Rethinking Executive Compensation

In my last article on executive compensation, I made the case that it matters because excessive executive compensation is a key driver of income inequality in the US, the most common approach of incentive pay may not have its intended effect, and may actually have significant adverse effects. But all of this begs the question of how we ended up where we are today with executive pay and what can really be done about. I’ll tackle the first part of that in this article.

The Myth of the Executive Talent Market

Is executive compensation out of balance?

Is executive compensation out of balance?

Perhaps the most fundamental assumption resulting in the way executives are compensated today is that there is an identifiable market of executive labor subject to the laws of the supply and demand. If this is the case, then this market can be measured and used as a source of benchmarking for determining executive compensation. The plain fact of the matter, however, is that the number of buyers and sellers in this is to small for it to be called a true market. In addition, the transactions in this so-called market are anything but transparent until well after the fact. This faulty assumption results in mining data on companies through compensation surveys. This process in and of itself plays a role in the continuous rise of executive pay. Pay is reported in quartiles. Can you think of a single company that would be excited about having its executive compensation classified as anything but the upper quartile? Directors, compensation committees and executives simply do not want shareholders or the public at large to see their companies as below average. It is one clear driver of increasing executive pay.

The Role of Consultants in Creating and Maintaining the System

As the business world became more complex, consultants came to the rescue of corporate boards trying to figure out how to compensate their executives. It was these consultants who promoted the idea of linking executive pay to performance, an idea as recently as the 1950s and 1960s was largely frowned upon. The problem is that it was just an idea that was not backed up by data. Incentive pay linked to performance metrics hasn’t proved itself to be effective. One study has shown that companies using total shareholder value as the metric linked to executive compensation actually, which is the metric of choice among many companies, saw their stocks decline by 0.18% in value over a five-year period. Companies that chose different metrics gained an average of average of 2.67%. The consultants may well have led the corporate world down the proverbial garden path when it comes to incentive pay. It is a handful of consultants that believe these faulty assumptions who are advising the boards of America’s major companies. Those companies would do well to at least be more careful about what sorts of metrics they choose to link to executive pay. And there’s still the question of whether or not a single CEO really has much control if any over the metric being used.

The Current System is About Negotiation, Not Market Forces

There is no invisible hand guiding the balance of supply and demand in executive pay. It is all based on negotiations between executives and corporate boards. It comes down to bargaining power and tactics, and it’s clear that the executives have the upper hand, in part thanks to the faulty assumptions popularized by compensation consultants.

The Primacy of Shareholder Value

It’s hard to envision how executive compensation could really change in light of what’s wrong with it. All the incentive and performance pay ideas that have come down the pike originate in the idea that the only or at least primary purpose of a corporation is to maximize the value delivered to shareholders. It’s easy to forget that this myopic focus on shareholder value is a recent development. After all, don’t we all want more from corporations than just their economic value? Don’t corporations have duties, responsibilities and obligations to society beyond merely increasing shareholder value? In today’s world that faces such challenges as extreme income inequality, global warming and climate change, pandemics, and political violence, I believe the answer to that question must be a resounding YES.

September 29, 2014   Updated :March 25, 2015   compensation metrics, executive compensation, executive pay   

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