Governance and Ethics – Practitioner – Unrealistic Management Compensation

The Incentive Bubble by Mihir Desai – Harvard Business Review, March 2012

Given the current situation of the financial markets and the lack of job growth and expansion, some have come to question the metrics on how we evaluate and compensate executive management, in particular those linked to financial services.  If one remembers not that long ago there were “cries” for regulators to step in and regulate executive compensation. To be fair at first people were speaking of the financial institutions that were being bailed out by us the tax payers, then somehow this eventually spread to all executive compensation.  That said this article focuses on compensation mainly related to the financial services, but in some respects they question all upper management compensation linked to financial performance of the underlying company share price and how the risks taken are not accounted for in the compensation methods.

            Today it is common place for executives to receive performance based compensation linked directly to asset performance.  As we all know over the past few years there has been somewhat of a financial crisis, tied to mortgage lending, bloated balance sheets, undue risk taking and etc...  It can be argued that a lack of corporate oversight or a lack of ethics is why we are where we are.  The desire to allure young talented executives has helped push the compensation structure to where it is today, leading to a more competitive environment to earn top dollar.  One of the major issues with this according to Mihir Desai is the lacking ability to discern the difference between “skill and Luck,” though possible this is difficult to distinguish.  Regardless of whether luck or skill in many cases management has been able to manipulate financial markets and stock prices by taking unneeded risk and by the creation of financial instruments that piggy back off of already existing derivatives, funds, etc...  After all if the performance of the particular asset or company was greater than investor expectations management was and is still rewarded handsomely no matter the risk taken.  The crux of the matter is that once management starts to take on more and more risk the potential for failure increases unproportional to the returns.  Adding to this the lack of corporate governance and investor oversight has let companies off easy due to the greed and want of exceptional returns.

How do executive boards and companies deal with the compensation issue?  Desai brings up a good point about adjusting the compensation to the amount of risk the company takes on, once the company has reached a sufficient “hurdle rate” everything in excess is fair game.  Another thing that has been done and was noted is that asset managers should not be allowed to rebrand and repackage the same assets.

From the looks of things the shift to a restructured compensation system is a long way off.  In the interim management should consider the long term impacts of taking on such risks just to line their pockets.  Are we taking on too much risk?  How does this affect the workers, investors, and stakeholders if we take on to much risk and fail?  These are things that every manager should ask themselves.  If companies continue on this path I feel that the government will step in because they feel the need to protect the consumer, we have already seen legislators in the House Financial Service Committee float the idea of executive pay caps (Yaron and Don 2009) so who’s to say in the future this will not affect all of management and all corporations.