Harvard Business Online

Getting Executive Compensation Right


Posted on How to Fix Executive Pay: June 22, 2009 2:15 PM It seems we are moving from an era when "greed was good" to one in which "jealousy is justified"—the executive-compensation regulations being considered now by the government and advocated by shareholder activists aren't very thoughtful, and I believe they're born out of jealousy and misinformation. But "How much should CEOs be paid?" is the wrong question to be asking right now. The right questions are: "How should they be paid?" and, just as important: "Should changes in the way CEOs are paid be mandatory or voluntary?" Pay must be structured to attract the right executives and give executives effective incentives to lead their companies to great performance. The poor showing of too many firms, despite ample CEO salaries and equity packages, and excessive compensation at times of poor performance shows that pay typically isn't structured correctly and that executive compensation practices need serious reform. All too often, executive incentives are based mostly on short-term financial metrics and shareholder returns. Financial results are the consequence of a firm's strategy formulation and implementation. Effective incentive systems should focus on effective organizational learning and growth, process improvements, and customer-related metrics and milestones. In addition, companies should design compensation packages to attract the right people for implementing the company's strategy. For instance, below market salaries coupled with aggressive incentive pay linked to individual performance is likely to attract self-motivated entrepreneurial individuals. Companies also need to assure their executives longer tenure and horizons. A CEO who is afraid of being fired for not making short-term financials will not focus on the long term. A board that is actively engaged in strategy formulation and implementation and compensates a CEO for strategy implementation milestones and monitoring long-term performance is more likely to understand, appreciate, and encourage a CEO's efforts even if they yield short-term financial results that are below expectations. Thus there is an urgent need for boards to evaluate their executives' performance annually to determine their progress on long-term goals. Simultaneously, boards should engage in active succession planning so that they do not find themselves looking for a superstar CEO to rescue them from their financial problems. It is precisely in those situations that CEOs are able to negotiate outrageous compensation packages. Simultaneously, companies should get rid of egregious practices such as over the top severance packages (more than two times annual compensation), grossing up taxes, defined-benefits plans, guaranteed returns on deferred compensation, accelerated vesting in the event of change in control, and time-based vesting of restricted stock. On the stock question, companies should require that equity pay vest on the basis of company performance relative to their peer group over five to ten years. It would be highly unfortunate if, as now seems possible, massive amounts of regulation and active government intervention were to be the dominant forces determining how American executives are compensated. Caps on pay, shareholder "say on pay," ceilings on ratios of CEO pay to worker pay, appointment of a federal compensation czar, and labeling of incentive pay as pay that causes excessive risk—all these would reduce innovation in American companies and hurt shareholders without necessarily reducing excessive executive compensation. Governmental and shareholder second-guessing on pay would create an environment of fear in which no board would dare try an approach that's different from the herd's or that is tailored to the company's particular strategy. And one size definitely does not fit all when it comes to compensation—when business strategies differ between companies, their compensation practices ought to differ as well. Worse, governmental regulation will probably have unintended consequences without curbing excessive pay. For instance, if the maximum ratio of CEO pay to worker pay were mandated, companies might respond by outsourcing the work of the lowest paid workers rather than curbing CEO pay. While compensation reform is needed, it must come from within—from executives and boards, acting in the company's best interests.
V. G. Narayanan is the Thomas D. Casserly, Jr. Professor of Business Administration at Harvard Business School, where he chairs the Board of Directors Compensation Committee Executive Education Program.

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