The first is whether the compensation package rewards a manager
only for what he can control. For example, the profit performance of an
oil producer is directly related to the price of oil, which is rather
volatile. But the oil company's CEO has no control of that price. If
bonuses and options are not indexed to the price of oil, the manager's
compensation is unrelated to his skill and effort.

Compensation also appears to be sticky on the way down. While
bonuses and salaries rise as a company does well, they do not decline
when a company does poorly. This not only exacerbates the first point
above, but it results in an incentive structure which is asymmetric
(heads, I win big...tails, I don't lose) leading to excessive
risk-taking. Golden parachutes also protect managers even following
poor performance.

Finally, managers have company-specific knowledge that the rest of
us don't, and so they are able to take advantage of situations with
their superior information. For example, they can sell shares or even retire when expectations are at their peak relative to fundamentals.

The above issues can be counterbalanced. Restricted stock (when
restricted until long after the end of a manager's employment),
structures which are aligned with what an executive can control, and
symmetric rewards/punishments are examples of how enlightened boards
are ensuring they are getting a good deal for their money. Investors
can protect themselves from falling victim to excesses in executive
compensation by ensuring the companies in which they invest have sound practices where shareholder interests are maintained.