Reference no: EM133334721

Assignment: Executive pay is a topic that continues to be an area of debate in the U.S. There are many different opinions on this subject as well as what to do to fix executive pay. Post a summary of the article as well as your reaction/opinion on the author's thoughts and ideas.

Performance-based pay has come under fire since the global financial crisis. And indeed, the evidence does suggest that incentive-based pay can be damaging in many settings. This research is summarized in a recent article from Dan Cable and Freek Vermeulen of London Business School. However, very little of the research they cite was actually conducted on business executives. The research that has been conducted on business leaders suggests that financial incentives can work... and quite often do.

And while it's true, as they write, that "large bonuses and stock options have been held responsible for overly risky behavior and short-term strategies," I know of no peer-reviewed evidence that the crisis was actually due to poor incentives, and their article cites none.

Cable and Vermeulen do present evidence that performance measures often only capture one element of a worker's job, and thus have a distorting effect on their work. For example, paying teachers according to student test scores may induce them to "teach to the test." Financial incentives only work in jobs where there's some kind of comprehensive performance measure that weights all the different dimensions appropriately. Clearly, for lots of jobs, no such measure exists.

But, for executives, you do have such a measure - the long-run stock price. In the long run, every executive decision will eventually show up in the stock price. The stock price captures not just current profits, but expected future profits, growth opportunities, balance sheet strength, corporate culture, customer satisfaction, relations with stakeholders, and so on, and weights them by their relative importance for firm value. Although critics have often called the stock price reductive, research shows it's more comprehensive than the caricature. For example, research I've conducted has shown that, if executives treat workers responsibly, this eventually boosts the stock price - the 100 Best Companies to Work For in America outperform their peers by 2-3% per year. Others have found similar results for other intangibles, such as customer satisfaction, environmental stewardship, and patent citations.

Of course, the key words are "in the long run." Cable and Vermeulen are correct that executives may "cook the books" in the short-run - but the effects of such transgressions will be felt in the long-run. For example, earnings restatements lead to a -9% return. Given the current levels of equity compensation, this would cost the average CEO $4.5 million - but it would cost zero if he had been given a flat salary. The flipside of rewards for good performance is they allow punishment for poor performance - but a CEO with a fixed salary gets off scot-free even when shareholders are suffering (particularly if performance is not bad enough to lead to firing). For example, JC Penney's CEO, Ron Johnson, suffered a 97% pay cut in 2012 due to poor performance. Jimmy Cayne of Bear Stearns lost over $900 million from the collapse of Bear Stearns.

Thus, while poorly designed incentives (e.g. those with short vesting periods, or paying according to quarterly earnings) can backfire, to completely scrap equity will throw the baby out with the bathwater. The solution is simple - to extend the vesting period to the long-term. And, this is another difference between executives and other workers. You can't pay regular workers according to performance in 5 to 10 years' time, because they need money now to live on. Executives are so highly paid that they're not hurt by having a significant proportion of their income deferred.

And not only do we have a comprehensive way to measure CEO performance, there is also evidence that suggests performance-based pay for CEOs does have benefits.

A paper in the Journal of Finance found that firms that give CEOs high equity incentives outperform those with low equity incentives by 4-10%/year. Moreover, the outperformance is over the long-term, not due to short-term tricks, and is most apparent in firms where it would be easiest for managers to coast (due to factors like weak governance, weak competition, or high managerial discretion).

Cable and Vermeulen argue that executives are intrinsically motivated, and that extrinsic motivators like performance-based pay will only crowd out these intrinsic motivators. But the evidence suggests that unincentivized executives may simply pursue the "quiet life" and allow the status quo to persist, avoiding hard tasks like major reorganizations, hard negotiations, or unpopular decisions. Indeed, a study in the Journal of Political Economy showed that CEOs with few incentives (in this case, due to takeover protection) did fail to close down old plants or create new plants - they just coasted, and productivity and profitability suffered.

In addition to motivating the executive once she arrives, incentives are useful in attracting motivated executives to begin with. Offering a contract that guarantees that your pay will never fall, no matter how bad your performance is, will attract "coasters" who desire the quiet life. A study showed that the introduction of incentive pay boosted productivity by 44%. While half of the increase stems greater effort by existing workers, the remaining half stems from coasters leaving and more motivated employees replacing them.

But, rewards are not only instrumental - to incentivize performance - but also to signal what is important to the organization. Consider the Nobel Prize, which comes with a $1.5 million award. The incentive effect of the cash is likely zero - the prize would have the same prestige without it. Moreover, why have a prize at all? It's highly unlikely that any researcher would work less hard without it. And, that's the same for best paper awards, all of which come with cash sums. These prizes are not to incentivize, but to show what the academic profession values, and thus shape the behavior of the broader research community.

Moreover, knowing that the CEO's fortunes are tied to the firm's success is a positive signal to workers, investors, customers, and suppliers. You'd prefer to be associated with a firm where the CEO is invested - quite literally - in its success.