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How Boards Can Rein In CEO Pay

The SEC’s push for greater transparency is a smart move, but it’s not enough to fix executive compensation.

(originally published by Booz & Company)

The SEC appears poised to require publicly traded corporations to disclose the compensation of top executives, the median pay of employees, and the ratio between the two figures. The intent of the proposed ruling is to create greater transparency with regard to executive compensation, in the hope that shareholders will then pressure boards to rein in what are widely perceived as outrageously generous CEO paychecks.  

I’m all in favor of greater transparency, but the goal shouldn’t be simply to limit CEO pay. Instead, it should be to make certain their compensation is tied to the company’s long-term performance. And it would be better for all concerned if boards, rather than regulators, assumed their rightful responsibility to get executive compensation right. Three general principles can serve as guidelines for responsible boards willing to take on that task.

The first is to put executive money at risk (the more at stake, the better). Because business owners face the prospect of tremendous gains or losses, they are continually motivated to produce the former outcome. Hence, boards of publicly traded corporations often try to encourage hired executives to “think like owners.” For two decades the preferred method has been to grant generous stock options. In theory, CEOs holding a significant number of options will work like mad to drive the stock price up in hopes of raking in a jackpot when their shares vest.

In practice, stock options too often lead to short-termism and, worse, attempts to manipulate stock prices through balance sheet and asset prestidigitation. In almost all cases, options fail to achieve their main purpose: motivating executives to think like owners. The problem is that nothing is really “at risk” with options, because those who hold them have little skin in the game. In effect, granting options is tantamount to treating executives like employees. Although options offer executives great upside potential, the downside is a theoretical loss of money they never had. It’s a bit like going to Vegas and playing with the casino’s cash: You’re encouraged to take wild bets, but if you lose it all, what the hell, it was just Monopoly money!

That’s why, ideally, it makes sense for corporations to pay a large portion of executive compensation in the form of actual stock (or to stipulate that executives must buy and hold a certain amount). Contractually, executives should agree not to sell any shares they hold in their company until at least a year or two after they retire (or leave for another job).  

Which brings us to the second principle: Compensation needs to encourage long-term thinking. The rub is that most frequently used forms of executive compensation reward short-term performance. For example, although bonuses are good motivators when linked directly to performance, they discourage long-term thinking. Theoretically, the size of bonuses should grow with each consecutive year of good performance: say 10 percent for one good year, 20 percent for two, 40 percent for three, and so on. That would encourage executives to make more sustainable investment decisions.

The third principle is fairness. Most of us are not terribly concerned with exactly how much we are paid; instead, we worry the person in the next cubicle is paid more than we are (while not performing nearly as well, of course.). At the executive level, this thinking goes to the ridiculous extreme of viewing compensation as a competitive game in which the winner is the highest-paid CEO. Compensation surveys play into this mentality; instead of providing comparative data for the purpose of setting fair salaries, they mainly serve the end of ratcheting up all salaries.

Fairness is, of course, a subjective measure. I have no idea what the proper ratio between CEO compensation and median worker salaries might be (although something smells wrong to me when a CEO takes home US$25 million and the receptionist in his office earns $25,000). Many retirement and severance packages also fail the ethical odor test. Jack Welch received a (non-disclosed) $417 million farewell buss from GE’s board (along with such perks as a lifetime box at Yankee Stadium). But at least Welch had delivered the goods to his shareholders. To the average investor and employee, what stinks to high heaven are large severance packages for failed CEOs who are axed after losing millions in shareholder wealth and causing thousands of workers to lose jobs (while receiving relatively meager, if any, severances). For example, in the midst of a stock options scandal, United Health Group’s William McGuire left in 2006 with a $286 million severance package.

In all, I suspect there would be less public outcry about executive compensation if those big bucks were seen as objectively earned. To that end, boards should offer CEOs only modestly outrageous base salaries (say, no more than 20 times the employee median) and load compensation packages with incentives to encourage long-term performance. Then, in the happy event the company strikes gold, let top executives haul in booty by the bushel!

James O'Toole

James O’Toole is director of the Neely Center for Ethical Leadership at the University of Southern California’s Marshall School of Business.

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