Are Executives Paid Too Much?

Are Executives Paid Too Much? By Judith F. Samuelson and Lynn A. Stout
Congress asks the wrong question and comes up with the wrong answer.

A last-minute provision added to the stimulus bill President Barack Obama signed into law on Feb. 17 restricts companies that accept federal bailout funds from paying performance bonuses that exceed one-third of an executive's total annual compensation. This punitive measure may be understandable as a reflection of populist fury over bonuses being paid to heads of failing companies that received billions in taxpayer money. But it utterly fails to fix the real problem with executive compensation: short-termism.

Our economy didn't get into this mess because executives were paid too much. Rather, they were paid too much for doing the wrong things.

There have been nearly as many reasons proposed for the current crisis as there are experts to propose them. But if we had to pick one overarching cause, it would be business leaders taking on excessive risk in the quest to increase next quarter's profits. This short-term thinking, in turn, was driven by two trends in the business world: shareholders' increasingly clamorous demands for higher earnings, and compensation plans that paid managers handsomely for taking on risks today that would only be realized later.

In the summer of 2006, well before most economists had any inkling of the calamity that was about to unfold, the Aspen Institute brought together a diverse mix of high-level business leaders, investment bankers, governance experts, pension fund managers, and union representatives. When you put successful people with such disparate and conflicting backgrounds and loyalties together in the same room, the result can be a shouting match. But the members of the newly formed Aspen Corporate Values Strategy Group found they shared an unprecedented consensus: Short-term thinking had become endemic in business and investment, and it posed a grave threat to the U.S. economy.

People in all walks of life need months or years to master a significant new project, whether it be getting a graduate degree or perfecting a 75 mph minor-league pitch into a 90 mph major-league fastball. Large corporations operate on a time scale that can be even longer. They pursue complex, uncertain projects that take years or decades to reach fruition: developing brand names, building specialized manufacturing facilities, exploring and drilling for oil and gas fields, or developing new drugs, products and technologies.

Yet over the past decade, corporations in general -- and banks and finance companies in particular -- have become increasingly focused on a single, short-term goal: raising share price. Rather than focusing on producing quality products and services, they have become consumed with earnings management, "financial engineering," and moving risks off their balance sheets.
This collective myopia had many causes. One cause, the Aspen Group concluded, was the demands of the very shareholders who are now suffering most from the stock market's collapse. It is extremely difficult for an outside investor to gauge whether a company is making sound, long-term investments by training employees, improving customer service, or developing promising new products. By comparison, it's easy to see whether the stock price went up today. As a result, institutional and individual investors alike became preoccupied with quarterly earnings forecasts and short-term share price changes, and were quick to challenge the management of any bank or corporation that failed to "maximize shareholder value."

Meanwhile, inside the firm, executives were being encouraged to adopt a similarly short-term focus through the widespread use of stock options. The value of a stock option depends entirely on the market price of the company's stock on the date the option is exercised. As a result, managers were incentivized to focus their efforts not on planning for the long term, but instead on making sure that share price was as high as possible on their option exercise date (usually only a year or two in the future), through whatever means possible.

Executives eager to maximize the value of stock options began adopting massive stock-buyback programs that drained much-needed capital out of firms; jumping into risky "proprietary trading" strategies with credit default swaps and other derivatives; cutting payroll and research-and-development budgets; and even resorting to outright accounting fraud, as Enron's options-fueled and stock-price obsessed executives did.

The system was perfectly designed to produce the results we have now. To get different results, we need a different system.

Simply cutting executive pay is not going to get either executives or investors to pay more attention to companies' long-term health. To get business back on track, the Aspen Group concluded, it is essential to focus on not just one but three strategies: designing new corporate performance metrics, changing the nature of investor communications, and reforming compensation structures.

Starting with metrics, we need new ways to measure long-run corporate performance, rather than simply relying on stock price. In terms of investor communications, companies need to ensure corporate officers and directors communicate with shareholders not about next quarter's expected profits, but about next year's and even next decade's.

Finally, and perhaps most importantly, companies must change the ways they reward not only CEOs and midlevel executives, but also institutional portfolio managers at hedge funds, mutual funds, and pension funds. Executives and managers should be rewarded for the actions and decisions within their control, not general market movements. Incentive-based pay should be based on long-term metrics, not one year's profits. Top executives who receive equity-based compensation should be prohibited from using derivatives and other hedging techniques to offload the risk that goes along with equity compensation, and instead be required to continue holding a significant portion of their equity for a period beyond their tenure.

It's always tempting in the midst of a crisis to look for a quick fix. But that's the kind of short-term focus that got the business world into trouble in the first place. So long as our metrics, disclosures and compensation systems encourage executives and institutional fund managers to look only a year or two ahead, we have to expect that that is what they'll continue to do. It's time for a long-term investment in promoting long-term business thinking.

Ms. Samuelson is the founder and executive director of the Aspen Institute Business and Society Program. Ms. Stout is professor of corporate and securities law at the UCLA School of Law and director of the UCLA-Sloan Research Program on Business Organizations.