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Wednesday, February 11, 2015

Strategic CSR - Executive pay

Something that has always struck me as weird about executive compensation is the idea of performance-related pay. I find this weird because the common way to describe how this works in practice is, as the article in the url below repeats, to say that executives should be paid:
"… according to their performance."
In reality, the executive is not paid according to his/her performance, but according to the performance of the firm. That is, what the executive actually does is not measured, but it is how the firm performs that is measured. This is primarily because it is easier to measure firm performance using one of the narrow accounting measures that exist and very hard to measure how effective an executive actually is. The assumption is, of course, that the performance of the firm is highly correlated with the performance of the executive. This arrangement is therefore very convenient for the executive because a great deal of research in this area suggests that they tend not to make much difference to the firm's performance. At a minimum, the firm's performance is determined by a large number of factors, some of which the executive is responsible for, but many of which s/he is not.
While the article in the url below does not focus on this distinction, it does do a good job of highlighting how ineffective many executives are and how, as a result, the idea of pay for performance is somewhat ridiculous on closer inspection:
"It is easy to get steamed up about how much executives earn. Some pay packets are ridiculously large: Tim Cook, Apple's boss, was paid $378m in 2011. Some are quite out of line with achievement: Martin Sullivan was paid $47m when he left AIG, despite the fact that, on his watch, the company's share price declined by 98% and the American taxpayer had to lend it $180 billion to keep it from collapsing."
In the process, the article, which is a review of a book titled Indispensable and Other Myths: Why the CEO Pay Experiment Failed and How to Fix It, also provides a bit of context in which to place the relatively recent introduction of performance related pay:
"During the glory years of the country's capitalism, from the late 1940s to the late 1960s, American bosses were paid salaries like other professionals (performance-related pay was for the lower classes). They were also paid about as much at the end of the period as at the beginning: about $1m a year (in inflation-adjusted dollars) for the heads of America's 50 biggest companies."
In the end, however, The Economist favors the overall effect of massive financial incentives (a dynamic economy with the world's best companies), rather than linger on any obscene anomalies, even if the relationship between what the CEO does and how the firm performs remains somewhat murky:
"Mr Dorff offers lots of examples of performance-related pay gone wrong. But what about pay that ignores performance? Professions that stick with rigid salary structures lose talent to more flexible ones: one reason why America's school system is in such a parlous state is that high-flyers refuse to join a profession in which the only way to get ahead is to get older. Public companies are already in a war for talent with more flexible entities, such as private companies or hedge funds. It would be an odd world if you could get seriously rich working for a private-equity company but not as the boss of General Electric."
Take care
David Chandler & Bill Werther
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October 25, 2014
The Economist