Wednesday, 4 March 2009

Executive Pay

(cartoon from www.

There are few universal truths in business. Here is one however. Everybody believes he should be paid more and everybody else should be paid less. The more senior the "else" is, he should definitely be paid a lot lesser.

A zillion words have been written on executive pay and how excessive it is. Politicians have fallen over themselves to criticise Wall Street "excesses" - this is the "I should be paid more and he should be paid less" syndrome at its best.

In general, I believe there is no such thing as "excessive" executive pay. Talent is a commodity, just like any other commodity. When oil price was $15/barrel, it wasn't "underpriced". When it was $ 150/barrel it wasn't "overpriced". It was just supply and demand working like in any other market - we may not like the outcome, but its still the most efficient pricing mechanism. So must be the case with talent. It will be priced according to demand and supply. If there is a shortage of talent in any field, salaries will go up; if there is a surfeit, salaries will come down. Period.

While this can be true in general, there are situations (especially with very senior management), where a true demand supply situation cannot exist. In such cases pricing is more difficult. Checks and balances can be however constructed ( for eg a truly independent and effective remuneration committee of the Board) to make the process as efficient as possible.

Any legislative cap on executive pay is simply daft. It can never work. Just like price control on commodities can never work - all it will encourage is a thriving black market. The same will be the case with capped executive pay. The only result will be a thriving remuneration consulting industry which will find ways of beating the cap.

The real issue, of course, is the difficulty of linking pay with performance. People are not objecting to the absolute quantum of pay. They are really objecting to what they consider excessive pay when the performance is not "excessive".

There are four broad components of executive pay. One is a fixed component that is both cash and perquisites. This is settled at the time of contract and is rarely the subject of public outcry.

The second, and possibly most controversial component, is the bonus or variable pay. This is usually an annual bonus linked to some targets. In some industries, notably the financial services industry, this has become a monster, with virtually no cap. The problem in this industry is that it started out as a partnership and therefore these "bonuses" were a form of profit sharing amongst partners. When they all became companies with shareholders, they were mistakenly allowed to carry forward this tradition and hence bonuses became many times the amount of fixed compensation. The bonuses were also linked to short term targets (the market should not moan about this as they themselves want companies to show quarterly results and to hell with the long term). All this must change. Bonuses must be capped to say twice the fixed compensation. Targets must be linked to both overall company performance and individual targets. Bonuses should be paid over a three year period - say 10% in Year 1, 40% in Year 2 and 50% in Year 3 just to ensure excessive risk taking over the short term does not happen. These bonuses are payable even if the individual has left the company in Year 2 or 3 - its just that the payment is deferred to ensure that there were no medium term fall outs. Such practices are already common in many industries.

The third component is stock options. In principle this is supposed to align the interests of shareholders and management and is supposed to be a good thing. In practice, the problem has been that managements often fiddle the timing and pricing of the options. So much so, that this has tended to go down in significance as a component of remuneration. My view is that this should be integrated with bonuses into a stock grant. Allow employees to take the bonus in shares or in cash, with a small incentive if he took it in shares. End of story.

The fourth component, and the one I have no sympathy with at all, is compensation for termination. Golden parachutes are the worst. They must simply be abolished. Nothing raises the heckles more than an executive sacked for performance and taking away a massive amount in compensation. I believe there should be no termination payments other than what is paid to any employee - usually x months salary for years of service. There should be nothing more than this and it should be the same for all employees in a company.

At the end of the day, much can be said and written on executive pay. It will all boil down to the values of the company and that of the executive. No amount of rules or policy is going to deter the executive who is just out to maximise his money at the expense of the company. Equally no rules are required for the ethical company and employee who both want a fair wage, but no more. As with all things relating to governance, its ethics that will finally rule; not legislation.

Will the Chief Ethics Officer please rise.


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