesses.
1- Macro problems can influence micro actions. Goldstein and Smith explain that in the early 1990’s the United States was going through a recession but CEO’s were still “getting rich while laying off their employees.” That doesn’t seem fair.
Campaigning for the White House, Bill Clinton promises – and delivers – legislation that creates a $1M limit for what companies can pay a CEO and deduct as an expense.
This is an example of “part of the reason thinking,” an idea taught by Sanjay Bakshi. Anytime we have what we think is the answer, we should understand that it’s only part of the answer (part of the reason).
Why did the federal government change accounting laws regarding CEO pay? Part of the reason is that the United States was in a recession. Why at this time? Part of the reason was the election cycle. Why choose $1M? Part of the reason is that it’s a nice round number.
Wide sweeping changes like macroeconomic or culture, are always part of the reason something happened. We saw this with Chris Dixon who said that one of his investing perespectives is to ask if an entrepreneur is part of a larger trend like with AirBnB or Uber.
A never leads to B by itself, there’s always a bigger issue at hand that is at least part of the reason.
2- Nudges work best in certain situations. Summarizing the legislation, Smith says, “It was a nudge from the federal government to pay CEO’s less.” Companies didn’t have to pay a CEO less than $1M, but if they didn’t, their tax consequences would change.
Part of this change was to allow a CEO to get stock options. This solved two complicated problems with one solution – pay a CEO less and have their income tied to the success of the company. (Though if you read our How to Solve Black Box Problems post, you know where this is headed.)
The nudges failed, and here’s why.
Nudges work best when people don’t feel like they’re losing something. To put it another way, nudges work best at the start of something or a break in the action. Notice these three examples from Nudge:
– Drivers who have a default opt-in for organ donation when they apply for a license remain organ donors more often than not.
– Students who have healthy foods at the start of the lunch line will buy more healthy foods.
– Employees who have a default retirement plan save more than those who have to choose.
The common theme to each of these successful nudges is that it happens at the start of a situation where the person may not know exactly what to do. This was not the case with CEO pay.
CEOs were not new hires and knew what they had been making. They didn’t have either feature of a successful nudge. Added to this was the feeling of loss aversion.
3-Loss aversion is a powerful emotion. The best story about loss aversion comes from professor Richard Thaler (author of the aforementioned Nudge).
He writes in Misbehaving about the famous coffee mug experiment. Thaler handed out coffee mugs with the college logo to half his class. Thaler wondered how much the kids with the mugs would sell them for, and how much the kids without them would buy them for.
There was no reason (he randomly handed them out) that the kids who had the mugs would want them more. Thaler then created a market. Students who had mugs wrote down their selling price. Students without mugs wrote down their buying price. Thaler acted as the intermediary to match sellers and buyers.
There were none. That’s right, in some trials of this experiment the lowest seller had a higher price that the highest buyer. The average coffee mug seller wanted $5.25 while the buyers offered only $2.25.
Just to recap: for a free gift, they just got, the students with coffee mugs wanted twice what the buyers offered. Thaler writes that Daniel Kahneman called this the “instant endowment effect.” As soon as you have something, you value it more.
The same human condition holds for a CEO as it does for a college student, you don’t want to lose what you have.
A large salary in exchange for a medium salary and potential stock gain is not something people tend to prefer. The research of the same Daniel Kahneman that Thaler mentions has shown that people would rather take a sure $100 over a 50/50 chance for $220 – but – they would take a 50/50 risk to not lose $80 rather than a sure loss of $50.
Toward the end of the podcast Smith and Goldstein talk about protests in Silicon Valley when the stock option was under threat of removal. WAIT A MINUTE? Didn’t I just explain that CEOs didn’t want stock options?
YES, and we see the endowment effect at play in both cases.
- Executives in the 1990’s didn’t want to trade salary for stock options.
- Technologists in the 2000’s didn’t want to trade stock options for salary.
The endowment effect and loss aversion are strong factors indeed.
4- Is it difficult or complicated? “We thought stock options were free,” said Barbara Franklin. Duh, who is this Barbara Franklin and why didn’t she realize this? Wait, Franklin is a HBS graduate and former secretary of commerce and serves on company boards.
My facetious hindsight bias aside, it’s worth noting the difference between difficult and complicated situations.
Franklin explained that because options didn’t cost anything to create – no money was deducted from an account – board members that decided executive compensation thought they were free. Boards thought they were dealing with difficult situations when in fact they were dealing with complicated ones.
As the United States economy slumbered out of the recession and into a few booming years, those free options became valuable. Someone given options at Procter & Gamble would have seen them go from ~10 to ~60. Caterpillar ~8 to ~32. Cisco ~1 to ~80.
That wasn’t the only effect. Those free shares out would have also diluted What others held. Image you’re an employee who earns company stock as part of your retirement plan. Your company has a market cap of $2M, 500K shares, and a share value of $4. Time passes, 1992 turns into 1997 – you go to the movies and see Jurassic Park, Forrest Gump, and Clueless – and then check on the stock again. The value of the company has grown to $3M, with 600K shares, and each share is worth $5. The company is worth 1.5X more, but your portfolio is only worth 1.25X more. Now you’re the clueless one.
Even though there were lots of smart people who wanted to rein in CEO pay, they didn’t (and maybe they couldn’t) predict the consequences. The best they, and we, can do is think of the second order effects.
5- Second order effects in systems, the differences between your spouse and a cookie. Systems, we’ve seen, talk to us if we listen. Imagine the system of baking cookies.
You follow a recipe, but miss the step that says to thoroughly mix the baking powder. You proceed with the recipe, and the cookies will come out with a funky taste. “Ah, I forgot to mix the baking powder,” you’ll tell yourself.
Now imagine that for Valentine’s Day you get your valentine a personalized, but not expensive gift. They on the other hand, get you something generic, but costly gift. “Should I have spent more?” you ask yourself.
- Cookies are simple, closed systems with easily definable parts and problems.
- Relationships are complex, open systems with hard to define causes and consequences.
Second order effects are easy to identify in simple systems (cookie making, dominos, eating Taco Bell). They are hard to identify much less figure out in complex systems.
To know where were stand can help us understand where we are. Ben Horowitz explains it this way:
“The problem with these books (about business) is that they attempt to provide a recipe for challenges that have no recipes. There’s no recipe for really complicated, dynamic situations.”
The more moving parts something has, the harder it is to figure out. Look at all the parts involved in CEO pay:
Macroeconomic forces and a presidential election forced the pay issue to come forth. The government delicately changed the accounting process to shift pay from salary to stock options. A stock market run (the S&P went from 330 in 1990 to 1500 in 2000) meant that those options diluted the shares of other people, and CEO’s still got paid.
The minor issue of CEO pay in the 1990’s has 5 lessons our decision making today:
- Nothing happens in a vacuum. Admit that part of reason is the environment.
- Nudges work best at the start when someone isn’t sure what to do.
- Loss aversion is very powerful.
- Identify what situations are difficult and what are complex. Doing so will influence your approach to problem solving.
- Second order effects to the type of problem you identify in #4 will vary widely. Proceed with caution.
Thanks for reading, I’m @mikedariano on Twitter.
P.S. If you liked this post, you may like the project I’m doing on Survivorship Bias. Check it out at Medium.