Compensation & incentives

Chief Executive, The, April, 2005 by Joseph G. Haubrich

I'm sometimes surprised at the anger over high executive pay: it seems that running a major corporation is as rare and valuable a skill as slam-dunking a basketball or looking good in spandex. But on reflection, that outrage is perhaps more understandable. The athlete with an MVP award, the singer with a number one hit, the model with a dozen magazine covers, have all obviously had a good year. A CEO's productivity is often less apparent, the take-home pay harder to justify.

From an economist's standpoint, stripping the question down to its essentials, bosses add value by making good outcomes more likely. This makes measuring their productivity difficult for two reasons. It's hard to specify in advance which actions will add the most value: motivating employees, picking the right growth areas, or cutting costs. More importantly, chance plays a role, and the best laid plans go oft astray. Was that run-up in the stock price skill, or luck?

This uncertainty over outcomes has a more subtle consequence, one that shifts the focus away from the headlines about the level of pay. The key issue becomes how pay depends on performance. In a word, the question becomes the incentives produced by executive pay. The answer determines how the chief executive's goals are aligned with the firm's. Tying pay closely to performance means the CEO shares in the downside as well as the upside, and faces risk to events beyond his or her control. It can make a leader too conservative. Giving the CEO the upside without the downside, though, can lead to more risk than the shareholders have bargained for. Designing compensation packages means making the trade-off between bearing risk and providing incentives. And of course the right incentives depend on the firm and the industry: whether it's growth oriented, R & D intensive start-up, or a mature, cost-conscious market leader.

Although most of the academic compensation literature starts from the premise that the essential problem is to induce effort without imposing too much risk, a strand of corporate finance that looks at capital structure takes a very different approach. This strand argues that the CEO is in fact too closely aligned with current shareholders. This works to the detriment of the firm, as profitable projects are passed up because raising money to fund them will dilute current shareholders' ownership share. From this perspective, executive pay may depend too closely on firm performance, particularly if stock grants and related schemes provide those incentives. Of course, a proper compensation scheme can solve this problem, but it's one more factor that a good design must balance.

Taken together, a sports analogy might not be a bad way to visualize the problem. Basing your point guard's salary on his scoring alone downplays passing, defense, and play calling, which also help the team. Incentives are important, but the wrong incentives hurt.

Finally, it's also important to keep in mind that executive compensation is only one part of the strategic alignment problem, or put differently, of the corporate governance question. It is thus part of a broader design question involving capital structure, the board of directors, and even regulators and the takeover market.

RELATED ARTICLE: The Quotable CEO on Executive Compensation

"We need more transparency in reporting to the SEC & shareholders about
executive compensation. When people don't have facts, they make up
stories!"
Katharine Halpin, President, The Halpin Companies

"There are a number of CEO's that are paid way too much given the
returns they give shareholders, sometimes even when they have good
returns to the shareholder. Executive compensation is based on a flawed
system."
James L. Packard, Chairman & CEO, Regal-Beloit Corporation

"CEO's get a bad rap based on the notable excesses touted in the press,
but the majority of executive compensation is certainly much more
reasonable by any measuring stick."
Jeffrey Evans, CEO and Chairman, The Will-Burt Company

"Executive compensation is rarely presented in context of corporate
value creation. But, neither is it done for highly paid professionals. I
have no concept of the impact Nicholas Cage brings to the bottom line of
a movie company. Neither do I have a very good idea of the value impact
of any CEO."
J. Laws, COO, Wilbur Curtis Co.

Joseph G. Haubrich is a consultant and Economist at the Federal Reserve Bank of Cleveland. The views stated here are those of the authors, and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System.