Why is our System of Executive Compensation so Broken? - 27 Apr 2009

Why is our System of Executive Compensation so Broken?

Robert H. Frank has an answer:

When the strength of positional concerns differs across
domains, the resulting conflict between individual and social welfare
is structurally identical to the one inherent in a military arms race.
To illustrate, consider rival nations faced with deciding how to
apportion available resources between domestic consumption and military
armaments. Each country’s valuations are typically more
context-dependent in the armaments domain than in the domain of
domestic consumption. After all, having lower domestic consumption than
one’s rival might entail psychological discomfort, but being less well
armed could spell the end of political independence. The familiar
result is a mutual escalation of expenditure on armaments that does not
enhance security for either nation. Because the extra spending comes at
the expense of
domestic consumption, its overall effect is to reduce welfare. Note
that if each country’s valuations were equally context-sensitive in the
two domains, there would be no arms race, for in that case the
attraction of having more arms than one’s rival would be exactly offset
by the penalties of having lower relative consumption.

So long as CEO pay performance is determined by what other CEOs are
getting paid rather than by how much value the company creates during
the CEO's tenure, CEO pay will be a positional good in Frank's terms,
which draws value away from employees, customers, and investors.

How could CEO pay become less positional? By giving other
stakeholders (but especially investors) more transparency into the
cash-flows in and out of the firm. Boards and shareholders are forced
to compete with other boards and shareholders because those
measurements of CEO performance are right now more reliable than more
direct measurements of company growth

For more information on Fixing Broken Executive Compensation.

Posted by Dan Walter

Performensation: Equity Compensation for High Performance Companies.