CEO Succession Planning: How Boards Can Pay Less and Get More

I recently had a conversation with the London-based CEO of a large growth fund, which focuses on locating new investment opportunities and pairing them with new management talent. I was struck by something he said, “Why do we have to pay so much for CEOs? It's crazy money!”

There are a couple of things that stand out, not the least of which is the notion that a CEO is criticising CEO pay as “crazy money.” We began talking about how this came about, and what could be done.

How we got here will have to be a subject for another time, although the very short answer is based on the concept of at or above “market pay” for everyone, whether they are special or not. My view is that these market levels cannot be sustained over the long term and the market will adjust in time, but more immediately there are things which can be done, specifically by remuneration committees.

The first is to look at succession as a strategic weapon rather than simply a to-do item for the human resources function. Those tasked with governing incentive pay can ensure that management is focused on bringing in talent with the skills oriented to the future state of the business and rapidly promoting the winners up the organisation. The pipeline of management skills, experience, and ideas will beenhanced enormously.

The second is to build a process around succession planning so that when, not if, you need to replace the CEO for whatever reason, his or her next-in-line is ready to do the job. We know based on data that chances are very good that this will be a much less expensive and much more productive option for the board than a talent search and all of the negotiation that comes with it.

Our UK CEO Value Index looks at the value added to shareholders by the company over a four-year period using data from S&P Capital IQ. This figure takes into account changes in market cap, dividends, and share buybacks. We then look at the total remuneration paid to that company’s CEO in the same period. The goal is to illustrate for shareholders clear evidence of when and where leadership is delivering value relative to the pay package.

We’ve found that year over year, there is a consistent set of companies who pay their CEOs the most, but also reap the most value for shareholders. The lesson here is that success is about creating value, not counting pennies! We have also discovered that CEOs with more at stake—more equity holdings—add more value than those with less “skin in the game.”

But when we are discussing leadership development and succession planning and the costs of new pay package negotiations, here is the gem in the data: CEOs who are promoted from within the company add more value and are paid less than those who are hired as CEO from outside the firm.

Seventy percent of new CEO appointments in the FTSE 100 in the last five years have been promoted within the business and they have added six percent more value, whilst being paid 20 percent less than those hired from outside.

Succession planning, it would seem, really does offer a ready-to-go pool of talent. It also stands to reason that there is generally a flatter learning curve for those promoted, a smoother transition for the organization during a period of change, and ultimately overall lower costs combined with better returns.

Our findings highlight the irony that whilst most CEOs are promoted from within, as opposed to being hired from a competitive external talent market, a lot of the executive pay debate and remuneration committee time is still spent on ‘benchmarking’ pay against peer companies.

What’s worse is that when executives are hired from outside, costing more, they are not necessarily adding value for that extra money. The pressures on remuneration committees, based on the fear of losing executives to competition, seems to be unfounded in many cases.

Our suggestion is that remuneration committees can be more effective by putting greater emphasis on succession planning and actively developing a wider pool of talent to choose from.

While this won’t fully solve the executive pay issues currently being debated around the world, it could be an active and productive step in the right direction.