What You Pay For

What You Pay For: Executive compensation and what’s wrong with bad performance, by Mark Chussil

I agree that executive compensation can be absurdly high, and I don’t buy the argument that it needs to be absurdly high to attract top talent. Then again, maybe I would buy the argument if I were paid enough. I can be had for eight figures, or for the today-only special sale price of seven. Act now, operators are standing by.

There is much talk about excessive executive compensation in these days of financial crisis. There was before the crisis too, as with New York’s suit against Richard Grasso, former CEO of the New York Stock Exchange, and shareholder revolts against non-performing management. Shareholder actions merely halt future pay, but the lawsuit illustrates that we have a mechanism for getting people to disgorge ill-gotten gains from the past. (The Grasso case was dismissed a few months ago, and I’m making no statement about the merits of the case itself. I’m only saying that there is an existing mechanism.)

Pushback against high pay begs the question as to whether high pay is, by definition, ill-gotten. The mere existence of high pay resulting from a contract between willing, competent (as in mentally sound, rather than skilled) people doesn’t necessarily imply wrong-doing. Perhaps high pay isn’t wise, but lack of wisdom isn’t illegal. Gains gotten by fraud, pilfering, and bad-enough negligence are another matter.

It is a knotty problem.

Should we limit pay for actors and athletes too? Tom Cruise made over $70 million for “War of the Worlds” and well into eight figures for each of nine other movies. New York Yankee Alex Rodriguez will make $28 million for the 2008 season. Use whatever adjective you want to describe those numbers — absurd, outrageous, enviable, well-deserved — but the largeness of the number by itself does not imply wrong-doing.

Should we limit pay for an entrepreneur who becomes a billionaire when he or she sells out? There’s the story of the Blockbuster founders, which I describe in my essay It’s working!. Wayne Huizenga and John Melk started the company and sold it a decade later for $11.6 billion in 2007 dollars. Ten years after the sale, the company was worth one-third of what it was sold for, and three years after that it was worth about 10% of that third. [Update, September 26, 2010: Blockbuster to Remake Itself Under Creditors, says the Wall Street Journal. Blockbuster filed for bankruptcy on September 23.] Should Huizenga and Melk be blamed? For what? Should they pay?

Even if we agree that executive pay is too high, there’s a deeper issue, and that is what praise or blame is appropriate to assign to the CEO or other executives. He or she doesn’t do all the work and doesn’t deserve all the credit when the stock is flying high, which is one reason why I think executive pay can be too high. Similarly, though, he or she didn’t unilaterally screw up and deserve all the blame if the stock falls. (One reason why I’m so fond of strategy decision tests  is that they provide insight into what part of performance is attributable to your decisions and what part is attributable to others’.) It is very hard to assign responsibility in complex systems to a single individual. Should the sellers of Blockbuster have to disgorge their profits because people invented the DVD, Netflix, and streaming video?

A related issue is that you get what you pay for. Not in the sense that you get better talent if you pay $105 million a year than if you pay $104 million (although in accordance with the size of that increase I personally would work 0.961538% harder). Rather, in the sense that if you reward an executive for the company’s stock price, she or he will care about the company’s stock price, and if you reward an executive for something else, he or she will care about something else. The pay-for-performance imperative to “make the numbers” can lead to shortsighted decisions. (See my essay Exalted numbers. See also the second and third Update, below.)

Going forward, there could be provisions for executive pay that hold some compensation in escrow for a period of time, to be paid when certain conditions are met. Many companies do something conceptually similar, with stock options or grants that vest years after they were awarded. Which has the problem of my successor’s lousy decisions affecting pay I justly earned with my brilliant decisions.

Yes, it is a knotty problem.

The problem might not be high pay per se. The problem might be high pay linked to low performance. We don’t feel outraged (or at least not so much) about Tom Cruise and Alex Rodriguez; they are providing high levels of performance and their performance is clearly attributable to them. We do feel outraged when the executives entrusted with the companies in which we have invested provide low levels of performance, regardless of attribution. [Update: the European Parliament will limit banker bonuses when performance is low. “Europe To Limit Banker Bonuses,” The Wall Street Journal, July 8, 2010, page 1.]

I don’t know how to solve the problem about the highness of pay. Perhaps, though, we can make headway on the different problem, the one concerning the link between pay and performance, because it is paying for bad performance that we resent. So, we might ask how to improve the quality of management decisions so that we don’t highly pay for bad performance.

There are ways to improve the quality of decisions. Most of them focus on financial oversight, which is necessary but insufficient in the sense that they document decisions and measure damage rather than prevent damage or exploit opportunity. No matter how microscopically you pore over financial statements, you won’t get warning of competitors’ moves, the effects of customer dissatisfaction, and more. There are other ways to improve decision quality, such as business war games and strategy simulations that stress-test decisions before risking fortunes and careers on them. (In fact, that interest in improving decision quality is why people like me enter the field of war-gaming and simulation in the first place.) Whatever the technique, though, we need to focus at least as much on the bad performance as we do on the high pay.

Update, November 30, 2009. See No More Executive Bonuses! in the Wall Street Journal. It was written by Henry Mintzberg, a professor at the Desautels Faculty of Management at McGill University in Montreal.

Update, March 2, 2010. From the Wall Street Journal, page 1: “An excessive focus on market share and profits was a key reason for Toyota’s quality problems, Akio Toyoda said while apologizing to consumers in China.

Update, September 21, 2010. See The Pay Problem: Time for a New Paradigm for Executive Compensation by Jay Lorsch and Rakesh Khurana of the Harvard Business School, published in the May-June 2010 issue of Harvard Magazine.