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.

5 comments

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

Forget populist dribble. If the directors of these banks and other corporations were in any other field, misleading (or outright lying) to investors and profiting from selling (inflated) shares with insider knowledge that the bubble was about to bust would constitute fraud, and they wold fall under the RICO act.

When is the government going to actually do the ethical thing, and prosecute and financially punish white collar criminal activity with the same vigor as other areas of society?

Take their homes, yachts, cars and assets, and trade it for prison jumpers and put them on road gangs.

That will finally end the outright theft of the American dream and economy at large.

Posted by Brian Foulkrod | Report as abusive

Salary caps are needed to reel in and control the excessive and corrupting greed that plagues Capitalism. $1 million absolute maximum yearly income ($500 per hour based on a 50 week/40 hour work with 2 weeks unpaid vacation).
As we’ve seen in the Wall Street Journal, massive abuse and corruption is aided and abetted by high salaries. Two of the top earning hedge fund managers netted over $2 billion personal profits even as shareholder values plummetted.
Looking at another CEO Dr. William McGuire of United Health Group netted $1.6 billion in salary, stock options and benefits in 2006 ($800,000 hourly salary based on above 50/40 formula) to aid and abet his naked greed as medical premiums skyrocketed and continue to gouge American families.
Even GM’s former CEO Rick Waggoner who mismanaged GM into bankruptcy and was finally fired for his incompetence was awarded a $20 million golden parachute to reward his parasitic service.
When left to their own devices we see that CEO’s routinely use corporations as their personal cash machines, and have no loyalty to the long term viability of the corporation or shareholders.
The only practical solution to stop the excessive abuse in salary compensation is to mandate salary caps to encourage fair play and honesty in the business world.

Posted by First | Report as abusive

James Pethokoukis wrote:

> Ultimately, it is shareholders and management who
> should decide what executives make.

Yes, and with the taxpayer money bailout, the taxpayer has effectively become a shareholder/investor, so if they want a bailout (*our* investment into *them*) to survive, they have to play by our rules. Otherwise, if they are not ok with their new investors’ tune, they are of course always free to tank in the sh*t storm out there. Be my guest.

Posted by Michael Holland | Report as abusive

I’d prefer to see the legislators look harder at tax, and tax minimization by top earners (I’m not against paying the market rate for top workers).
The government should ensure they are taxing all earnings fairly across the board (no higher rates of tax are needed, just make sure all earnings are taxed), and that includes all benefits accrued in the remuneration package. Sure there will be some difficulty on quantifying the shifting nature of shares and similar bonus schemes but that risk should be born by the recipient, not the tax department. It would in the long-run bring in more money than salary caps that’ll disappear as soon as the next hot topic hits the front pages.

Posted by Peter H | Report as abusive

The US needs to stop supporting a corporate aristocracy. The gross and outrageous compensations for some of these Top Managers is nothing more than the US paying to support these individuals in a lifestyle they have become accustom to. By no means are these individuals worth this much to the corporation. No one could be worth these kinds of compensations. Some are over 400 times the average compensation of their employees. No corporate board could begin to justify that one person is worth that kind of compensation. Yet, that kind of compensation exists today in publicly traded corporations. What else would you call it but the support for a corporate aristocracy?

Publicly traded companies fall under federal laws. The Government does not have to “own” a piece of them to set rules upon them in order to protect the public.

The compensation of top management should be tied to the compensation of the average employee. Let’s face it they all had a part of the success or failure of the business. Some countries have put limits on publicly traded company’s top management at 10 times the average employee compensation. Compensation would include salary, stock options, and bonuses. To compute this they take middle management, front line managers and their employees including all secretarial and office administrative staff and average their total compensation. No one in upper management can make more compensation than 10 times this amount. This value is recalculated each year to set limits on the next year. Within this limit salary, stock options and bonuses are paid. If upper management wants a raise, they need to raise the compensation of their employees.

This type of pay limitations provides incentive for profits and efficiency while ensuring the benefits of a job well done are given to those that do a good job. These benefits will flow up a year later. And I am all for upper management being given incentives to think in terms of the long haul by withholding some pay in the form of stock purchases.

I for one am against maintaining a corporate aristocracy. We need fiscal responsibility forced back upon the corporate industry.

Posted by B.Free | Report as abusive