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New Pay Paradigm: A Beauty Contest

Posted By Jay Lorsch On May 12, 2010 @ 11:03 am In Blogs,Compensation | 1 Comment

Concerns about the compensation of chief executive officers and other top executives of American public companies have reached fever pitch since the financial crisis and the economic meltdown of 2009. Some observers blame the recent recession in part on the flawed compensation arrangements for the top management of major financial institutions. Nor are such concerns new. For almost 20 years, a growing chorus of voices—including some shareholders, the business media, policymakers, and academics—have been criticizing the way top managers are paid. The criticisms focus particularly on CEOs not only because they are the highest paid, but also because their compensation sets the pattern for executives beneath them.

Jay Lorsch is the Louis E. Kirstein Professor of Human Relations at Harvard Business School. This post on The Harvard Law School Forum  on Corporate Governance and Financial Regulation blog [1] is based on an article by Professor Lorsch and Professor Rakesh Khurana that first appeared in Harvard Magazine.

Like previous criticisms, the current complaints focus on two issues: executives are paid too much, and current incentive-pay schemes are flawed because the connection between executive pay and company performance is mixed at best—and at worst has led to a series of dysfunctional behaviors.

Whether executives are paid too much is highly contested. Some institutional shareholders, politicians, and the public (as measured by opinion surveys) believe that CEOs are overpaid, while other shareholders, board members, and executives themselves disagree. What cannot be disputed is that American CEOs make more money than CEOs in other countries, largely because of a greater reliance on incentive pay (see the details in the chart above). Further, American CEOs are paid increasingly large amounts relative to the average employee and their immediate subordinates. Finally, it is clear that the rise in executive pay contributes to the skewing of income distribution in the United States.

Less clear is evidence about the link between executive compensation and performance. The most comprehensive survey examining the link between CEO pay and performance found that changes in firm performance account for only 4 percent of the variance in CEO pay. [1] This may in part reflect CEOs’ ability to game the system, or even the perverse effects of incentives that promote dysfunctional behavior.

The solutions offered for the problems of excessive levels of executive pay and the need to strengthen the link between pay and performance often hit on the same themes: strengthen the independence of directors and compensation committees; increase the shareholders’ rights to elect directors and to express their views on compensation plans, to discourage gaming and align incentives more closely with the aims of the owners. It is also tempting to suggest that these problems can be solved by better compensation schemes or improved techniques to link CEO pay to stock performance.

We disagree with the premises underlying these remedies. Instead, we find that the current compensation trouble stems in large part from unexamined assumptions that have fundamentally changed the nature of executive compensation and radically shifted the way that boards, executives, and even the larger society regard the corporation and its broader purpose.

In fact, the problems of executive compensation are symptomatic of larger societal questions. They cannot be resolved without considering the purpose of executive compensation—what behaviors, attitudes, and values we are trying to motivate in our business leaders—and indeed the larger purpose of business in American society. We assert that the current approach to executive compensation is an outgrowth of a pervasive paradigm that boards, senior executives, and indeed even those of us educating future and current business leaders have adopted about the purpose of the corporation, what it means to be a business executive, and to whom and for what executives are responsible.

Click here [1] for the entire post.

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[1] The Harvard Law School Forum  on Corporate Governance and Financial Regulation blog: http://blogs.law.harvard.edu/corpgov/2010/05/12/towards-a-new-paradigm-for-executive-compensation/#more-9227

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