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Macro Economics
Circular Logic of Executive Compensation

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By deadcat2
December 15, 2009

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

From steve203's post (#314496) regarding this article:

Officials from the Fed and Treasury asked Feinberg to relax pay rules for workers they deemed essential to its success, concerned that too many departures could cripple the company. Treasury owns nearly 80 percent of AIG. Feinberg said out of several dozen requests, he allowed about 12 employees to earn up to $1.5 million in cash for 2009. [...]

The departures isolate the companies that remain under his control. The concern is particularly acute at Citigroup, whose best investment bankers easily could defect, and at AIG, whose reputation is so sullied that it struggles to retain talent.

"I'm very leery of imposing particularly tough pay restrictions on these companies in which the taxpayer has a big stake," Elliott said. "But other people feel it's important to underline a moral lesson here."


The whole issue of executive compensation and retention is yet another bubble of such gargantuan proportions that it's difficult to see a painless way out. To complicate matters, executive pay is not just about money. It can be a very public proxy for status, power and self-worth and therefore, discussions about pay become an excruciatingly sensitive topic. Compensation within the upper ranks of management has grown at a phenomenal pace over the past several years and given the nature of the beast, "fixing" executive pay is not going to be easy.

On the one hand, there is the very real argument that retaining key employees is essential and therefore, pay must meet competitive standards within an industry. On the other hand, those very standards are established by pay practices within the industry itself. When the banking behemoths, for example, say they have to deliver on their inflated pay packages or risk losing talent, it's much like someone who makes the rules and then says with a shrug "What am I to do? I gotta follow the rules." Let's consider all the players...

First, there is the company itself. Let's say they make the strategic decision to target their pay at the 75th percentile. The irony is that nearly all major corporations believe their pay should be targeted at the 75th percentile (hey, we're world class, right?!). Of course this means that the 75th percentile very quickly becomes the 50th percentile. So, the 75th percentile can quickly ratchet up from year to year.

Next, there is the Board of Directors, many of whom sit on one another's boards. Typically the Compensation Committee for the Board is but a rubber stamp; what board member wants to dissent to a pay package when they consider that the package for their own corporation will soon come under review? To maintain arm's length on the topic (and conveniently abdicate personal responsibility for the decision), the corporation hires an expensive consulting firm to review and suggest salary levels and bonuses.

Of course the consulting firm is eager to please their client. After all, this top echelon of executives are the ones who will determine whether the consulting firm does further work for the corporation. To remain in business and yet retain some sense of integrity, consultants will interview executives, learning which companies the executives believe are their prime competitors (not atypically, these will often be corporations that are known for their generous pay practices). From this shorter list, the consulting firm will conduct a survey of pay practices unique to this subset. Within this smaller and more richly compensated group, a new 75th percentile will be drawn. To encourage the selected companies to participate in the survey, they will generally be promised a free or very cheap copy of the results. Voilà! A new reference for the level of pay has been "objectively" developed by the "independent" consultant and all the companies within this subset now have new and actionable data from their competitive peer group.

Then there are the headhunters. The incestuous relationships that exist between top corporations, recruiting firms and individual executives can be powerful, long lasting and very beneficial to all parties involved. Any executive placed in a new position by the recruiting firm will likely engage that same firm for further placements within the executive's area of responsibility. Many of those placements might come from a whole new roster of candidates (read as potential assets for the headhunter) provided by the executive from his previous place(s) of employment. Of course this endless round of musical chairs inflates salaries and pay packages every time the music plays.

Executives who are adept at playing this game will likely call upon their headhunter within 3-5 years to seek a new position with greater "challenges", higher levels of responsibility and, of course, a much enhanced pay package. It's best to move on before inertia sets in and the executive can claim the fullest credit for what is often no more than the Hawthorn Effect (http://en.wikipedia.org/wiki/Hawthorn_Effect).

In a previous life I worked for nearly 25 years in the human resources department of some very large firms. Most of that time was spent in the specialized discipline of compensation - wages and salaries, stock option plans and incentive or bonus plans. This rant derives from personal observation. As a company grows larger, innovation in human resource practices is not necessarily the objective. Many times I was asked to create "something new and different - something completely outside of the box." When these outside-the-box plans were presented, however, the usual response was, "Are any of our competitors doing this?" No one was really comfortable doing anything much different from mainstream practice. More often than not, the compensation team was asked to replicate what some other Fortune 500 company was doing, gleaned by some executive from an in-flight magazine.

Since I've just written about it, I should mention another group that also contributes to the problem, albeit often with a clenched jaw - the employee of the corporation performing the executive compensation function. Clearly top management has the greatest leverage over this group. In not so many words I myself have been told "give me my money or give me your job." The solution? The same as the Board of Directors - hire an outside consulting firm. To keep his/her job or integrity, more often than not the executive comp team gives up the role of designer and becomes an administrator, coordinating the activities of the outside consultant, providing them data, and responding to the transactional demands of the executive team.

I see this rapid rise in executive pay as analogous to what we've seen in the housing market. There are many players who had a hand in the inflation of the housing bubble: politicians, mortgage brokers, real estate brokers and appraisers, bond raters, investment houses, investors and homeowners. There's plenty of blame to go around.

So it is with compensation - especially at the executive level. The only way that total compensation will come back to reasonable levels is through an uncomfortable and no doubt painful upheaval. Back in 2006, who in that chain of bubble participants above was likely to call attention to the emperor's lack of clothes? Similarly, corporations probably feel locked into the cycle of ever increasing pay packages because no one wants to be the first to make the change that could very well reduce the size and quality of their resource pool. If they could make such a change (not for themselves but certainly for their lower level employees), I'm sure they would. In fact, the current recession has been a great excuse to make some of those changes (though of course top tier talent can't be compromised ;-).

On top of everything, there is the enormous hubris of the Fed and Treasury who seem to believe they can arbitrarily make changes in this very complex arena, down to individual employee recommendations. Given that we the taxpayers have a substantial stake in some of these companies, perhaps it's reasonable that limits are set and at least for the companies we effectively own, that we have a say. However, given that the top tier of many of these companies has remained intact, or replaced with their clones, I don't have a lot of confidence in the human resource expertise of the government. For example, where do they get the information to make decisions about the employees who must be retained? I'm hesitant to accept the judgment of anyone in a position of authority who has allowed - knowingly or not - the unraveling of their corporation on their watch.

The solution as I see it is to begin shifting pay from fixed costs to truly variable costs. That was always the intent of incentive plans - to substitute some of the fixed costs of salary with the variable costs of a plan that pays for results. Pay well for exceptional results; don't pay for mediocre results. Of course over time those plans, particularly at the executive level, became entitlements. Few corporations are in the business of delivering anything less than "target" pay. Executives sign contracts guaranteeing their pay and their severance packages, even if they screw up royally. Why? Because that's the practice among these companies. Don't do it and you don't attract and retain. The trade off to this contractual security is risk, and risk has a price. While there may be some executives who would be willing to sign on for less entitlement, they will expect an even greater and immediate reward for success. One solution is to get back to real variability of pay so that short and longer term results of the corporation as a whole are appropriately reflected in the overall pay levels of executives. In today's environment, more often than not an executive experiences a cut in bonus for poor performance when loss of their job would be the appropriate remedy.

Another shift would be to change the focus of bonus plans from short to longer term. When decisions are made for the next quarter or even the current year alone, the long term health of the corporation is ignored. While measurements necessarily have to be short term, they must support the long term strategy. The other issue here is that schedules for bonus pay should be lengthened as well. Rather than huge annual bonuses based on results that might later be modified, payments should require some vesting schedule, allowing claw-back (or enhancement) of monies or stock options already rewarded. 3-5 years seems appropriate.

Then there's the design of the plan. Is there a proper balance between short and long term goals and objectives? Are the objectives themselves appropriately measured? What does the corporation need to focus on? Is there a strategic focus? Is that focus properly reflected in the intermediate measures of success? Are the bonus plans tight, or is there wide opportunity for interpretation? As a designer of sales compensation plans, we told the executives that "the good news about sales plans is that they work. The bad news about sales plans is... that they work." For people who are paid to make as much money as they can in as short a time possible, they'll find the loopholes, guaranteed. As for interpretation, a telecommunications company for which I worked realized that bonus plans would not be paid one year. So they sold an office building and signed a long-term lease-back agreement, booked the capital gains (the plan element that was supposed to be measured was revenue) and sufficiently raised net income to ensure everyone - including themselves - would receive a full bonus that year.

Executive pay is excessive because ultimately, executives themselves design it that way. I suppose it's only natural that anyone given that amount of authority would surmise they were exceedingly valuable. And in some sectors like banking, executives find themselves very valuable indeed. I know the argument will be made that the problem lies in our collective values, explaining why super athletes and entertainers are paid unfathomable sums. That may be the case, but the agent of the superstar still needs to negotiate with the buyer. If I am negotiating with myself, however, I suspect I could drive a much harder bargain ;-).

As for creating an environment where shareholder input is considered in corporate pay decisions, I'm not sure how much difference that would make. Downsides might also include the likelihood that investors would be unwilling to sacrifice short-term returns for longer term competitive and/or strategic advantages. There is also the issue of expertise. How many individual investors would be in a position to assess the quality of a particular pay plan, whether it is competitive, unnecessarily expensive, designed with more loopholes than a Boy Scout knot-tying contest?

Transparency should certainly be an overriding factor as we move forward. But this transparency also needs to be front and center, easily accessible and not buried somewhere in the footnotes of quarterly and annual reports. A website that collects the most pertinent data easily viewed and compared would be ideal. Perhaps something like a "Greed Factor" could be calculated. All aspects of compensation should be compared - salary, stock options, perks, etc., both as individual items as well as a total value. Compare those elements against meaningful metrics, such as total pay as a function of cash flow, or top line revenue, or net income. The effectiveness of such a site would be dependent on its simplicity, ease of access, and a comprehensive company comparison. Rather than limiting the data to the top 5 earners, I'd like to see it expanded to perhaps the top 10-20 earners, depending on the size of the corporation. It would be a challenging endeavor, to be sure, but I believe it could go a long way toward shining a light on some of these outrageous pay practices.

Admittedly I have painted with a broad brush; I would hope that a minority of executives are driven by profound greed but I fear that that minority may be sizable. Also, I haven't even delved into the belief that variable pay - bonus plans - is not necessarily the best driver of behavior in all cases.

End of rant. For those of you who actually made it to the end of this exceedingly long post, thanks for listening.

Derek