A Smarter Way to Set CEO Pay

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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 BusinessWeek.com.