Christian Science Monitor: A better way to pay CEOs
… No, I'm not calling for limits on CEO pay. Capitalism thrives on incentives, and compensation ceilings distort those incentives. But there is a better way to pay CEOs, by using incentives to refocus them on building longer-term, sustainable company value. …
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Since the mid-1990s, American CEOs have been paid primarily in megagrants of stock and stock options – especially high-octane options – on the theory that having lots of "skin" in the game better aligns CEO interests with those of the firm's shareholders than would a large base salary. As is well known by now, these high-powered incentives have, in recent years, prompted a small minority of corporate CEOs to cheat by falsifying their accounting. But far more broadly, they have enticed honest CEOs to gamble imprudently with (mostly) other people's money, because it makes sense within these pay structures to play for unlimited upside while – at least in terms of compensation – there is a floor to downside risk.
Investing huge sums in subprime mortgage securities held out the prospect of massive returns if CEOs bet right. True, as Morgan's Mack and many of his peers have learned the hard way, betting wrong isn't cost-free. But with sky-high upside if the gamble pays off, and downside risk limited to a foregone bonus – or even, in extreme cases, a firing softened by the lucrative exit packages now taken for granted – there isn't enough deterrent to reckless investments.
A better compensation system would set CEO pay based on current-year company performance, but would hold back the bulk of it (in a good year) on paper as only a tentative payable. That credit balance would be subject to meaningful reduction in the event of a subsequent poor year. The Harvard Management Company, which has had enormous success investing a university endowment that has now grown to $35 billion, has compensated its executives in this manner for many years.
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