(By Cristiana Couceiro)

This piece is part of an On Leadership round table exploring the reasons behind the persistence and prevalence of outsized executive pay.

All CEOs are paid like entrepreneurs. Therefore, all CEOs are entrepreneurs.

At first glance, that sentence may make sense. But only half of it is true: Not all CEOs are entrepreneurs, but all CEOs are paid like them.

That’s because they receive incentive packages that were originally designed to reward entrepreneurs who generated revenue for cash-strapped enterprises. It’s hard to remember, especially now that high bonuses, large stock-option grants and restricted stock awards (on top of substantial base salaries, generous retirement plans, benefits and perquisites) are standard in every executive pay package, but rewarding entrepreneurs is what stock options were first created to do.

Put simply, it does not make sense to award stock options every year — they were never designed to be given out that way. The typical CEO of a large blue-chip corporation is managing the company for growth, but not entrepreneurial growth. Slow, steady value accretion is what shareholders expect, and why they invest in indices made up of these companies. But such gradual growth means that the only way for CEOs to earn a substantial amount through a stock-option grant is to award them with ever larger numbers of them. And this is what boards are doing.

The fact is that most CEOs are managers, not entrepreneurs, and should be paid like other managers. They are not stars. They are team leaders, and should be rewarded as part of the team. But according to an analysis by GMI Ratings, more than half of the S&P 500 pays its CEO more than three times the median pay received by the company’s other top executives. More than 50 CEOs are paid more than five times the median.

This makes no sense.

And yet, the practice persists, even though a more equitable pay scale among a senior management team has long been considered an indicator of a balance of power in the boardroom, better morale on the executive team, and the existence of an adequate succession plan. If a CEO is earning three times as much as the most valued team members, it sends a message that the others are not qualified to succeed him or her and that too much power resides with one individual. What’s more, a board that sets up an excessive differential between pay for its CEO and his senior team is less likely to challenge the CEO.

Why does this continue? The first reason is that once a certain level of CEO pay is reached, it is difficult — if not impossible — for any compensation committee to reduce pay from that level. The second reason is the tyranny of the market. But just because big stock-option grants are common does not make them right.

Consider what happened when the stock market collapsed in 2008. The most common reaction the following year was not to dock CEOs’ pay in line with shareholder losses. Rather, in order to preserve the estimated value of their awards, boards of directors handed out many, many more shares than was typical in order to make up for the potential loss. This practice didn’t just make CEOs whole while shareholders lost money — in many cases it paid CEOs far more. When the market rebounded, these “mega-grants” rose exponentially.

That wasn’t the only way boards tried to make up for CEOs’ “lost” pay. After two years of not paying bonuses, many boards introduced discretionary awards based on looser metrics or set easier targets because the missing bonuses were “creating retention problems.” Such a nonsensical response reveals a complete misunderstanding of performance-driven pay. If bonuses are expected to be paid each year, they are not functioning as an incentive at all. And where were those other high-paying jobs? If all executive pay was down, where exactly was the temptation for a CEO to leave?

The reactions to the recent financial crisis and the prevalence of excessive pay differentials show that boards of directors do not fully understand the purpose of CEO compensation. Despite being aware of the leadership downsides of paying a CEO many times more than his executive team — lower morale, an accumulation of power with one individual, poor succession planning — compensation committees continue to treat CEOs not like the managers they are but the entrepreneurs for whom their rewards were designed. Until companies start paying CEOs like stewards of the large, steadily growing corporations that investors expect, nothing will change. Perhaps it’s time to wipe the board clean and start again.

Paul Hodgson is a senior research associate at GMI Ratings, a corporate governance research firm.Follow him on Twitter @pghwrites.

Full On Leadership round table on executive pay:

Inside the head of an overpaid CEO

The original sin of executive pay

Why we can’t seem to cure CEO pay

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