HermannM

Is Executive Pay Really the Problem

In Finance on March 21, 2009 at 7:19 pm

Recent discussions about bonuses for AIG executives inspired me to give more thought to the role of executive pay in American business.  I recognize that financial literacy is sorely lacking and this is one topic where more clarity is needed.  First, a few facts on CEO pay:

  • A CEO who commands a hefty compensation package doesn’t earn it all in cash.
  • Most Fortune 500 chief executives earn between $350,000 and $3m in the cash portion of their total compensation.
  • The IRS allows a company to deduct up to $1 million of executive compensation for for tax purposes. So unless a CEO has extraordinary skills, s/he is unlikely to earn a cash salary much higher than that million dollar mark.
  • The cash component of the bonus, which averages $4m to $5m and usually tops out at $10m, is almost always tied to the achievement of agreed upon and verifiable milestones.
  • The remainder of CEO compensation is in the form of stocks and options, whose value is subject to change at any point in time.
  • Some portion of the bonus and equity components may be unachievable, due to market conditions, vesting restrictions, strike prices on options, blah blah blah.
  • Very few executives actually earn the “marquis” compensation that is published.

Overall, this structure of executive compensation (base salary + performance bonus + equity) reflects good corporate governance. Tying the bulk of CEO pay to performance milestones aligns their interests with that of investors. It also leads to positive results.  The average American may not know the finer details of executive pay; no one explains it properly and this information doesn’t sell newspapers, draw YouTube viewership or generate Facebook posts. But, this is the truth, so help me God.

Some clarity is also needed on the AIG bonuses being debated.  In a service economy, there is a role for retention bonuses, believe it or not.  Unlike in manufacturing, the business executive is the product.  Unlike in manufacturing, value is created from the thoughts, unique abilities and relationships of that business executive.  Unlike in manufacturing, the value of a business executive is not easily replaced. The fact that business executives, invariably a company’s most valued asset, can walk out the door at any time, creates a continuity problem.  Because the loss of key executives can bring any service institution to its knees, many companies rely on retention bonuses as an economic incentive (read contractual bribe) to achieve loyalty.  It is actually an efficient market solution; it’s also the nature of the beast.

On average, chief executives, like politicians, start out with good intentions.  If they fall, it is more likely the result of their having been corrupted by the machinations of a broken system than anything else.  What is needed in American business are structural and regulatory safeguards that fix the system and keep good executives from going rogue or ‘breaking bad.’  One example of a break in the system may be finance-driven strategy.  CEOs whose compensation is heavily tied to stock price tend to manage for the short term at the expense of long term growth.  This was a problem when I was an M&A banker and it is still a problem now.  A FIX IS SORELY NEEDED.  Another problem may be the prisoner’s dilemma of employee turnover. “Why should I be loyal, creative or efficient if I suspect everyone else isn’t?”  A FIX IS SORELY NEEDED. Another  problem may be stacked boards and poor internal oversight. Again, A FIX IS SORELY NEEDED.  And there are many more.

In my humble opinion, CEO pay is not the problem. Retention bonuses are also not the problem. I stipulate that there is greed and incompetence in the system and recognize that Madoff, that thief, ripped us off. These topics, indeed, sell newspapers but they don’t address the root causes of our down economy. The real problem is baked into the fabric of how we see ourselves, live our lives and make everyday decisions. Until we address our tendency towards myopia and lack of empathy for other economic stakeholders, we cannot begin to fix the problems in our system.

Self-interest is a powerful motivator and it is the essential catalyst for innovation, progress and growth. But capitalism, at its purest, has limits.  With the exception of the German Empire, the First Reich (think Gutenberg & Martin Luther, not Hitler), every great empire has been overtaken by attacks from within.  Civil war is the likely result of any society purely focused on self-interest. Similarly, mutiny is the more likely fate of a pirate than is retirement. The fathers of our Revolution recognized this and took steps to build the American Empire on a more solid foundation.  The rocks on which our society stands are mutual accountability, systems of checks and balances and limits against the perpetual consolidation of power, status and wealth. Fixing the American economy involves a return to these fundamental values.

As a banker, I conducted due diligence on healthy and bankrupt companies, many were turn-around situations and a few were downright houses-of-cards, perhaps too many. Overall, I remain convinced that business executives are inherently good and that they are adequately compensated. Interviews of employees and mid-level managers at bankrupt companies are surprisingly easy to conduct; many can’t wait for a restructuring consultant to ask about the kinks in the company’s armor. They can all identify the economic weak joints and information bottlenecks as well as discern the value creators from the fraudulent fiefdoms of fear and control. [I’m so dramatic, I know.] Although they know the problems of the company, most ignore them because they feel powerless to implement real solutions. This is the tragedy of American business.  Only by fixing the incentive, empowerment, reporting and regulatory systems that impact all levels of performance within our companies can we work our way out of this economic quagmire and restore faith in market-based systems.

It is going to take a concerted effort on all our parts since there are no silver bullet solutions in business anymore.  Paraphrasing Benjamin Franklin, “we must all hang together, or most assuredly, we shall be hanged separately.” Well the economy is doing to us what King George could not do to the colonists.  Until we recognize that we are in this together, AIG executive, government worker and consumer alike, we’ll just continue to spin of our wheels, build monuments of nothing and cross expensive bridges to nowhere.

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