Home > News > Hear From Business Schools > Executive Pay Caps Could Be Raw Deal All Round

Executive Pay Caps Could Be Raw Deal All Round

Wharton professor thinks paying less may turn off talented managers and reduce taxpayers' chances of a return

The US Treasury plan to cap executive pay at firms receiving federal bailouts may reduce taxpayers’ chances of getting their money back, according to a Wharton finance professor.

 
“Economically, it’s uncertain how effective these new regulations will be”, said Alex Edmans, who discussed some ideas with government pay czar Ken Feinberg earlier this year. “It’s not clear that high levels of pay were behind the crisis”.
 
Feinberg, the Treasury’s special master for executive compensation, has announced a 50 per cent cut in compensation for the top 25 executives at the seven firms receiving a federal bailout. 
 
However factors other than pay may have played a bigger role in bringing on the financial crisis, including poor risk modeling, argues Edmans. And even if pay is to blame, its sensitivity to company performance and the time horizon over which awards are made are more significant than the overall level.
 
“Paying less may mean that these firms are not able to attract good CEOs, or the CEOs may not be incentivized,” he added. Some current CEOs may have contributed to the financial crisis, but rather than paying them less they should simply be fired.
 
Taxpayers’ chances of getting their investment back are maximized by “putting the right person in charge and giving him the incentives to work hard.”
 
Edmans and three academic colleagues sent a proposal to restructure executive pay to Feinberg in June, thinking he “wouldn’t read it”. To his surprise, the pay czar followed up with a conference call. “He seemed extremely open minded and willing to talk,” said Edmans.
 
The proposal by Edmans, Xavier Gabaix and Tomasz Sadzik of New York University and Yuliy Sannikov of Princeton, emphasized what they think is the major problem with corporate America’s compensation: short-term incentives rather than too much pay.
 
Their solution is to set up “dynamic incentive accounts”. Managers’ compensation is placed in these accounts and invested in a pre-determined mix of company stock and cash. Each month the account is rebalanced, so if it is 60 per cent in stock, and the company’s stock price falls, cash will be drawn down to buy more of it, ensuring that managers are exposed to the company’s stock even after it falls. 
 
The problem with existing schemes is that, if a company is in trouble and the stock price falls, the executive’s shares and options are worth little and provide few incentives.
 
Each month, a fraction of the incentive account vests and is paid out to the manager, only getting paid out in full a number of years after he or she leaves the firm, tying the manager into the firm’s long-term success.
 
Edmans has said that government regulators may not be best placed to set up compensation plans, as government regulation tends to be "one size fits all." Thedynamic incentive accounts are designed to be deployed flexibly, precisely because Edmans and colleagues wanted a scheme that applied to all firms, not just bailout recipients.
 
In the new plan, cash salaries for affected executives have been capped at $500k annually and are down an average of 90 per cent.
 
One of Feinberg’s stated goals was to “vastly diminish” cash salaries and instead require that executives “buy into stock that they must hold for a number of years”, the latter being in line with the proposal of Edmans and colleagues
 
“I believe he’s open-minded,” added Edmans. “Feinberg strikes me as someone who proceeds thoughtfully and step-by-step. [These are] only his first guidelines, there may be more to come later.”
 
Edmans is a “bit of a legend” in financial economics circles according to a student pursuing the same PhD that Edmans completed at MIT in 2007. His research has covered the effect of soccer results on stock market sentiment, the link between employee satisfaction and firm performance, and the effect of investment banking advisors on deal performance.
 
“He divides opinion between people who think he’s great and people who are narked off because every time they think of a research idea, Alex has already done it,” said the MIT PhD student.
 
The former Morgan Stanley banker is also one of a handful of professors to have worked in the field he teaches. That real-world perspective may be the reason he’s pragmatic about the new pay rules.
 
“Politically, the regulations are useful to temper some of the public’s anger. Even though economists often like to belittle political motives… they’re not unimportant", he said. “If it restores people’s trust in the financial system, it’s useful”.

Comments.

Wednesday 25th November 2009, 19.44 (UTC)

By

definitely agree employee bonuses should be linked to share price value - and should be paid out on longer-term basis...

Leave a comment.

Maximum 1000 characters