October 07, 2003

Compensating Executives

Add to the to-be-read pile: Brian Hall on how to compensate executives:

Six Challenges in Designing Equity-Based Pay: This paper analyzes why the primary goal of the equity-pay explosion--creating long-run ownership incentives for top executives--has often been difficult to achieve in practice. More generally, I describe six challenges in the design of equity-based pay plans and discuss potential solutions. The six challenges involve: 1. mismatched time horizons; 2. gaming; 3. the value-cost wedge; 4. the leverage-fragility tradeoff; 5. aligning risk-taking incentives; and 6. avoiding excessive compensation. The paper also discussed the merits of stock versus options and concludes that restricted stock is often a superior form of compensation.

The point that restricted stock is better than options is surely 100% correct.

Posted by DeLong at October 7, 2003 05:35 AM | TrackBack

Comments

Here's a simple idea. Pay them a little better than
normal people. Then see if they do any worse
or better. Is there any proof that people
with elaborate pay packages do any better than
people without? Isn't performance more related
to the economy than the leaders?

In my industry the execs voted themselves a
retention bonus when there was no place else to go.

Posted by: lower class on October 7, 2003 06:44 AM

What, isn't this suggesting that there isn't a perfectly competitive market for executive pay? That is sacrilege! That would mean that all wealth isn't earned! Well, I've been told it's my money! This has to be wrong, it's mine, mine, all mine...

Posted by: Stan on October 7, 2003 07:19 AM

lower class, the research does indicate a correlation of higher pay and better results. Not surprizingly incentives do work. The research also shows a problem of decreasing returns at a non specific point (i.e., another dollar doesn't yield an improved result at some point). That is the offensive case.

There is also the defensive case. To some degree executives' possess knowledge (much of it provided as on the job training - aka an investment) that they are free to take with them (due to our anti-slavery laws :). Your competitors can effectively buy your investment and potentially use it against you. Needless to say, the market is anything but perfectly competitive.

Posted by: Stan on October 7, 2003 07:49 AM

Stan, can you point to some research that says
extremely high multiples lead to extremely
high results? Do companies led by higher paid
executives do better in downturns? For the most
part companies seem to do well when the economy
is good. Who is at the help seems to make little
difference.

Posted by: lower class on October 7, 2003 10:10 AM

I can't get at the complete paper, but from what I see the subject seems academic, in the sense of "not very helpful in the real world". That is, who is to implement any such plans? Company boards made up of CEO's of other companies? Unlikely. What am I missing?

My entirely unsupported 2 cents on the mechanics of executive pay is that companies tend to set pay by comparison to other companies. For many jobs, they will pay the average of what other companies pay, but for "important" jobs, they will tend to pay a bit above the going rate, to "get the best". Once most companies do this, the obvious end result is spiralling pay at these few "important" jobs.

Posted by: Tom Slee on October 7, 2003 10:19 AM

lower class, the answer from what I can tell is yes and no. From what I've read, eventually the multiples come to have no apparent performance value but they do up to a point. As I said earlier, the point isn't necessarily specified.

I do not specialize in executive pay. I'm pretty confident that Brian Hall's literature review will show you pieces supporting my generalizations. If you have something showing no increase, I wouldn't mind being pointed to it though I'd start off sceptical. I personally respond to incentives.

Tom, the obvious flaw in the one up method should get all compensation committees using it fired. Any chance the market is telling these committees to learn something useful? :)

Posted by: Stan on October 7, 2003 11:31 AM

Stan -- I'm not so sure there is an obvious flaw from the point of view of an individual company. Do they really want to hire a substandard CEO? Arms races are not all that easy to get out of, however stupid they may seem. Or am I missing the point of what you said?

Posted by: Tom Slee on October 7, 2003 12:21 PM

Tom, I'm sorry. My question was rhetorical about the market actually punishing the practice. I'm not sure it can or will.

Posted by: Stan on October 7, 2003 01:05 PM

"Arms races are not all that easy to get out of, however stupid they may seem."

One way out is to realize that the extra arms may not improve security. In the present context, I think boards ought to ask whether the "excess" pay really gets anything in terms of company performance.

I am one of those who believes the importance of the CEO is overestimated, and that there are many more executives capable of doing a competent job than there are positions.

Posted by: Bernard Yomtov on October 7, 2003 01:39 PM

"Arms races are not all that easy to get out of, however stupid they may seem."

One way out is to realize that the extra arms may not improve security. In the present context, I think boards ought to ask whether the "excess" pay really gets anything in terms of company performance.

I am one of those who believes the importance of the CEO is overestimated, and that there are many more executives capable of doing a competent job than there are positions.

Posted by: Bernard Yomtov on October 7, 2003 01:44 PM

One simple solution would be to have all compensation agreements other than the initial one used to hire the ceo be put up for a shareholder vote. None of this bs compensation committee stuff where the ceo stuffs his neighbhors, headmaster at his children's school, and other such assorted cronies on the board of directors.

Posted by: William Utley on October 7, 2003 05:11 PM

There are always several candidates competing for an open CEO position, but I don't believe I've ever heard a company announce that they went with their close second choice because they were willing to work for half the salary and a quarter of the stock options. And you know many would be willing as it's still a pay hike for them and an increase in prestige.

Posted by: snsterling on October 7, 2003 09:31 PM

what I'm curious about in the world of restricted stock is the stipulation that top executives own a certain number of shares outright. I get the basic idea, that is you are more apt to be aligned with shareholder interest if a substantial percentage of your net worth is tied up in company stock, but I don't understand any practical way of doing this.

as every CEO will have a large difference on net worth going into a given job, how can you set a level of stock ownership? percentage of net worth? seems very unlikely.

Posted by: jjj on October 7, 2003 09:34 PM

How 'bout having CEO receive compensation that is a fraction of the market capitalization of the company, rather than options. That way, a CEO doesn't benefit when the company goes up temporarily.

A CEO with options to buy at $50 who can get the company up to $60 one year and have it fall to $40 the next benefits, whereas a CEO with pay based on a fraction of market cap would not.

Maybe dividedends paid be the firm could be added to the fraction of payment? (so that a CEO who is paid 0.1% of market cap/year, whose company paid out $1 billion in dividends, would have that 0.1% fraction permenantly (as far as the CEO's tenure, at least) increased until the value of it was higher by $1 million)

That's the most intuitively obvious way I can think of of aligning shareholder and CEO interests.

Problem: A CEO who gets his company to $70 a share, then $50 a share next year, is still better off than a CEO who gets his company from$50 the first year, then $60 the next, even though shareholders benefit more from the second.

I dunno. I'm no businessman.

Posted by: Julian Elson on October 7, 2003 10:02 PM

Joseph Stiglitz made a good part of his name by drawing the consequences from the fact that new workers have better information than employers about how hard they are prepared to work. Asymmetric information creates the problem of worker incentives and equilibrium non-clearing wages. The asymmetry applies a bit to shareholders as employers of CEOs, not so much about industriousness as about integrity (power and opportunity corrupt, so a track record at lower levels doesn’t prove it).

What is less noticed is that the asymmetry applies in reverse to workers applying for a job: they don’t know whether top management are honest bastards out to make money for the shareholders - which workers can live with because there’s a long-run convergence of interests – or crooked bastards out to extract rent from shareholders and workers alike, and flush the latter’s investment in on-the-job training down the toilet. This looks to me like a good long-run equilibrium argument for trade unions as discovery mechanisms for workers about management.

Posted by: James on October 8, 2003 12:23 AM

Joseph Stiglitz made a good part of his name by drawing the consequences from the fact that new workers have better information than employers about how hard they are prepared to work. Asymmetric information creates the problem of worker incentives and equilibrium non-clearing wages. The asymmetry applies a bit to shareholders as employers of CEOs, not so much about industriousness as about integrity (power and opportunity corrupt, so a track record at lower levels doesn’t prove it).

What is less noticed is that the asymmetry applies in reverse to workers applying for a job: they don’t know whether top management are honest bastards out to make money for the shareholders - which workers can live with because there’s a long-run convergence of interests – or crooked bastards out to extract rent from shareholders and workers alike, and flush the latter’s investment in on-the-job training down the toilet. This looks to me like a good long-run equilibrium argument for trade unions as discovery mechanisms for workers about management.

Posted by: James on October 8, 2003 01:52 AM

Stan, to your question about the market correction process -- don't you remember "corporate raiders"? Like in Pretty Woman & Wall Street? Set the rich to screw the rich -- cause they're the only ones who can.
Really. The regs passed to stop hostile takeovers is why exec pay has become obscene.

Posted by: Tom on October 9, 2003 05:51 PM
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