The disparity in pay between the CEO and the next highest paid senior executive may tell an important story about a company’s preparedness for CEO succession. New research investigates how these pay discrepancies are associated with CEO succession.
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Board Signaling and Preparedness for CEO Succession
Directors on boards of major organizations are quick to share that the most important decision their boards must make is the selection of a new CEO. The value of the CEO for setting company strategy and building its culture is well known, perhaps never more so than throughout the “people crisis” associated with the COVID-19 pandemic, which has accentuated the importance of having the right leader in place.
While many companies claim to have succession plans in place, the reality is that most are less prepared than anticipated and unaware of important signaling with regard to CEO succession. Unfortunately, many boards fail to follow systematic practices to prepare them to make optimal CEO selection decisions and are otherwise unaware of the signals they are sending to stakeholders (internal or external) regarding their preparedness for succession events.
One such signal often identified by watchdog agencies (e.g., proxy advisors such as Glass Lewis or ISS) is the disparity in pay between the CEO and the next highest paid senior executive, which may tell an important story about a company’s preparedness for CEO succession. Until recently, however, there was little clarity surrounding whether this pay disparity is a meaningful signal related to succession or what exactly it predicts. Recent research (2021) by Spenser Essman, DJ Schepker, Anthony Nyberg and Caitlin Ray, through sponsorship of the not-for-profit, academic institution, Center for Executive Succession (CES), brought much-needed clarity to this idea by investigating how these pay discrepancies are actually associated with CEO succession.
They found that, preceding a succession event, larger pay differences between the CEO and the next highest paid named executive (often the most likely internal successor) signal an increased likelihood of the company choosing an outside CEO successor. As such, the signal represented by this pay disparity is that the company, whether knowingly or not, feels less certain about their potential internal candidates, including this ostensible most-likely successor. Boards should thus be aware of the signal the pay disparity between their CEO and next highest paid executive sends to both external and internal stakeholders. For instance, investors who are keen to this information, and to watchdog guidance on its potential concerns, may react negatively to firms with greater pay discrepancies between CEOs and other executives, fearing a lack of internal preparedness and planning for any ensuing succession events.
Further, this pay gap can signal an increased likelihood that the organization will need to seek outside executive talent, which may help attract external candidates but also may put the company in an unfavorable negotiating position with those candidates given their lack of internal candidates. More generally, this signal may very well be unintentional, and if the board is not aware of how such pay differences are perceived in the marketplace, they may be blindsided by unexpected stakeholder reactions to their succession decisions, particularly if they ultimately select a CEO that contradicts this apparent signal (i.e., selecting an internal successor despite a larger pay gap or an external successor despite a smaller gap).
Of course, these pay differences can also send important signals to internal talent. Since higher pay differences are empirically associated with a greater likelihood that the organization will seek an outside successor, internal candidates may be led to conclude that large pay gaps are ominous for their chances of becoming the next CEO. As such, they may choose to leave the company in favor of opportunities elsewhere, reducing the internal talent pool from which the board can select a successor. If the pay gap does not accurately convey the board’s intentions, it may cost them valuable talent that they otherwise could have convinced to stay had they been more aware of the unintentional signals they were sending. Consequently, recognizing the source of the pay disparity signal should help boards identify when to develop and adjust the pay of internal talent or recruit external talent.
Lack of Succession Preparedness
Notwithstanding the unintended signals they send to internal and external stakeholders regarding their preparedness, boards have a responsibility to be well-prepared for CEO succession. However, despite the clear importance of CEO succession planning and extraordinary costs associated with getting this process wrong, recent surveys indicate that more than a third of major, multinational companies have minimal (if any) processes in place to plan for and execute a CEO succession. Further, many of those that do have such processes note that, in practice, their processes are relatively generic and less systematic than those they use to hire entry-level employees. The lack of systematic processes is an even more glaring issue outside of the Fortune 500, as surveys have revealed that more midsize and smaller companies have no formalized, systematic processes for succession than those that do.
The CES at the University of South Carolina’s Darla Moore School of Business has been engaged in academic research involving CEO succession since 2014. In aggregate, this research has identified seven critical steps, with the contributions of six key actors (board members, lead independent directors, CHROs, incumbent CEOs, successor CEOs and external consultants), that make-up best practices for boards to prepare themselves for CEO succession. How well is your company doing in these seven steps?
Stage 1: Define the Process
Actions. As Figure 1 shows, a starting point for each succession requires the board to define the process, including who will be responsible at each stage of the process. In a survey conducted by the CES, only 23 percent of respondents reported a defined transition timeframe. There was also considerable variance among explanations for what even constituted a well-defined process. This stage is critical because there are substantial differences in board dynamics, as well as with outgoing CEOs, that impact how these processes are likely to unfold. For example, challenges often exist in coordinating a group of independent directors (often 9–12 board members) to focus on the same goal as it relates to their hiring a successful CEO. This coordination problem is accentuated by the varying backgrounds and experiences of each board member, which may lead them to approach succession discussions and processes quite differently. As such, defining how the process will work is critical to ensuring the process is not derailed by the individual interests of those involved (both board members and executives), and keeping them on the same page.
Actors. In this initial stage, boards must work with the incumbent CEO to identify an appropriate timeline. One common mistake that boards make at this stage is to be too timid in initiating discussions with CEOs about succession processes, particularly when the current CEO is performing well. This head-in-the sand approach is, in some ways, understandable but also means that boards will be less proactive in identifying the most appropriate successor or properly developing talent in the organization. Boards that relinquish that responsibility to the current CEO are not adequately performing arguably their most important duty. To this end, the CHRO of the company occupies an important position in this stage, ideally helping to assist the board in establishing a strong process and helping the incumbent CEO understand the need to establish a reasonable timeline. The CHRO should also be working to develop credible relationships between the board and potential successors.
Stage 2: Identify Strategic Challenges
Actions. Boards must focus on identifying future strategic challenges separate from the issues confronting the current CEO. While this may be apparent especially in the context of succession planning, only 61 percent of the firms surveyed reported that their board conducted a five-year (or longer) business strategy analysis as part of succession planning. Such an analysis is challenging because it requires examining external trends, making projections about an uncertain future and predicting the types of strategies and opportunities it hopes the next CEO will pursue. While it can be difficult to separate this forward thinking from their recent experiences, in part because boards often value leadership consistency, being able to realistically identify the future strategic needs of their company can help the board align the successor’s capabilities with those needs.
Actors. Boards must separate future strategic organizational needs from the incumbent CEO’s strengths to remain focused on identifying the characteristics that will be most useful in the future CEO. The CHRO should work with the board to help collect the necessary information to conduct their strategic analyses. External consultants can help facilitate discussions with directors about their desired future strategies for the company.
Stage 3: Develop Role Profile and Identify Competencies
Actions. Identifying the competencies required to drive the organization forward enables firms to build an appropriate candidate profile. However, responses to the CES surveys indicated that only about 57 percent of firms develop role profiles aligned with business strategy. Board members also frequently fall victim to the successes and failures of the current CEO, meaning that in good times they may simply try to emulate the incumbent’s skillset or, in bad times, find candidates with contrasting characteristics. Such backward looking can impede the board’s ability to identify a successor who will fit the strategic goals of the future.
Actors. Boards needs to engage the CEO for their own understanding of the tasks and responsibilities that may be required for the next CEO. The CHRO plays an integral role in helping the board understand the specific skills that fit their projected future needs and facilitate future organizational performance. To do this, the CHRO can develop tools to help the board understand and identify the competencies they are looking for and build a CEO scorecard to help coach potential successors around the company’s needs.
Stage 4: Identify and Evaluate Potential Successors
Actions. After identifying the competencies needed to address critical strategic challenges, boards must assess potential successors. To aid these efforts, boards can categorize candidates around three primary timelines: those ready to take over now; those who could be ready within two years with appropriate development; and those with CEO potential but are several years away from being ready. CES surveys indicate that 82 percent of firms have formal processes to ensure the board’s exposure to a talent pipeline; however, only 49 percent employ formal assessment tools, and only 22 percent explore the external market for talent.
Actors. Lead independent directors should work with the current CEO to identify candidates and work with the CHRO to accurately profile those candidates. With the information developed from these efforts, the lead independent director can then share with the full board in a concise and understandable manner. While the current CEO inherently has substantial influence in this stage, assessment decisions are ultimately made by board members, making it incumbent upon the board to vigilantly seek their own opportunities to identify and evaluate candidates without undue influence of the CEO. The current CEO is responsible for sharing his or her evaluations of internal employees with the board, primarily to inform the board about candidate readiness, with the board’s understanding that the CEO may be filtering these evaluations in ways that may not be fully transparent. The CHRO plays a critical intermediary role by independently securing information from the CEO to help the board develop a complete and accurate set of information about the candidates.
Stage 5: Develop Candidates
Actions. After identifying candidates, the board should assess candidate skills relative to the desired competencies determined in Stage 3. For any particular skills that candidates may lack, the board should direct current CEOs to provide those candidates with experiential opportunities to develop such skills, for instance, by putting the candidate in charge of a large division. According to the CES surveys, three of the most prevalent practices for developing talent are giving candidates exposure to the board (82 percent), conducting ongoing assessment of candidates (73 percent) and scheduling conversations with the CEO (74 percent). Providing candidates deemed to have CEO potential with personalized coaching and mentoring can also be an effective practice at this stage.
Actors. Boards must vigilantly ensure that the CEO provides developmental opportunities for board-identified candidates. CEOs may not always value these long-term talent development goals as much as the board and thus may (intentionally or unintentionally) fail to prioritize these candidate growth opportunities, especially if concerns about short-term performance exist. The board has the ultimate responsibility for ensuring potential successors are sufficiently prepared and thus must avoid deferring these responsibilities to the CEO. Concurrently, the CHRO should help the board identify developmental opportunities and update them on how candidates are progressing. The CHRO should also maintain open communication with candidates, particularly about the value of their developmental assignments and the importance of strengthening support systems, including those of families and friends.
Stage 6: Select the Successor
Actions. Finally, boards must select the CEO successor. Board members reported in CES surveys that this choice was typically clear if they had properly vetted candidates before reaching this stage. In fact, by the time the board is ready to make a final choice, there are rarely more than two candidates remaining. Importantly, while board members are often reluctant to disagree with one another about the choice, deliberations should include rigorous discussions among board members and a willingness to change course if the board has meaningful reservations.
Actors. The lead independent director should solicit input, privately if necessary, from all board members and then work to develop consensus through an objective decision-making process. The board should (and usually does) come to unanimous consensus (at least in the final vote) for their selection of a successor, but only following rigorous discussion and debate regarding their final candidates. The current CEO should support the board’s decision (both internally and to the public), while also remaining clear that this was ultimately the board’s decision. The CEO should also start developing a transition plan, including for how they can support and mentor the incoming CEO during the transition period. The CHRO should also support the board’s decision and help build the company’s plan to transition the current CEO out and the new CEO into the role. The CHRO should also serve as a conduit for communication between the board, the incoming CEO and the outgoing CEO.
Stage 7: Transition the CEO Role
Actions. Once a successor is chosen, formal onboarding processes for new leader assimilation should be planned, including scheduling listening and town hall tours, meeting with key stakeholders, establishing the specific timeframe for the transfer of responsibilities and defining the ongoing role of the incumbent CEO.
Actors. The board must work steadfastly to welcome, counsel and nurture the incoming CEO. Board members, particularly the chair, need to help the CEO understand the position, communicate their expectations and serve as an appropriate sounding board when necessary. As part of this process, the outgoing CEO should ideally work extensively with the incoming CEO to explain the job and provide exposure to its more novel aspects, although this may depend on the circumstances surrounding their departure.
The CHRO should also help formulate the plan to acclimate the incoming CEO while also assisting the incumbent CEO develop their exit plan from the company and think about their next career steps.
Successful Succession Signaling
Signaling your intent and then aligning organizational action with those signals builds trust and clarity—both internally and externally. Boards have a responsibility to be well prepared for CEO succession. Yet despite the clear importance of CEO succession planning, the data shows that most multinational companies are woefully underprepared. Even those that proport to have processes in place are often less systematic than those they use to hire entry-level employees. The lack of systematic processes is even more problematic for mid-sized companies.
This research has identified seven critical steps, with the contributions of six key actors that make up best practices for boards to prepare themselves for CEO succession. How well is your company doing with regard to the key actors and critical steps of succession preparation?
7. Transition the CEO role.
It is concerning to note that only 61 percent of the firms surveyed reported that their board conducted a five-year (or longer) business strategy analysis as part of succession planning. As part of a long-term strategy, senior pay-gap information should be seriously considered.
Whether the company knows it or not, large pay differences between the CEO and the next highest paid executive signal an increased likelihood of a company choosing an outside CEO successor. As such, the signal represented by this pay disparity is that the company feels less certain about their potential internal candidates which may have an unintended effect on both external candidates and internal talent. Investors who are keen to this information, and to watchdog guidance on its potential concerns, may react negatively to firms with greater pay discrepancies fearing a lack of internal preparedness and planning for any ensuing succession events.
Board members, CEOs and CHROs should consider the following questions:
These and other questions can begin a discussion that may be critical to an organization’s succession success. Boards, company executives and CHROs should thus be aware of the signals being sent based on pay disparity and the extent to which best succession practices are actually being implemented. Taking inventory of these key factors will increase the likelihood of future successful leadership transitions.
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