How to Fix the Biggest Problem With CEO Pay

In the video below, The Motley Fool speaks with Roger Martin, strategy expert and dean of the Rotman School of Management at the University of Toronto. We discuss how to fix the biggest problem with executive compensation, which Martin believes is that it incentivizes CEOs to make decisions based on the short term, not based on the long-term benefits of the business. Martin argues that we would be better off if executives were compensated in stock that began to vest after the CEO retired, therefore incentivizing the CEO to focus on the long-term health of the company. 

A transcript follows the video.

The full interview with Roger Martin can be seen here, in which we discuss a number of topics including Bill Ackman, innovation, corporate responsibility, executive compensation, and how to pick great companies. Martin is the coauthor of Playing to Win, a new book focusing on strategy written with former Procter & Gamble CEO A.G. Lafley.

Brendan Byrnes: Should CEOs not get any stock-based compensation?

Roger Martin: I think the world would work a lot better if they didn't. We have this now romantic attachment to stock-based compensation. If people feel that they have to use stock-based compensation, I think they have to do two things.

One is, in the case when I hired you, I'd say, "Brendan, this is your only grant of stock-based compensation you are ever going to get as CEO. It's a really big one, but we're not going to give you one annually."

And, "These are restricted. They're restricted until three years after you retire."

If that was the case, then you wouldn't try to drive things down to drive them back up because you're not going to get some more stock at a low value, and you won't try and time it right to the end and do all sorts of extravagant, crazy things at the end -- gigantic acquisitions, massive cost-cutting of all R&D and everything -- to get the stock as high as possible when you retire, because it's going to have to perform well for several years until you leave. That's what I would do.

Brendan: And maybe you would focus more on grooming a successor.

Martin: Oh, you sure would. You sure would.

Brendan: Waiting three years afterwards.

Martin: Yeah, because that person, you really depend on them. Again, back to P&G (PG 0.68%) and A.G. Lafley, he went to the board and said, "You know all my stock-based compensation? I think you should make it vest in 10% increments in each year after I retire." He did that, not the board.

He said, "This would be better for P&G and P&G shareholders." That means he's going to leave a company in the best shape possible with the best management team there, because he doesn't cash out until that last 10% comes 10 years after he retired; 2019. That's the kind of thing you would want, but that was A.G. saying it to the board, not vice versa.

Brendan: The stock-based compensation system is pretty entrenched right now. Do you have any faith that it can change, going forward?

Martin: I guess I do. I see that large changes in these things are made on the basis of theories and ideas. This all came into being because of one article written in 1976 by Jensen and Meckling, who posited that we needed to create this alignment through stock-based compensation.

I think in due course people will just say, "You know what? This is bad theory." Mike Jensen says it's a bad theory, interestingly enough. He said, "It's been misinterpreted, and what's happening is not consistent with my article."

But these things tend to take awhile. There's such an infrastructure built up around it, including all the proxy voting services. They give advice to the pension funds that say, "You need to make sure there's big stock-based compensation," so the pension funds say, "OK, I guess I'll vote for more stock-based compensation rather than less."

You've got compensation consultants out there who say, "Oh, stock is a really important part of your compensation package." When you have all of that infrastructure around, it takes longer to break out of that.