March 18, 2009 — In humorist Garrison Keillor’s fictional hometown of Lake Wobegon, all children are above average. Corporations may want investors to believe the same thing about highly paid CEOs and this effect may explain high CEO pay, according to a new study by two researchers in the University of Utah’s David Eccles School of Business.

After all, an above-average CEO may be able to deliver above-average performance, say finance professor and economist Scott Schaefer and accounting professor Rachel M. Hayes in their study, “CEO Pay and the Lake Wobegon Effect,” which is forthcoming in The Journal of Financial Economics. Schaefer believes this is the first to apply the Lake Wobegon effect to CEO compensation.

Their research shows that companies have incentives to pay even bargain-basement CEOs highly to keep up stock prices, even if investors catch on to firms’ over-pricing.

“Everyone knows that in well-functioning labor markets, better performers earn higher salaries,” Schaefer points out. “The reason the Yankees pay star pitcher C.C. Sabathia $161 million is that some other team was willing to pay him $160 million.”

If a firm hires a hires a CEO with poor labor-market options, it could pay a low salary; say, $1 million a year, says Schaefer. Investors then might conclude the CEO isn’t great and downgrade the firm’s stock. If the firm decides to pay its bargain-basement CEO as if he were a superstar, investors might conclude he is a superstar and share prices might jump. If stock prices increase more than the CEO’s salary, then this could be a good move for the firm.

“The Lake Wobegon idea as applied to CEOs seems to presume that investors aren’t very smart,” he says. ” You can imagine investors being fooled once or twice, but over time you’d think they’d catch on as highly touted and well-paid CEOs consistently fail to deliver.”

And if investors understand a firm’s incentives to goose CEO pay just to pump up stock prices, then wouldn’t firms give up trying?

The answer, Schaefer argues, is no. “Our research shows that the Lake Wobegon effect can drive up pay even if investors are super smart about it. The key is investors’ expectations,” says Schaefer, co-author of the “Economics of Strategy,” a leading textbook in strategic management.

Investors may conclude that any CEO who is paid “only” $1 million must be truly unqualified, and the firm’s share price would drop like a rock, he explains. The firm might therefore be better off overpaying its manager, even if investors are not fooled.

Lake Wobegon Effect

To determine that the Lake Wobegon effect can occur and under what conditions, Schaefer and Hayes used game theory – a widely used method in economic research based on the work of two Nobel laureates – to create a mathematical model of what a firm wants, what a manager wants and what investors want. Then, they analyzed various strategies players might use to achieve their goals and compare the likely outcome to the Lake Wobegon effect as described in the popular press.

Schaefer says the practice of rewarding managers regardless of companies’ success should be re-examined.

“Pay packages have gotten so high that the repercussions of getting fired are minimal because these guys are so wealthy,” he says. “They’re not afraid of taking risks.”

Despite this, he’s not a proponent of across-the-board compensation limitations which “are likely to push CEOs from executive leadership to more lucrative positions, such as consultants who have less vested in a firm’s success.” However, he doesn’t support an “anything goes” approach.

Schaefer is outraged at AIG’s actions: “What AIG is doing right now is paying a lot of money to people whose actions destroyed a lot of value. But, what the administration’s pay restrictions are doing is preventing people who are brought in to clean up the mess from being rewarded for doing so.”

He also believes that federal regulation is not the solution. He cites the1993 million-dollar rule that companies had to show that CEO salaries over $1 million were tied to firm performance in order to be tax deductible. Firms simply limited salaries and increased bonuses.

He believes the solution is to tie pay to long-run value-creation in firms by lengthening the vesting periods for CEO stock and stock-option grants. This will insure that the CEO’s path to wealth is the creation of sustainable, long-run value for shareholders.

The University of Utah’s finance department has been ranked 20th for its research productivity from 2003 to 2007 by the Finance Management Association and Arizona State University which annually evaluate finance departments in colleges and universities worldwide according to the number of articles published in the field’s premier academic journals.

About the authors

Scott Schaefer is a professor of finance and David Eccles faculty scholar at the University of Utah’s David Eccles School of Business. He also is an investigator with the Institute for Public and International Affairs at the University of Utah. His research focuses on the economics of organization, with an emphasis on understanding employment relationships and decision-making inside firms and has been published widely in top academic journals. He is a co-author of “Economics of Strategy,” a leading textbook in the field of strategic management. Before joining the Utah faculty in 2005, Schaefer spent 10 years at Northwestern University’s Kellogg School of Management, where he held the Richard M. Paget chair in management policy. He earned a Ph.D. in economic analysis and policy from the Stanford Graduate School of Business in 1995.

Rachel M. Hayes is a professor and David Eccles faculty scholar in the School of Accounting at the University of Utah’s David Eccles School of Business. She currently serves on the editorial boards of the Journal of Accounting Research and The Accounting Review. After receiving her Ph.D. at the Stanford University Graduate School of Business, she taught at Northwestern University and the University of Chicago before moving to Utah. Her research, which has been published in leading journals, focuses on disclosure and use of accounting information in compensation and other governance settings.

About the David Eccles School of Business

With emphasis on interdisciplinary education and experiential learning, the David Eccles School of Business has programs in entrepreneurship, technology innovation and venture capital management. It launched the country’s largest student-run venture capital fund with $18.3 million, and the Association of University Technology Officers ranks the school second in the country (following MIT) in taking university-generated technology to market.

Founded in 1917 in Salt Lake City, the school later established the first accredited MBA program in the Intermountain West. Some 3,500 students are enrolled in its undergraduate, graduate and executive degree programs as well as joint MBA programs in architecture, law and health administration.