An article by V. G. Naraynan published in Harvard Business Review on Monday June 22, titled ‘Executive Pay: It’s About “How,” Not “How Much“’ got our editorial board talking.
The “how” vs “how much” question certainly begins to touch on the core issues at hand. However, these issues are more complex and multifaceted than the article suggests, and unfortunately, as is often the case, the media has little inclination to report the details. As Grahall’s Michael Graham shared in his 2008 book “Effective Executive Compensation“, Americans love the “sound bite logic” of X therefore Y. The problem is that with complex systems like total rewards, the ”logic” is correspondingly complex, and the media’s approach correspondingly lacking
As we see it, there are three components to compensation structure. We call them the three “M’s”: Money, Mix and Messages.
Money – This is what we call M1, the “how much”. One look at the most egregious of the “point-to” examples of executive compensation excesses shows there is way too much money doled out by boards. The pattern gets worse when management benefits from the general economic growth as “all boats lift with the rising tide.”
Mix – This is M2, the “how”. For most companies, the mix is tilted far to the “short-term” side of the equation. Large corporations have time-span-of-discretion and decision horizons of easily five to ten years. But much or all of the executive’s compensation is vested in 4 or fewer years. And even the “longer-term” performance factors are not legitimate measures of true long term performance.
Messages – This is M3, the way in which the above two “Ms” drive behaviors. The messages that companies send to their executive employees is the area where almost no one currently has it right and where the media, the government (and its regulatory agencies) and the American public have so far failed to grasp the nature of the problem we face. As a simple example, stock option awards pay executives for stock price performance. Paying executives in this way will drive behaviors that increase stock price short term – without regard to risk. A better approach would be to reward for incremental performance above a general index or an index of direct competitors. In this way, it is clear whether or not management has added value above the average. Yet, any company that wishes to do so would actually be penalized by the current accounting rules.
Years ago, reciprocal loyalty between companies and employees was a stronger motivator. That bond was broken when, a few years back, employers remixed compensation away from long-term retention tools — such as pension plans and retiree medical plans — to shorter-term programs like a 401(k), the latest benefits to be cut back. (Next up is employer sponsored medical benefits – especially of the “public-private” scheme makes its way into law – you can say you heard it here first!)
Well, loyalty no longer binds companies with their executive employees either. We anticipate that executive turnover will grow, especially among TARP companies that lose competitive advantage under government-imposed pay restrictions. Other companies too will feel the pressure.
Ironically, while long-term retention oriented programs no longer bind rank and file employees to the company, the executive world will see a shift in the opposite direction. And a growing shift TO longer-term pay may drive turnover. A long view is hard to muster in the face of quarterly stock price pressures. Only the most confident of executives would like a substantial portion of their pay to be based on long-term results.
Today, politics not economics drives the discussion and the decisions around executive pay. Our government cannot legislate greed and stupidity out of existence, but it can serve as a referee to keep the playing field level. America’s reputation as a fair and safe place to do business is critical to our economic future. Without a level playing field, foreign money may stop flowing in.
The broad challenge we face in the financial world is much like global warming, an environmental problem that, like this one, has become politicized. To a large extent we can each contribute to improving and extending the life of the planet IF we make some sacrifices. In the same way executives and boards of directors can contribute to improving the world of compensation – its structures and behaviors – by turning away from “short-term greed” to “long-term good.” Executives will need to make sacrifices for the good of the enterprise, the industry and the economy as a whole. Otherwise, we’d have to think it’s decadence that we’re observing.
The “3M’s” concept is as simple as we can make it, and still doesn’t meet the “sound bite” threshold condition for a news program. Reporters scratch the surface of the issues and deliver 500 or 1,000-word articles on subjects that require 100,000 words. With editors sometimes knowing less than the journalists on these subjects, who’s to say that any of these articles provide an accurate view?
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