Fixing Executive Compensation: It’s Not a Simple Job

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Expert Perspective by Grahall’s OmniMedia Editorial Board

In his article for the Huffington Post (Wall Street CEO Pay Problems Worsened By New Regulations, Report Says) William Alden writes that “…one of the primary forces encouraging greater risk [and setting off the ‘Great Recession’] was the way that executives at major banks were compensated: Aggressive moves that made stock prices soar in the short-term triggered hefty bonuses, and even when those same moves led to longer-term disasters, the chieftains got to keep the money, leaving taxpayers on the hook for the losses.  A new regulatory framework and much talk of lessons learned was supposed to have changed all that, putting the fortunes of the bank chiefs on the line, and tying their pay to the longer-term health of their companies.”

Alden refers to a report  issued by the Council of Institutional Investors, an association of public and private pension funds (Wall Street Pay) which suggests that the new regulations have done little to reduce risk since the changes simply result in companies increasing stock payouts in lieu of cash bonuses.  The “…council report concludes that simply focusing on boosting stock as a percentage of overall compensation inadequately protects against excessive risk-taking by banking executives.”

We agree, sort of. 

First of all, it is important to remember that many warning signs of the coming economic crisis were essentially ignored by regulators and legislators.   Certainly compensation practices helped to fuel the fires that led to our economic meltdown, and there is no excuse for Boards or Executives who managed compensation irresponsibly.  In our view, compensation is an effective tool for guiding behavior but also one that can come with many unintended consequences if there is not a deep understanding of the messages embedded in different compensation elements.  Those messages need to be understood not only by compensation committee and human resources who set compensation policy at individual companies but also by regulators and legislators who look to control and manage risk by regulating compensation.  You have only to look at the 162(m) Rules for some renewed appreciation of unintended consequences.  These rules were designed to limit executive salaries to $1 million, which then led to an increased the use of short term incentives that, arguably, resulted in the compensation structures blamed for the recent recession. There’s some irony for you.  And how likely is it that our legislators got it right this time?

In our blog, “Risk Through Rose Colored Glasses” we discuss risk and compensation structure in the financial service industry, saying that striking a balance will be a tough task made tougher still if the Treasury is not fully equipped to understand the true messages embedded in some commonly used incentive programs.  Even compensation consultants’ reports rarely address the risk exposure of varying programs, perhaps other than to state the obvious that stock options are riskier than restricted stock.  In fact, any uncapped payout that doesn’t have some sort of negative component through clawbacks, high water performance marks or delayed payout subject to multi-year performance has an extremely high sensitivity to volatility.

We also agree that increasing stock as a percentage of compensation will not appropriately control risk.  But there are definitely two sides to that coin. The one rarely considered is that of an “over-equitied” aging CEO.  Perhaps he has run the company with appropriate risk management over the years of his tenure, perhaps in part due to his significant equity position, taking on the right level of risk to get a reasonable level of reward.  As we wrote in our blog “The baby or the bath water?” too much stock can sometimes tempt an executive, especially one nearing retirement, to avoid taking even acceptable risks.   

So how can the “problem” of executive compensation be “fixed”?   It is critical to remember that one size does not fit all. Companies cannot apply a prescriptive list and regulators cannot apply band aid regulations to so large an issue as executive compensation.  Better they should read Michael Graham’s book “Effective Executive Compensation” so they can identify ways  “to reward both organizational and individual performance in such a way that the company is the absolute best it can be… the mutual benefit of all stakeholders, shareholders, employees, customers, and partners is a major consideration for the executive reward program.”

Contact Grahall’s OmniMedia Editorial Board at edie.kingston@grahall.com

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