Warren Buffett on Executive Compensation: "Ratchet, Ratchet and Bingo!"

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Warren Buffett generally strikes an upbeat, optimistic tone, but he turns critical when asked about boards and their role in setting compensation for their company’s CEO.  “Boards have not done a good job on that.  I’ve been on nineteen boards and one time they put me on the comp committee.  I am the comp committee for the 70-some companies we have, and we have never lost a manager so it isn’t that I don’t know something about comp, they just don’t want somebody who knows something about comp on the comp committee.” (In the interest of disclosure: in the time since I conducted this interview in 2009, my brother Steve joined the Berkshire-Hathaway board of directors.)

Buffett describes the typical compensation-setting process this way. “The human relations director comes in and recommends a consultant to the board’s comp committee,” he says. “The human relations director is an employee of the CEO, his or her salary gets determined by the CEO, so what kind of a recommendation do you make to the comp committee?   I don’t think comp committees should have consultants.  If you don’t know enough about the game to work out a fair compensation arrangement get off the committee and put somebody on there who does know.”

He continues, getting more animated as he goes, “They (compensation committees) go in and put in a couple of hours a quarter, at most, and you’ve got a consultant that’s been picked by the management and basically it just keeps ratcheting upward and upward and upward and the targets get easier.  And I would say that that has deteriorated enormously from fifty years ago.” 

Buffett describes situations where compensation consultants present to the board the pay of CEO’s of other firms in their industry.  These are usually expressed with averages and rankings by quartiles.  Since boards tend to believe that their CEO’s, like the children of Lake Wobegon, are all above average, they pay them accordingly.  As this occurs across the industry, the consultant’s calculated averages ratchet higher.

“I was on a board one time,” he says, chuckling, “and I forget the exact term I used to call their consulting firm, but I think it was ‘Ratchet, Ratchet and Bingo’ or something like that.  But if you’re a consultant, what do you want?  You want more consulting jobs.  And how do you get more consulting jobs?  You have CEOs who say you’re terrific.  And how do you get CEOs to say you’re terrific?  You give them a lot of money.  It’s an accidentally corrupt system.  It isn’t that comp committees set out to make it that way or anything like that.  But, basically the only check on a CEO is the directors.  The shareholders are not an effective check in most cases.   So, the CEO keeps the directors very happy.”

Takeaways

The compensation of chief executives is a complicated business and one that inspires a lot of controversy.  Excessive pay for CEO's can have a negative impact on an organization, especially one that might be going through tough times.  I recall speaking to someone who worked at a cable network that was part of a larger media company that was in the process of executing large-scale layoffs and other cost cutting measures.  He told me that the parent company’s CEO flew to his network's headquarters for an all-hands meeting and throughout the building people had cut out articles about his multi-million dollar pay package and pinned them to the walls of their cubicles.  It's tough to show deliver bad news or show empathy to impacted workers then they know how much your pay dwarfs their own.  Boards of directors are the ultimate arbiters of how much the chief executive should make, and individual members would do well to heed Buffett's cautions and advice.

William Burke