incentives fleshed out

Last post I discussed the importance of incentives for helping to change behavior and I would like to expand on that a little bit today.

Today’s extraordinarily excessive exec pay packages have a very skewed sense of reward. You frequently hear justification for these enormous dollar awards along the lines of, “Well the head of the ABC Corp. has very large responsibility and therefore, his pay compensates him for that.” Well originally it was salary that was supposed to compensate an executive for the responsibilities and stresses associated with a job. And make no mistake, the salaries of corporate execs are very high indeed. But more on this in a moment. Bonuses and other awards were designed to reward executives who had exceeded expectations and who had contributed dramatically to the growth of the business’s profitability, and to the growth of the health of the business. However, the norm is that executives earn huge bonuses for any performance, good or bad. Imagine if at your job your decisions led to a measurable decline in the profitability of the firm, layoffs of your fellow employees, and diminished overall strength; is this the sort of performance you would expect would lead to a huge cash payout? No, you would likely be fired. So what makes the executives of businesses different than you?

The answer is that your job has oversight, whereas top execs do not have oversight. In name, if not in practice, the board of directors of a corporation is supposed to provide oversight of executives. Unfortunately, most board members are principally there to collect large remuneration for, at most, 8-16 days of work per year, and to improve their Rolodexes. So they are a fairly casual observer of what goes on inside of a corporation. But, boards are supposed to represent the concerns of the owners of a firm, aka shareholders, aka you and me! All too often though, they are management’s too forgiving, and over-indulgent, grandparents.

And ultimately, boards of directors are nominated and elected by shareholders. So who are these shareholders? Well primarily they are institutional investors, such as mutual funds, pension funds, insurance companies, etc. I am comfortable in guessing that around 60% of all shares of stock in a business are owned by such institutions. The other 40% is owned by the general public – which, again, means you and me!

So what can you do to affect change so that executive compensation actually rewards excellent performance and so that it encourages ethical behavior? Well, if you directly own shares of stock in any business then you must pay attention to, and vote your company’s annual proxy – these typically are sent to shareholders in the springtime. If you own shares indirectly, in a mutual fund or a pension, then you have to encourage your fund managers to take their responsibility as an owner in a business seriously and to become more activist in their participation as an owner in any firm whose shares they own.

I believe that these are good first steps to correcting the massive imbalance that exists between executive performance and executive pay.

So to summarize the blog so far:

• The financial crisis is really a crisis of poor ethics
• The ethical issue in question is self-responsibility
• Ethics are an economic issue

One of the ways to combat this problem is to return to the laws that were put in place after the Great Depression.
Another way to combat this problem is to change the way executives are compensated. This is because economic incentives do work.
Yet another way to combat this problem is to become an activist shareholder of businesses that you own in order to change how business leaders are compensated.

Let’s be careful out there!

Jason

P.S. – I encourage you to go to http://www.sec.gov/edgar/searchedgar/companysearch.html, type in a ticker symbol for a business. Then look for the firm’s “definitive proxy statement,” or DEF14A. Over on the upper-right hand side you can enter the form type and it will take you directly to the proxy statements. If you peruse through these docs you will see the huge dollar amounts drained out of businesses to reward the leadership of your chosen company. As an exercise type in the ticker symbol “GE” if you want to know how their execs are compensated. I think you will be surprised.