Tuesday, October 23, 2007

Joe Torre, executive pay martyr?

Is executive pay destined to rise ever higher? The Economist's Business.view column thinks so and they turn to a rather unusual example, Joe Torre, the New York Yankee's former manager, to make its case.

To recap, Torre quit after a long, successful tenure (although his team hasn't reached the World Series for six years) after the Yankees organization offered to extend his contract one more year, reducing base pay but offering generous performance-based incentives. Torre called it an insult and quit.

The column argues that:

....Once a pay level has been reached, it becomes a minimum. Mr Torre may still have been the best paid manager in baseball under the new contract, but he would not have been as well paid as before. He is already wealthy and successful. He needs the extra money less than he needs respect—much like the typical boss of a big company after a few years in the job.

Perhaps the Yankees had decided that they really did not want to retain Mr Torre, but also did not want to be the target of abuse from supporters for firing a popular manager. So they hit on the brilliant reverse—“Godfather” strategy of making him an offer he was bound to refuse. But if they did want to keep him, they should have realised that the only executive who is likely to accept a pay cut is the one you don’t want to keep.

The same may be true when it comes to hiring a replacement—the best moment, in theory, to ratchet down excessive pay levels relatively painlessly. Of course, there is nobody available with a record like Mr Torre’s, so a little pay-trimming will be hard to quibble with.

But what self-respecting manager would settle for a pay package significantly less generous than his predecessor’s? Even if the market for executives functions better in future than in the past, when it comes to pay, the only rational way is up.

This just doesn't make any sense in any context. Here's why.

It's simply not true that a new CEO will demand, and earn, as much as a successful predecessor. GE provides a good example. This is just common sense. What high executive would not jump at the chance to run a firm even if he didn't earn as much as the previous CEO? Let's keep in mind that the gap between a CEO's pay and that of his top lieutenants is huge, so a CFO climbing to the top rung will make much more, even if pay at the CEO position is cut.

The main problem with executive pay is that incentives are not meaningfully aligned with actual performance. As a result, underperforming CEOs (which logic dictates are 50% of the total) are usually paid way too much. In that sense, true compensation reform would probably not penalize success, but rather avoid rewarding failure.

Now, the tricky bit is measuring performance, which is difficult even in baseball, the most statistically-centered sport. How much of the Yankees remarkable success over the past 10 years is attributable to Joe Torre's coaching compared to the team's overall talent level? This ultimately involves some judgement calls, although the sabermetrics crowd has developed valuable objective indicators to measure this(see here and here). It's high time boards used similar methods to set executive pay.

As for Joe Torre, this argument sounds about right.