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(originally published by Booz & Company)


Prodding a CEO with a Deep Pay Cut

In contrast, the likelihood of CEOs getting a sharp pay cut following a downturn in performance was higher in companies with large institutional ownership — meaning most of the shares were held by banks, hedge funds, and other large entities likely to exert influence over the firm.

But how did the firms and their CEOs perform after the pay cut? On average, the authors found, a firm that slashed its CEO’s pay saw its stock go up 7 percent the following year, reversing a decline of 10 percent in the year of the cut. Similarly, the average return on assets climbed to nearly 12 percent in the three years succeeding a pay cut, reversing a decline of 4 percentage points, to 9 percent, in the three years leading up to the cut.

“Similar to the effect of forced turnover, pay cuts are indeed associated with performance turnaround, consistent with being an effective substitute [for] turnover,” the authors write.

And CEOs responded to their pay cut in ways similar to the adjustments made by new CEOs whose predecessor had been forced out: They curtailed capital expenditures, reduced research and development expenses, and allocated funds to decrease leverage. Those pay-cut CEOs who masterminded a turnaround saw their pay fully restored within three years, the authors found.

“Pay cuts are twice as likely as dismissals, making them the more common response to poor performance,” the authors conclude. “Not only are sharp pay cuts an important part of dynamic adjustments made to compensation, they are also part of the explanation why CEO forced turnover appears to be so rare.”

Bottom Line:
Why aren’t the CEOs of poorly performing companies fired or forced out more often? Because boards are more likely to enact drastic pay cuts as a substitute. And the approach is effective: Firm performance improves after the slash in pay, and CEOs typically stay in office and eventually have their pay restored.

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