One factor behind the astonishing rise of CEO pay over the last several decades is a kind of Lake Wobegon effect, after the famous Garrison Keiler joke about a town in which all the children are above average. When a Board of Directors decides the pay level for its CEO, it usually first consults the average compensation for peer companies. Since nobody believes, or wants to admit, they hired a below average CEO, the board invariably picks a number at or (more commonly) above the average. Thus the average level climbs and climbs.
I thought of that today when University of Michigan Athletic Director Dave Brandon, a former CEO himself, announced the contract terms for head football coach Brady Hoke:
Among the 12 Big Ten coaches, Hoke's salary ranks fourth based on a list of 2010 salaries. Last season, Ohio State coach Jim Tressel made $3.88 million, Iowa coach Kirk Ferentz $3.78 million and Nebraska coach Bo Pelini made $2.1 million.
"If you're going to be the Michigan coach, you should be paid in the top third of the conference," Brandon said. "Brady has a big job, and Brady feels like he's being well compensated for the big job he's now responsible for. I have a happy employee, and my employee has a happy employer.
It's a perfect example of the benchmarking method: First you calculate what your peers are paying, and then you pay a little more. And, indeed, the pay of college football coaches has exploded over the last few decades. (Thirty years ago Michigan head coach Bo Schembechler, one of the greatest coaches in football history, earned $110,000.)
Now, the official explanation for the rise of CEO pay is market forces -- the CEOs are just so valuable that companies have to pay this much for their services, or they'll lose valuable leaders. For various, easily quantifiable reasons, I find this unpersuasive. But Hoke's contract at Michigan actually offers a rare test case. Brandon publicly admitted -- indeed, he boasted -- that Hoke agreed to accept the job without even asking what he'd be paid. Hoke himself called Michigan his "dream job," and said he "would have walked" from his previous job in San Diego for the Michigan job.
Given all this, Hoke's market leverage appeared to be very slight. He had left his old job and couldn't go back. No other program still had a coaching vacancy, and in any case when there had been openings the months before, there were no reports of other programs pursuing him. He publicly admitted he would have done anything for the Michigan job. Given that Hoke had been earning $700,000 a year, what would the market dictate that Michigan pay him now? The answer turns out to be more than quadruple his previous salary package.
I would really like to see an economics textbook try to explain the negotiating dynamic here. Certainly, even though Brandon is a businessman by trade, University athletic departments don't operate exactly like a business. But certainly some of the principles apply. And the case of a massive raise for an executive who had forfeited all bargaining leverage is an instructive lesson in the rise of CEO pay.