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.

More executive pay lunacy

The (mis)use of options is not the only problem with current executive compensation schemes. As this article explains, there's the issue of transparency. The SEC's chairman offers a pithy quote:

The rules significantly expanded the disclosures that companies are required to make about compensation for their highest-paid executives. Christopher Cox, SEC chairman, has said that investors "should not need a machete and a pith helmet to go hunting for what the CEO makes".

But it also presents a fact that is capable of shocking even a jaded veteran such as yours truly: CEOs often make as much as ten times as their top lieutenants. Wow. This is just plain nuts.

Kudos to the SEC for finally beginning to address these issues.

Executive pay: Out of the money

Nowadays, options make up the bulk of high-level executive compensation. They are hailed as an efficient way to align the interests of management with those of shareholders. But is this true?

This piece in The Economist presents evidence to the contrary:

Belatedly, the evidence is now mounting that share options are not all they were cracked up to be. Consider, for example, “Swinging for the fences: The Effect of CEO Stock Options on Company Risk-taking and Performance,” a study in the October issue of The Academy of Management Journal.

The authors, two economists, Gerard Sanders and Donald Hambrick, observe that options create asymmetric incentives: they pay out when a firm’s share price rises above the option exercise price, but once they fall below the exercise price, all further falls make no difference to the ultimate payout, which is nothing. This, posit the authors, gives an incentive to take big bets, by investing in risky activities with long odds on a high pay-off. They also posit that these bets will produce more extreme losses than extreme wins.

To test these theories, they examine the impact of the options awarded to the chief executives of some 950 American firms during 1993-2000. This showed that the bigger the role played by share options in the boss’s pay package, the more likely firms were to invest heavily in risky activities. It also confirmed that high levels of share options were associated with more extreme ups and downs in a firm’s share price, and that the big downs significantly exceeded the extreme highs.

The authors conclude that “not only does this asymmetry affect the selection of strategic initiatives, as we have discussed, but it may also cause CEOs to be inattuned to early signs of project failure and generally careless about risk mitigation.” Surely this is not the sort of motivational incentives that shareholders want.

These results are not suprising and my guess is that they would've been much more evident if there hadn't been a huge bull market for stocks during that period.

It's not just a question of asymmetrical payoffs. My main beef with options is that they only reward absolute rather than relative performance.

In lackluster or bear market conditions a firm may have outsanding operational and financial results and yet see its stock price fall simply due to macro factors outside its control. Conversely, in a bull market a firm's stock price may rise despite poor results relative to its competitors. Executives would receive a large payoff in the second case, but not in the first, an outcome that defies all logic.

Yet, I have yet to see a compensation plan that takes this issue (or others, such as favoring short-term appreciation versus long-term gains) into account. Strike prices are usually the price of shares at the time the options are issued.

Outrage about executive pay is misplaced. Focusing only on its level is not helpful. It may or may not be excessive. But the real problem is that the way compensation is determined makes no sense at all.