The Truth about Executive Pay

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There's a line of reasoning being echoed in the Obama administration that if we cap CEO pay for bailed-out companies in the financial markets, the best and brightest will leave, seeking greener pastures with foreign companies which don't have similar restrictions.

This is false reasoning.

Executive pay must be tied to long-term performance if anything is going to change. Here's some thinking on the issue from Stephen F. O’Byrne and S. David Young in HBR:

The justification for maintaining pay competitiveness is that it reduces the risk of losing good managers, who could be costly to replace. Corporate boards could also argue that it minimizes the risk of seriously overpaying managers as a consequence of large, windfall gains from surging share prices. In short, the claim is that competitive pay policies not only help lower retention risk but also impose limits on shareholder cost. This is false logic. By causing companies to overpay underperforming managers and underpay star performers, a competitive pay policy will actually increase retention risk. The poor performers stay on and the good ones go. What’s more, it ignores the potential wealth-creating effects of strong financial incentives.

Despite their commitment to competitive pay policies, compensation committees sometimes do act to strengthen incentives by increasing option grant shares after a year of strong stock-price performance or decreasing them after a bad year. On the surface, this appears to be good news. But such moves have little overall impact because directors tend to reverse their actions in the following year. In other words, an option grant that rewards good performance or penalizes poor performance is followed, almost half the time, by a grant that penalizes good performance or rewards poor performance. On balance, therefore, ad hoc adjustments by boards contribute almost nothing to wealth leverage.

If companies are serious about rewarding performance and retaining star performers, they will first have to wean themselves off competitive pay. They should give managers fixed-share interests in stock appreciation and economic profit improvement, thereby increasing the impact of future pay on executive wealth. Perhaps most important, they need to review vesting and holding requirements to prevent managers from unilaterally cashing out share-based pay, which also reduces the sensitivity of their wealth to company value.

Secondly, we know the financial sector is grossly overpaid. Even the Chinese will tell you this. I blogged earlier about China's Gao Xiqing, president of the China Investment Corporation:

- "If you look at every one of these [derivative] products, they make sense. But in aggregate, they are bullshit. They are crap. They serve to cheat people.

- "I have to say it: you have to do something about pay in the financial system. People in this field have way too much money. And this is not right."

He's not mincing words, and neither is the Economist >>

I say let them go. It's time these executives we came back to Earth. If they want to risk their own money great, but why should we subsidize irresponsible management practices?

I'm with Warren Buffet when he says in this letter:

"CEO perks at one company are quickly copied elsewhere. “All the other kids have one” may seem a thought too juvenile to use as a rationale in the boardroom. But consultants employ precisely this argument, phrased more elegantly of course, when they make recommendations to comp committees.

Irrational and excessive comp practices will not be materially changed by disclosure or by “independent” comp committee members. Indeed, I think it’s likely that the reason I was rejected for service on so many comp committees was that I was regarded as too independent. Compensation reform will only occur if the largest institutional shareholders – it would only take a few – demand a fresh look at the whole system. The consultants’ present drill of deftly selecting “peer” companies to compare with their clients will only perpetuate present excesses."

No one is saying we should stop paying for performance. What we're saying is let's stop rewarding unsustainable business practices and outright fraud.

Where are we going to find low-cost, competent CEOs? That's a business GE should look into. A CEO-for-Hire profit center. Training grounds? India and China, of course.

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The War on Greed from ChristianSarkar.com on February 17, 2009 2:00 PM

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This page contains a single entry by Christian Sarkar published on February 16, 2009 10:13 AM.

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