BIG SHOTS AND BIG BUCKS

Why do big shots make big bucks? The standard answer is that the prospect of a bonus encourages corporate executives to maximize stockholder return. But some behavioral economists argue that incentive compensation may be counterproductive. See Dan Ariely, What’s the Value of a Big Bonus?, New York Times, November 20, 2008, at A33:1. In a series of experiments, Ariely and his team discovered that if they offered a big reward for performing a task that required even rudimentary cognitive skill, performance was worse than when they offered a modest reward. On the other hand, a big reward induced better performance if the task required effort only and no skill. They found a similar effect when the tasks were performed in public rather than in private.

 

The suggestion is that generous incentive compensation for CEOs and other high ranking officers of public corporations may be counterproductive. If so, a big bonus is a waste of money and stockholder wealth. Moreover, Ariely suggests that the effect may be due to stress. So maybe it is really for their own good that we should limit incentive pay for corporate executives.

 

The problem with the argument – and the implicit assumption behind the experiment – is that incentives are intended to affect performance. There is another more likely possibility. It may be that incentives are really about sharing gain. Maybe incentives are about attracting the best talent possible to do whatever they do however they do it.

 

Is there any reason to think that Tiger Woods plays better in a major tournament than he would play for lesser stakes? Possibly. Tiger may play better in a major because he thrives on the stress and because the stress makes others choke. But the more likely reason is that Tiger plays only in a handful of tournaments because he knows how good he is.

 

Similarly, in the business world, incentives may be more about attracting talent than about encouraging better performance. Indeed, it may be that the best CEOs thrive on stress. So maybe incentive compensation is about attracting those who do better under stress and maybe even increasing the stress that goes with job.

 

Presumably, a talented businessperson with choices will sign with the company that is most likely to succeed. And sometimes that success may be assured by attracting the talent that already knows what will work – like the engineer who arrives on the scene, pushes one button, and sends a big bill for his services. From the company viewpoint, it may be more efficient to buy talent than to train it. From the employee viewpoint, a job is like an investment. You seek the highest return at the lowest risk. Nothing wrong with that. So a better experiment would be to see if it makes any difference if individuals can choose the task or the incentive or both.

 

A cynic might reply that incentive pay should be about inducing better performance and not about bribing folks just to do their job. An economist would call it rent. But so does a holder of a patent or copyright command rent for existing goods. Why should talent or a business strategy be seen as different from other forms of intellectual property?

 

Many critics cite greed and unregulated executive compensation as causing or contributing to the current financial mess. At the very least, they advocate a crackdown on executive compensation at the troubled banks and other financial institutions that get government assistance. There is little doubt that those who originated and securitized subprime mortgages did so to make money. Nor is there any doubt that many did enjoy handsome compensation in the process. But it is not at all clear that cracking down on compensation makes sense.

 

The problem at the moment appears to be that the banks refuse to lend even to many good customers with good credit. One way to thaw out the credit markets is to reward bankers who make good loans. But if we ban pay for performance because of the worry that it will induce risky business, there is little reason for anyone to make good loans. There is no reason to take a chance when there is no upside. Better to buy risk-free government securities – even if they yield next to nothing – rather than risk one's job on making a bad loan.

 

Moreover, limits on pay are likely to drive much of the banking and finance business into the private realm. No one would suggest that a trader who trades for his own account enjoys excessive pay when he makes a killing. Pay is one thing. Profits are another. Or maybe not. The point is that compensation is an issue only if the employer is a publicly traded company. If we limit pay, the talent is likely to gravitate to nonpublic companies -- private equity and hedge funds. That is not necessarily a bad result. It would effectively insulate investors in the future from the risks that have come home to roost in the current crisis. But it would also deny the public access to the returns that go with that risk. Do we really want to go back to the days when we had a soviet-style choice between a fixed return on passbook savings or a Series E savings bond?

 

Still, one might argue that it is wrong that Wall Street executives should be able to keep the pay they took over the past few years. The argument seems to be that past performance was somehow a fraud or that those in charge knew what was coming or that taking generous pay implicitly guaranteed future performance (despite explicit warnings to the contrary on every pack of stocks sold by mutual funds). The fallacy in this argument is that the market always looks forward. Market prices reflect a guess about the future. So when stock prices increase, and CEOs cash in their options, it is because the market approves. To be sure, a stock may rise because of fraud as with Enron. But the current crisis is not about one or even a few companies. It is about the whole of the market. No one would seriously argue that the entire financial services industry was engaged in a coordinated fraud. But it is easy to take pot shots at individual CEOs. So what we have is an odd collective action problem in which it is easy to cast blame on individuals who cannot defend themselves. No one would dare argue that everyone was doing it, even though in this case that appears to be a perfectly good excuse.

 

Moreover, suppose that we could somehow claw back past pay for no performance. What if -- as Deep Throat suggested -- we follow the money? Where is it now? Maybe it is sitting as cash in a bank account somewhere. It is more likely that the money was invested in stocks, or bonds, or real estate, and has shrunk with all such investments. There is no place to hide in a financial meltdown.

 

Finally, many critics have focused their ire on severance pay which they see as pay without performance or indeed reward for failure. Never mind that A Rod gets paid to play win or lose. (And Marbury gets paid no matter what.)

 

There is another side to the severance story. Golden parachutes were invented in the 1980s to counter the tendency of CEOs to resist takeovers even though stockholders stood to gain from such deals. Equity compensation was an obvious extension of the idea. Equity compensation is the best way to induce the CEO to maximize stockholder wealth -- whether by growing or shrinking the company. In the old days, CEOs got paid for reporting ever higher earnings, which encouraged growth – whether sensible or not – and conglomerate corporations. Since the early 1990s, most CEO pay has been in the form of stock options and restricted stock. And conglomerates have gone the way of the wooly mammoth.

 

Equity compensation also means that the CEO has a significant ownership stake in the business. So generous severance pay should not be seen as a reward so much as a buyout. A CEO who is forced to depart his business, loses the chance to finish what he started and to share in future gains. In any other setting it would seem quite natural for a part owner to be paid in exchange for his share of the business. This is not to say that the system cannot be abused. It is only to say that one must see severance for what it is. It is at least as much buyout as payout. 

 

The real question is where did we get the idea that a CEO is a glorified employee – or indeed a volunteer -- and that executive pay is really a big tip that the stockholders might or might not choose to pay? Is there some reason that working for a piece of the action is inconsistent with the public corporation as an institution? There is also a grand tradition of sweat equity. I suspect that attitudes toward executive pay are an outgrowth of the notion that a corporation is owned by the stockholders. But it is the height of irony that executive pay has become the big gripe of stockholder activists when for years the complaint was the separation of ownership from control. Stockholder ownership is a useful metaphor. But we should not let metaphors get in the way of good sense.