It’s was tempting to say out loud that “Great minds think alike” when reading David Chamption’s post on Harvard Business Review’s blog. We wrote here few times now that executive compensation’s best practices in the financial sector must be revised. Tax payers are forced to own these companies and hence overpay executives for poor performance. Chamption is hinting that compensation for executives in the financial industry should not be much different than compensation for other federal bureaucrats (we wrote about this before). He also suggests to implement indexed pay systems , which is not a bad idea. Here’s the full quote:
When stock prices were rising and job markets were booming, no-one was too fussed to see CEOs and top bankers rake in their mammoth bonuses. It was the tolerable price we paid for a healthy capitalist system. These people took smart bets and fairly earned the rewards. Fair play to them.
With the Dow off 40%, unemployment at its highest in a decade and rising, and a bankrupted financial system, we’ve turned on the fat cats. Now, they’re responsible. No more than $500,000 for the CEO, we’re saying, at least as long as the taxpayer owns the shares. Fair play to us.
It shouldn’t take a financial rocket scientist to tell you that this kind of cap isn’t the smartest way to clean up the mess. Let’s imagine we’ve fast-forwarded to 2011, the financial crisis is over, and Bank of America is turning in record profits, after carefully cleaning its loan books all by itself and managing growth well, and the government is poised to sell its holdings to an eager public.
Suppose also that JP Morgan has gone down the tubes, having failed to manage its loan portfolio, and is asking for more cash (my apologies to CEO Jamie Dimon for this liberty).
According to the new wisdom we’d pay the CEOs of both establishments $500,000 a year. Yet, as shareholders in Bank of America we should be falling over ourselves to reward the team that delivered such results. (Of course, once the banks are out of trouble, the pay caps go away, but that rewards the performance after the turnaround, not the performance that delivered it).
But as shareholders of JP Morgan, we’d have to be asking ourselves what did those bozos do with the money?
Actually, there is a smarter way to pay top executives. Former Kellogg Professor Al Rappaport wrote an article about it, back in March of 1999.
Rappaport argued that the proper way to reward CEOs was through granting them options whose strike prices were tied to an index of peer group of companies. If the company outperformed competitors, the manager got rewarded. If the company didn’t outperform or did worse, there was no reward. More to the point, if the company did better than competitors even in a falling market (i.e., its share price fell by less than the peer group index) the manager would get a payout, maybe even a hefty one, so it would be perfect for the scenario I just pictured as it would provide incentive for performing in hard times, when you arguably need it most.
Rappaport isn’t the only proponent of indexed pay. Over here in Europe, Herman Stern, CEO of Zurich-based financial consultants Obermatt, has been talking about the same topic. Intuitively, it’s hard to argue with the approach, and it’s likely that more and more people will advocate that companies adopt it.
But if it’s such a good idea, why didn’t companies adopt it years ago? The short answer is that turkeys don’t vote for Thanksgiving. Executives won’t voluntarily switch to compensation schemes that make it harder to pick up the big bucks. Of course, in a recession and in the wake of a financial crisis it might be easier to get over that problem.
But the short answer isn’t good enough anyway. Unfortunately there’s a more serious obstacle to indexed pay. When the economy heats up again, the war for talent will warm up with it. One of the easy ways for companies to compete in that war is by offering easy dollars. In that case, companies that stick to virtuous indexing may end up losing the best executives. If the Yankees offer a pitcher guaranteed money and the Red Sox offer that same pitcher money for each win over the average pitcher’s wins, where will that pitcher sign?
Would you bet against companies falling back into bad habits of excessive pay if they can afford to?
So the question we should be asking ourselves is not how we should be paying bosses – we’ve lots of good ideas about that-but rather how can we make fair pay schemes stick.
It’s a question I put to Stern, and I hope he – or someone – can answer it. Maybe you can. How would you make indexed pay systems stick?
Our thought process, outrageous as it may be for some people, leads to somewhat of the same conclusion as of some of the good people at HBS.