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.
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