The Challenge of Executive Compensation and Why it Matters

In the wake of the Great Recession and the focus on income inequality raised by the Occupy Movement, there has been a renewed focus on executive pay and the effects it has on both the business world and society at large. Most of that attention has been negative, with a rising tide of concerns and complaints about excessive executive compensation. In spite of all that attention, executive pay continues to climb ever higher. In 2013, the median compensation for US CEOs was a staggering $13.9 million, a 9% increase from 2012 (source). Is all the attention paid to executive compensation just a case of media hype or are there substantial issues that need to be addressed? In other words, does executive pay matter? I think it does, and I’ll explain why through a series of questions raised by the issue of executive compensation.

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Does Executive Pay Drive Income Inequality?

Does compensation reward performance or vice versa?

Does compensation reward performance or vice versa?

Whether you agree or not with what the Occupy Movement wants, it is right about at least one thing: The gap between the rich and the poor is only getting wider. Thomas Piketty, an economist from the Paris School of Economics, writes in his new book, Capital in the 21st Century, that back in 1960 the top 10% of US earners took in 33.5% of all income. In 2010, that top 10% grabbed 47.9% of the total pie. Besides the shocking lack of progress on income inequality over the last 50 years, what’s even more disturbing is that Piketty says two-thirds of that increase is from higher wages, and that rising executive compensation makes up most of that. He argues persuasively that the whole idea behind “trickle-down economics,” that making sure everyone at the top does very well cascades down through the ranks and makes everyone’s lives better, is not borne out by the data and simply doesn’t work. Not only does it not work, it seems people are starting to get really fed up about it, as evidenced by the recent protests of fast-food and other low-wage workers for better pay.

Is Executive Pay for Performance Effective?

The basic idea of linking a CEO’s pay to how well the company performs under his or her leadership makes logical sense on the surface. But the reality is quite different. To begin with, if incentive pay is linked to the overall performance of a company’s stock or shareholder value, since when does a single individual have the ability to control a company’s stock price? There are forces at play beyond anyone’s control, and it seems more logical that a company’s performance depends on everyone who works there, not just one person at the top. The data show that it may not really work in the end. One study revealed that company performance only explained about 4% of the variance in executive compensation (source).

Does Incentive Pay Lead to Gaming the System?

It’s fairly common knowledge that incentives only work well when a person can see a direct link between their effort and the pay-off. Given that company performance depends on the work of many people in the company, that direct link between CEO actions and the pay-off simply isn’t there. That is, unless they find ways to make that link themselves. When compensation is linked to some kind of company financial performance metric, it’s inevitable that the chosen metric becomes a huge focus for executives, making them vulnerable to temptation to do whatever it takes to affect that metric in the way that pays off. It happened at Enron in a major way with off-balance-sheet transactions. It happened at many companies that cut corners on approving what should have been far too risky mortgage loans, a major factor leading to the Great Recession.

Executive compensation is a challenging issue that has no easy solutions. Given how ever-rising pay packages for business leaders have real impacts throughout the business world and society at large, it is an issue that does matter. In my next article, I’ll try to get at the root of what has driven the way executives are compensated, and how the entire project might be rethought.

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September 29, 2014   Updated :June 10, 2015   compensation, executive pay, incentive pay   

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