The real prob­lem with CEO pay

The Pak Banker - - OPINION - Paula Dwyer

The Se­cu­ri­ties and Ex­change Com­mis­sion did as it was told more than five years ago and is­sued a pay-ra­tio rule to­day. It says public com­pa­nies must dis­close how their chief ex­ec­u­tive of­fi­cers' com­pen­sa­tion com­pares with their me­dian work­ers' pay.

Unions and lib­eral ad­vo­cacy groups like the rule as much as cor­po­ra­tions dis­like it. For the same rea­son, too: The point is public sham­ing. Once the world knows that a CEO makes hun­dreds of times more than an em­ployee, the think­ing goes, CEOs will look grasp­ing and greedy. And then, voilá! Red­faced cor­po­rate boards will have no choice but to cut pay for bosses or raise it for work­ers.

Don't be­lieve it. Sure, the com­par­isons -which won't ap­pear un­til 2017 -- will get a great deal of no­tice. Best and worst lists will ap­pear. And CEO pay will keep go­ing up. Re­search shows that CEOs de­mand pay raises, not cuts, when they dis­cover bet­ter-com­pen­sated peers. Boards com­ply out of fear that the CEO will jump ship.

In­stead of ob­sess­ing about how much CEOs earn, it would make sense to fo­cus on how their pay is de­ter­mined. CEO pay is al­most al­ways tied to how well a com­pany's shares are do­ing. These days, most bonuses come in the form of shares that vest over the years. Even more de­tailed per­for­mance met­rics, such as to­tal share­holder re­turn (shareprice ap­pre­ci­a­tion plus div­i­dends over time), that de­ter­mine how much of a CEO's po­ten­tial bonus will be paid out, are based largely on how well the stock is do­ing.

Eq­uity-based com­pen­sa­tion, how­ever, doesn't nec­es­sar­ily mea­sure how well or poor- ly a CEO has man­aged a com­pany. Shares rise and fall with the broader econ­omy, bring­ing most com­pa­nies' stock along for the ride. Shares can jump be­cause of a ri­val com­pany's merger deal. That re­wards a CEO for be­ing lucky. Eq­uity-based pay also can give CEOs an in­cen­tive to take on risk. If stock re­turns dip, for ex­am­ple, it's only nat­u­ral that chief ex­ec­u­tives will start to worry about their port­fo­lios. An ac­qui­si­tion or share buy­back fi­nanced with bor­rowed money can nudge the shares up­ward. But the com­pany's long-term prospects may suf­fer if there's too much debt, or if an ac­qui­si­tion loses money.

A fall­ing share price, on the other hand, isn't al­ways an in­di­ca­tor of poor per­for­mance. It can re­flect a de­ter­mined CEO's at­tempt to re­fo­cus a com­pany by selling poorly per­form­ing as­sets and in­vest­ing prof­its (rather than re­turn­ing them to share­hold­ers) in new prod­ucts or new mar­kets that may not pay off for sev­eral years. Why not con­sider al­ter­na­tive forms of pay­ment and per­for­mance mea­sure­ments? Sal­lie Krawcheck, a for­mer Bank of Amer­ica and Cit­i­group ex­ec­u­tive, has joined sev­eral aca­demics sug­gest­ing pay­ing ex­ec­u­tives with cor­po­rate bonds, which would give ex­ec­u­tives rea­sons to bor­row less, take fewer risks and man­age for the longer term. (This would be es­pe­cially ap­pro­pri­ate for banks.)

They're onto some­thing. Con­sider the sub­prime lend­ing cri­sis, in which the eq­ui­ty­based bonus sys­tem en­cour­aged fi­nan­cial com­pa­nies to orig­i­nate home loans that had lit­tle hope of be­ing re­paid. That didn't mat­ter to the mort­gage bankers mak­ing the loans, whose stock-based bonuses de­pended on the vol­ume of loans they made and whose fu­ture li­a­bil­ity (once those loans im­ploded) was lim­ited.But if those mort­gage bankers had been paid in debt -- ei­ther di­rectly with cor­po­rate bonds or debt-like in­stru­ments (de­fined-ben­e­fit pen­sions or de­ferred com­pen­sa­tion) or in­di­rectly by link­ing bonuses to the price of their com­pany's 10-year bonds or its credit rat­ing - - they would have had to stand in line with other cred­i­tors to get their money out.

Amer­i­can In­ter­na­tional Group, whose bonus-ea­ger ex­ec­u­tives sold bil­lions worth of in­sur­ance on mort­gage bonds that AIG couldn't make good on once the hous­ing bub­ble burst, likes the debt com­pen­sa­tion ap­proach. In 2010, it said that 80 per­cent of ex­ec­u­tive bonuses will de­pend on com­pany bond prices, and only 20 per­cent on the share price. Other aca­demics sug­gest re­plac­ing to­tal share­holder re­turn as the main per­for­mance mea­sure­ment -- about 60 per­cent of com­pany boards use it now --- with a "mar­ket-value added" gauge. One way to do this is to base com­pen­sa­tion on the dif­fer­ence be­tween the mar­ket value of a com­pany's debt and eq­uity and the amount of cap­i­tal in­vested. In­stead of bas­ing pay on the fi­nan­cial mar­ket's ex­pec­ta­tions, mar­ket-value added de­pends on a com­pany's ab­so­lute per­for­mance.

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