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What (Not) To Do About Executive Compensation…

February 10th, 2009 · 4 Comments

I feel a little like a broken record nowadays- in terms of policy decisions, it is often the case that the solution that is intuitively appealing is not the solution that is actually, let’s say for the sake of argument, correct, or, put less judgmentally, going to achieve the desired outcome. Usually this conflict arises because of the inherent tradeoff between efficiency and equity, with equity being the more politically palatable side of the fence to be on.

Let me start with a motivating example. Consider Harvard Management Company (HMC)- you know, the guys that manage Harvard’s endowment. (On an unrelated note, I am still peeved at the NYT for putting out an article explaining that the value of Harvard’s endowment had decreased 22% and implied that the HMC guys were supposed to be smarter than that or something. Since the overall market had declined 30% at that point, I would argue that HMC made an economic profit of 8%. But hey, the NYT needs a story, and it’s Harvard, so…) It is a well-known fact that investment managers make a lot of money, and in general (at least until recently) few balked at this notion. But the idea of sky-high pay somehow becomes less palatable when applied to those managing the endowment of what is technically a non-profit organization. So what happened? To boost their public persona on the matter, Harvard put a cap on the compensation that the HMC managers could receive, and, big shock, the ones that would have been affected by the cap (i.e. the good ones) left for other companies. HMC then invested part of the endowment with the firms that these managers left for and paid commissions that easily outweighed the amount that they would have paid the managers. But commissions don’t garner news headlines like “Harvard Endowment Managers Made $26.8 Million”, so all is good. (The details of the situation can be found in a Harvard Business School case on HMC, which should be available through Harvard Business School Publishing.)

Now let’s get back to the matter at hand. President Obama recently set a pay cap of $500,000 (with some restricted stock exceptions) for chief executives at corporations that are receiving government bailout money. On the surface this seems like a fine idea, since why in the hell should these CEOs be paid handsomely when their companies are in the toilet so much that they essentially need corporate welfare from the government? That’s clearly the fairness argument. But let’s think about an efficiency argument. Suppose you were on the board of a company that was not receiving bailout money…wouldn’t there be an incentive to try to poach the CEOs of the companies being bailed out, since presumably you could get them for cheap? This would result in a flight of talent from the bailed-out firms, which is probably not going to help them become self-sufficient anytime soon.

I can hear what you’re thinking: “But those CEOs probably wouldn’t be poached since they can’t be that good if they got their companies into these messes in the first place.” This is certainly a fair point, and I don’t really know how many comopanies need bailouts because of poor management as opposed to simply unfortunate circumstances. However, the compensation limits are attached to the companies, not the current CEOs. Therefore, the bailed-out firms are at a competitive disadvantage even when trying to hire new, better chief executives who might actually be able to turn things around for them. “Um, yeah, our company is struggling to the point of needing government assistance, and we’re not really allowed to pay you what you are used to, but can you come help us out of this mess?” That’s one hell of a value proposition. To me, a better value proposition would be “We’ll hire you as a consultant so that we don’t have to give you the chief executive title and thus not have you be subject to the limits. We’ll keep the existing guy on as a CEO figurehead and pay him his $500,000.” Don’t underestimate the ability of people and organizations to game the system- that’s kind of how we got into this mess in the first place.

So what would be a better answer? I’m not sure, but I am open to suggestions. It’s a tough call, since any policy that targets only firms that get bailouts puts them at a competitive disadvantage for talent, but any policy that targets all companies “punishes” those companies that didn’t ask for anything from the government…yet, at least.

I will do a follow up post on why high executive compensation is not necessarily a bad thing. Stay tuned…

Tags: Policy

4 responses so far ↓

  • 1 Dan L // Feb 11, 2009 at 12:00 am

    I’m staying tuned. Personally, I think that the problem (if there is one?) of high executive compensation is just a symptom of the greater problem of corporate governance. Not only do Boards of Directors not serve the interests of shareholders, but I’m not sure that the notion of “interests of shareholders” even makes any sense.

    I agree with you that the 500K thing is sort of silly, but as you hinted, I bet that one way or another this provision won’t have any effect on anything.

    As an aside, I browsed that article on Harvard’s endowment and didn’t see anything that “implied that the HMC guys were supposed to be smarter.” Maybe I didn’t read it carefully enough. In any case, I think that I read somewhere that Harvard’s losses are likely to be much worse than 22% if the assets are valued correctly (which is impossible of course, but the idea is that 22% is wishful thinking).

  • 2 econgirl // Feb 23, 2009 at 5:25 pm

    You are correct in your last paragraph- that evidence was in another article that I couldn’t find, since, as far as I can tell, the NYT took away its saved pages feature with no notice.

    You are also right about the corporate governance issue, to the degree that it might warrant a follow up post.

  • 3 Denis // Mar 7, 2009 at 9:52 am

    Great post! The issue of trying to cap these so-called “golden parachute” incentives will have unexpected results.

    You made the perfect point when you said it wasn’t even necessarily bad management, but unfortunate circumstances that led to the current situation in many cases. I think that’s a key consideration right there. Even good managers find themselves in a precarious situation.

    There is a reason these CEO’s are paid as handsomely as they are. Long hours, education and/or experience, the responsibilities and decisions they are faced with… But most importantly, it’s what was determined by a (mostly) free market.

    My favorite is the complaints about severance packages being too good, and the assumption if your firm is acquired by a competitor that you necessarily failed. I think we might be seeing that, too, in some firms that received bailout money – those which were well run but simply got caught up in the downturn. There will be a public outcry that these CEO’s ran their company to the ground and get a huge severance. Not an outcry that they did a great job making the company viable for purchase despite events, and were actually a good CEO. Besides, it’s not just CEO’s who get severance packages.

    You’re absolutely right that those firms receiving government assistance will now be at a competitive disadvantage. Great blog! 🙂

  • 4 econboy // Mar 11, 2009 at 8:21 am

    If these companies can find away around the $500K cap, as you seem to suggest, then they are not at a competitive disadvantage.

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