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A Smarter Way to Set CEO Pay

The opening sentence of Alexis de Tocqueville's Democracy in America, the social philosopher's magisterial epic investigation into early 19th century America, highlights how central the idea of equality has been in society: "No novelty in the United States struck me more vividly during my stay there than the equality of conditions."

But a visit to 21st century America might give de Tocqueville pause.

The era that the French author chronicled and the periods that followed were indeed a time of unparalleled opportunity. Immigrants swarmed to the U.S. to make a better life for themselves and their families. Americans looked at themselves as middle class, neither aristocrats nor working class, just common folk trying to get ahead, making a better life for their children. "Ordinary Americans came to believe that no one in a basic down-to-earth and day-in-and-day-out manner was really better than anyone else," writes Gordon S. Wood in The Radicalism of the American Revolution. "That was equality as no other nation has ever quite had it."

A Society Open to Talent

Of course, equality, so appealing in theory, was hard to obtain in practice. African Americans were excluded. So were the people who lived here before the European settlers. Society divided along the lines of money, power, and education. The gulf was wide between first class and steerage on the Titanic or the gilded mansions of Newport and the crowded tenements on New York's Lower East Side.

Nevertheless, the American economy was more egalitarian and open to talent than anywhere else. Horatio Alger's working boy heroes and Charles Foster Kane are fictional characters, but for Daniel Boone and Andrew Carnegie the climb from rags to riches was very real.

Indeed, it's striking that Americans have long tolerated greater income inequality than other major industrialized nations. One reason is the powerful belief in equality of opportunity, that society rewards merit, pluck, risk-taking, and luck. Another factor is that for long periods of time the economic gains of rising productivity and increased innovation were widely shared.

A Small Few Have Benefited

A less savory influence on the acceptance of greater inequality is a cottage industry of consultants, lobbyists, and think-tank entrepreneurs that justified the extraordinary gains at the top of the income spectrum as the just rewards for brains and merit.

Problem is, none of these arguments hold anymore. Corporate America's productivity gains of the past three decades or so have largely gone to a relatively small number of executives. The ominous combination of recession and credit crunch makes it hard to argue that the gains have been the returns to "talent" in the 2000s.

Perhaps most disturbing, Corporate America is becoming a pay-for-failure economy for its top executives and a Darwinian existence for everyone else. There's something wrong in a world where former chief executives like Stanley O'Neal of Merrill Lynch, Charles Prince of Citigroup (C), and the retention bonus bunch at AIG (AIG) and others lose billions of dollars of shareholder money yet pocket millions on the way out.

Drucker Hated High Exec Salaries

"Too often, executive compensation in the U.S. is ridiculously out of line with performance," says Warren Buffett, the legendary investor. "The upshot is that a mediocre-or-worse CEO—aided by his handpicked VP of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet, and Bingo—all too often receives gobs of money from an ill-designed compensation arrangement."

Peter Drucker, the late management philosopher, couldn't stand exorbitant executive salaries. The average CEO of the Standard & Poor's 500 companies gets about 400 times the average pay of an American worker. Drucker believed a gap like that damaged corporate productivity, reduced employee innovation, and tore at society's fabric. He argued for a ratio around 20 or 25 to 1.

It's a safe forecast that it won't happen. It's also safe to say that there will be angry calls for reform, demands that the board of directors be transparent with CEO compensation and that consultants design improved benchmarks for judging pay for performance. This has been the mantra since the earlier debacles of Enron and Worldcom. We all know that not much has changed.

Entrepreneurs Take Real Risks

Yet it seems there's an easy solution, modeled after the seeming antithesis of the well-protected CEO: the American entrepreneur. Think about it. When was the last time you heard someone complain about an entrepreneur making too much money? We applaud their achievement. The reason is that we are all aware that the entrepreneur took a real risk. The odds of success are slim, too, since far more entrepreneurs fail than succeed. The entrepreneur takes a genuine risk with no guaranteed reward. CEOs get a guaranteed reward whether they succeed or not. It's the better balance between risk and reward that we admire.

About a decade ago, I had a conversation with a radio entrepreneur. He was middle-aged, and he wondered how to go about rebuilding his retirement savings. It turned out that he and his wife had an idea called satellite radio. They believed in their product. They drained their retirement savings and borrowed against their home. But the idea didn't take off when they took their gamble. Perhaps they were too early, maybe their pockets weren't deep enough for the business. Anyway, the business failed. They managed to save the home, but their retirement savings were gone.

How different were they from John Mackey, a college dropout, and his partner when they opened a natural foods store in Austin, Tex., in 1978? To save money they even moved into their store, bathing with a hose attached to the dishwasher. Two years later, after merging with another natural foods store they opened Whole Foods (WFMI). It's now a company with $8 billion in annual revenues.

Top Brass Unfamiliar with the Downside

So, here's the deal: Let's make CEOs no different from any other employee in most areas. They should face the same risks as everyone else in the organization. They get the compensation package, including health care and pension plan, as everyone else. If the senior management gets the ax, they can do a rollover IRA with their pension and purchase Cobra for health insurance coverage like everyone else. They'll be better paid than anyone else, but the bulk of their pay will go into stock—and not into stock options that can be backdated. They can start selling stock over a 10-year period after they retire or move on (much like an old partnership structure).

Of course, for the top brass there may be an unaccustomed downside to failure. If the stock tanks like Citigroup, AIG, and other blue-chip penny stocks, they're poorer. Of course, the details of a plan like this should be fleshed out by much smarter people than me.

Here's the rub: If corporate directors don't bring the CEO risk-to-reward ratio in line with other employees and the American entrepreneur, the danger is that Congress will do it for them. That would be a huge mistake. But at that point the big brains that inhabit America's boardrooms will have no one to blame but themselves.

Farrell is contributing economics editor for BusinessWeek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace. His Sound Money column appears on

Farrell is contributing economics editor for Bloomberg Businessweek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace.

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