Reference no: EM133775860

Problem

Corporate America has been tying more and more of top executives' compensation to some measure of firm performance, in an effort to provide them with strong incentives to manage aggressively in the stockholder's best interest. While top executives at Fortune-500 companies may have annual base salaries that can exceed $1 million dollars, it is typical that their base salary will represent only a small percentage of total compensation in normal years, with few limits placed on how high that compensation can go if the company is very successful (Jensen, 2019, para 4).

Designing an executive compensation system to achieve desired performance is a difficult task. If performance is judged based on annual profits, executives might become overly focused on the short run and not position the company properly for the long run. The same can be true if performance is evaluated on the basis of short-term fluctuations in stock market prices. In addition, profits (and subsequently, stock prices) are really the result of the efforts of thousands of workers. Perhaps even more importantly, profits are frequently the result of a strong economy or a "hot" sector, and may have little to do with executive decisions. The large bonuses so many executives received in 2004 followed a banner year in corporate profits.

But, if all of corporate America is doing so well, are the CEO's really doing anything special to deserve such large compensation packages, especially when their workforces are receiving relatively little in the way of raises? Despite the annual attention in the business press, and increasing opposition from shareholder groups such as large pension funds, few companies follow one of the most basic economic principles in designing CEO compensation plans. That principle would reward based on relative company performance but few companies tie annual bonuses to comparisons with peer group performance.

Jensen, M. (2019). CEO Incentives-It's Not How Much You Pay, But How.

1) Many companies have defended large executive compensation packages that don't appear to be justified with current company performance, as rewards for past performance. Do such rewards make sense?

2) Another justification often cited by companies for seemingly extravagant executive compensation packages is that competitive market pressures require them to pay well in order to attract and retain top managerial talent. Could paying less for less high-profile talent be a good bargain for these companies? Why or why not?

3) Pay-for-performance is much easier when performance is easily measured, such as counting the number of units of specified quality a factory worker produces, or the number of hits a baseball player gets. As suggested in the case, deciding how to measure performance for CEOs is more challenging. Describe what you think would be an appropriate set of measures for CEO performance, and briefly explain it in terms of how it would provide the appropriate incentives.