Leave pay to companies, shareholders

June 11, 2009

James Pethokoukis – James Pethokoukis is a Reuters columnist. The views expressed are his own –

For the populists who really, really want to make Wall Street pay by slashing their pay, Treasury Secretary Timothy Geithner certainly isn’t giving them what they want.

Yes, the top executives of the remaining TARP firms seem destined to be salary serfs to the “pay czar”, Kenneth Feinberg.

Of course, it’s hard for even the most die-hard free marketeer to feel sorry for financial firms that mismanaged their businesses terribly, took government bailout money and now find themselves under Uncle Sam’s thumb.

But as for everyone else? Well, here’s how Geithner put it: “We are not setting forth precise prescriptions for how companies should set compensation which can often be counterproductive. Instead, we will continue to work to develop standards that reward innovation and prudent risk-taking, without creating misaligned incentives.”

Even worse for those who wanted the Treasury secretary to bring down the hammer, he went on to highlight how the financial sector is already making changes on pay and how he looks forward to a “continuing conversation”. Yes, self regulation in action! Hardly what the torch-and-pitchfork crowd craved to hear.

That’s just too bad. To his credit,  Geithner seemingly understands his goal isn’t to punish, but to play a constructive role in nudging financial industry compensation in a direction that better connects risk and reward.

Ultimately, it is shareholders and management who should decide what executives make. Indeed, Geithner’s recommendations centered on empowering the Securities and Exchange Commission to give shareholders a stronger say over executive pay.

And changes are taking place. Firms like Credit Suisse, Morgan Stanley and Goldman Sachs have tried to rework pay systems by allowing bonus clawbacks, for instance.

Good thing, too. Government has a terrible record in rejiggering executive compensation. Example: Legislation back in 1993 intended to rein in corporate pay by eliminating the tax-deductibility of executive compensation above $1 million unless pay was linked to performance.

But one unintended effect of the law, academics James Wallace and Kenneth Ferris have found, “was that executives’ total compensation actually increased in the post-1993 period” thanks in big part to the use of stock options.

Not surprisingly, executive pay issues moved back into the spotlight earlier this decade after Enron and other corporate scandals. One part of the 2002 Sarbanes-Oxley Act prohibited executive loans. As with the 1993 law, corporations responded in ways perhaps not anticipated by legislators.

Signing bonuses and fatter severance packages became more popular — just the sorts of things now being frowned upon.

What sort of compensation might work better to align executive compensation with long-term shareholder interests? A group of academics — Alex Edmans of Wharton, Xavier Gabaix and Tomasz Sadzik of New York University and Yuliy Sannikov of Princeton — have devised an approach based on what they call “dynamic incentive accounts.”

Unlike bonus clawbacks, this system doesn’t try to recoup money already sent out the door.

Here is how it works, according to their new study: Executive pay is escrowed into an account, a fraction of which is invested in the firm’s stock and the remainder in cash. The account would be rebalanced each month according to company guidelines — rules would certainly also vary by industry — and by how close the executive is to retirement.

The gradual vesting of the account — cash from a sold stock cannot quickly withdrawn — even after retirement, “allows the CEO to consume while simultaneously deterring myopic actions.”

In other words, the goal is to promote long-term thinking over short-term manipulation.

For instance: If company’s stock soared, the executive could sell, though the proceeds would say in the account. If the stock then dropped, that money would have to be used to buy more stock. He couldn’t just take the money and run.

Is this the best system out there?. Maybe, maybe not. Or maybe for some firms or sectors and not for others. But that is why you don’t want a one-size-fits-all plan devised in Washington, particularly one with political rather than economic goals. That is a pothole that Barack Obama and Timothy Geithner have so far avoided.


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