The Advisors' Blog

– Broc Romanek, CompensationStandards.com

Here’s an excerpt from this Huffington Post piece:

We’re doing CEO pay wrong. Incentive pay — compensation based on verifiable performance measures like stock price — is on the rise. It’s supposed to help align executives’ interests with those of shareholders. Instead, it leads corporate boards to pay executives more than necessary, and ultimately hurts shareholders and workers.

With incentive pay, the company could end up paying the CEO for something over which he had no real influence. Or the company could end up not paying the CEO for actions that were good for the company, but for some reason didn’t raise the stock price. Most likely, the CEO will single-mindedly pursue actions that will boost the metric he’s paid on, even if they only succeed in the short term. Over the longer term, paying your CEO a fantastic amount can hurt stock performance.

The solution, according to a new paper by Peter Cebon, of the Melbourne Business School, and Benjamin Hermalin, a finance professor at the University of California’s Haas School of Business, is for the government to limit performance-based executive contracts and make informal pay agreements more attractive.

An informal contract, in its broadest and perhaps too-simple but illustrative sense, is like a board telling a CEO: “We will pay you for being a good CEO. The better a CEO you are, the more we’ll pay you.” It is, Hermalin said, really just a “series of promises” that aren’t legally enforceable.

Alluding to Odysseus’ escape from the Sirens, the paper’s authors write that corporate boards setting executive pay need be to “lashed to the mast” with restrictions on the size of formal executive pay packages, which are the sorts of contracts that tie pay to objective, verifiable outcomes like the company’s stock price or specific accounting metrics.

But boards can’t actually tie themselves to a mast, Hermalin noted to The Huffington Post. That’s why they need the government to restrict their options. This could be done, he said, by boosting taxes on all performance-based pay, by dramatically increasing taxes on incentive pay above a certain level, or simply putting a cap on total formal incentive-based pay.