27/04/2012 06:03 BST | Updated 26/06/2012 06:12 BST

How Executive Pay Gets So Out of Control: Boards Are Tone-Deaf in a Soundproof Room

Why is it that executive pay continues to seem so out of line with what common sense would tell us is justified?

We've seen a number of striking examples over the past several months of compensation packages that, when exposed to the light of public scrutiny, evoke a range of negative reactions, making people anywhere from mildly annoyed to genuinely appalled. The packages seem out of line with results, and pay ratios are striking. Recent cases are unbounded by sector or location and include AstraZeneca, Barclays Bank and Shell. So what happens in the boardroom that lets such a package emerge?

In most board structures, a remunerations committee is assigned to set the level of compensation and determine the components of the pay package that senior executives receive, including base pay, bonus, stock and privileges such as use of the company jet. In recent years this committee assignment has gone from fairly light to as time-consuming as the audit committee.

There are several factors at play as the remunerations committee and the board as a whole try to weave together pay packages.

Compensation consultants

Often compensation consultants are used to help determine the packages of senior executives. Although many make a sincere attempt to prepare a comprehensive view, taking into consideration peer groups, market pressure, and many other factors, they may not fully appreciate how such a package will appear to stakeholders. What they advise may seem fair in the vacuum of the boardroom or on paper, but oftentimes it does not reflect other realities and pressures on the company from stakeholders such as investors, employees and the community at large. Also, there is a real danger that consultants can become part of the problem, driving up compensation packages as they create an aura of ensuring that the CEO and senior team feel fairly compensated relative to their peer group - a sort of 'keeping up with the Joneses'.

Personal feelings

Directors may have developed personal relationships with the CEO and senior team and feel as if they must give them a certain compensation to 'save face'. Or the directors may feel that the work the executives have done and are being asked to do in the future is onerous and must be compensated in a predetermined way - a way the board is accustomed to and feels reluctant to stray from. This can be a slippery slope, or rather a speedy escalator, as each year the desire to reward and inspire means that ever grander packages need to be put in place.

A disconnect from today's reality

Those of us in the boardroom can often feel we are in a soundproof room. Even though we come armed with a great deal of knowledge and information, it is hard to factor in all the input from outside voices or truly take seriously some of those voices. The conversation around the table about compensation may sound reasonable in the vacuum of that room, where big numbers can be bandied about, but it is vital that directors have a finger on the pulse of the market and consider how the pay package, or severance package for that matter, will be received by the wider world. Board members who have been through this process often express surprise at the response by the public and had little appreciation or understanding of the impact their decision would have on the company's reputation.

A lack of direct accountability

To date, most board members have done their work in a 'black box', so the decisions they made went fairly unscrutinised. Even if there was any outcry about the package, the issue was usually not linked back to the board. As such, there was little accountability for individual board members; they did not have to deal personally with any backlash that came as a result of unpopular choices.

This is changing rapidly. The perception and accountability of the boardroom, and indeed the personal accountability of individual board members, has been transformed. Increasingly board members have to demonstrate why they have taken certain decisions or voted in a certain way, and remuneration committees are being asked to substantiate their choices.

Boards need to come to grips with compensation structures of their senior executive teams, and stakeholders need to continue to voice their concerns about compensation packages. CEOs and other members of the C-suite deserve fair compensation for running companies, particularly in demanding economic times, when only organizations with the best talent will survive and thrive. On the other hand, these difficult economic times call for judicious decisions about compensation packages that are more clearly linked to performance and demonstrate that board members are not tone-deaf in a soundproof room.

Note: Lucy P. Marcus is a columnist for Reuters, where this article first appeared.

Lucy P. Marcus is the founder and CEO of Marcus Venture Consulting, and she serves as non-executive chair of the Mobius Life Sciences Fund and chair of the Mobius Life Sciences Fund Investment Panel. Lucy is a board chair and non-executive director who is challenging conventional wisdom inside and outside the board room. She has emerged as the voice setting the agenda on future proofing boardrooms and companies around the world, and was recently recognised with the Thinkers 50 "Future Thinkers" Award and was ranked 19th on the Reuters & Klout 50 list of "Most Influential Execs on the Web". She is also Professor of Leadership and Governance at IE Business School, focusing on corporate governance, ethics and leadership, and she writes a column for Reuters on the intersection of boards, leadership, and ethics.