Radical Reform of Executive Pay

Andrew Lo has written a few guest posts here before, and now he’s back with another excellent one — so excellent, in fact, that we asked if he’d join our corps of recurring guest bloggers. Happily for all of us, he accepted.

The recent proposal by the Fed to regulate bankers’ compensation practices is understandable given the events of the past two years, but setting caps on salaries and bonuses misses the fundamental problem of compensation on Wall Street. Despite the public resentment surrounding finance-industry payouts, the fact is that no one objects to paying for performance. We just want to make sure we’re not getting fleeced or paying for pure dumb luck, and this is where the problem lies.

To correctly link pay to performance, we need two key ingredients: a reasonably well-functioning labor market for talent and an accurate measure of performance. If either of these inputs is missing or broken, compensation levels can easily get out of whack, disrupting several industries as employers and workers respond to potentially misleading wage differentials.

To see how, consider first an industry with eye-popping compensation contracts that no one seems to complain about: professional sports. The process for recruiting new talent in every major spectator sport is certainly well-organized, and the labor market for professional athletes is relatively liquid and transparent compared to other labor markets. But what about those outrageous multi-million-dollar contracts? In fact, such contracts generate little public outrage because pay and performance are so directly linked in these instances, and because performance is not only easily measured, but is thoroughly analyzed by millions of fans as well as the franchise managers ultimately responsible for justifying these contracts to their shareholders. Is Tom Brady — the 2007 NFL MVP with a career record of .787, a playoff record of .824, 197 career touchdown passes, a 63.0 percent completion percentage, and a 92.9 percent passer rating — really worth the $8,001,320 he was paid in 2008? Absolutely. There is an even more direct connection between pay and performance in professional sports: ticket sales and advertising revenues. Brady’s star power can literally be measured in dollars and cents.

Now consider financial services: the usual performance measures used to structure Wall Street compensation — investment return, stock price appreciation, assets under management, and the dollar-value of deals closed, for example — may simply be too noisy to gauge the genuine value-added of even the most talented masters of the universe. The main reason is risk.

Virtually every aspect of financial decision-making involves making trade-offs between risk and reward, and even the most savvy investor is rarely correct more than 55 percent of the time. For example, a trader who generates a profit of 2 percent per day with 55 percent probability and -2 percent per day with 45 percent probability is wrong 45 percent of the time, but over the course of a year the expected compound return of his portfolio is 65 percent! However, the annual standard deviation — a common risk measure — of this trader’s compound return is a whopping 53 percent (for comparison, the annual standard deviation of the S&P 500 is currently around 25 percent). Such a high level of risk implies an 11 percent chance that this highly skilled trader’s annual return is negative in any given year (assuming normality), and a 30 percent chance that over a 10-year period, at least two years will show negative returns.

This example illustrates the challenge of determining who has skill and who got lucky, a considerably more difficult task in financial contexts than in professional sports, manufacturing, retail sales, entertainment, and many other industries. Therefore, we shouldn’t expect the traditional employment contracts and incentives to work the same way in financial services.

Now regarding the arcane probability calculations above, the shareholders of recently failed financial firms might say that this is exactly the kind of fast talking that got them in trouble in the first place, and sadly, they’re probably right. Far too often, sophisticated risk/reward computations have been used to justify enormous payouts to those who happened to be in charge when good outcomes occurred, only to leave shareholders holding the bag when the bad outcomes came along — a case of “Heads I win, tails you lose”.

The only way to meet this challenge is to restore the intellectual balance of power between executives and shareholders by: 1) constructing new compensation contracts that are as sophisticated as the business activities of the managers being compensated, and 2) educating shareholders, auditors, accountants, and lawyers so they can make more intelligent risk-based choices. Such contracts and decisions must be based on new, more accurate and more relevant measures of performance that explicitly account for risk, incentive effects, time horizon, and the uncertainties of the performance-attribution process. One size cannot fit all, and we should expect contracts to differ according to the risk/reward profiles of different financial services and their respective shareholders’ objectives.

Radical compensation reform will be no easy feat given the complexities of most financial institutions and the politics surrounding this effort. However, it will take more than bonus caps if we ever hope to create a more stable and robust financial system that will be free from the tyranny of bubbles, crashes, and credit cycles.


Mike

I disagree with provision #1, anytime you add complication to something it makes it harder to figure out what's going on and easier to hide things from people. I actually like what Mark Cuban said a couple of months ago (http://blogmaverick.com/2009/04/01/fixing-executive-compensation/) Basically, pay executives in money not equity. Then the shareholders will see directly how much the executive is costing them and see if it's worth it for how much they help the stock. Much simpler and much more easy to evaluate.

steve

A bit "wonkish" but nice piece. How about reforming banks so when they lend they are responsible for the loan ?

This would make judging their performance and therefore compensation relatively easy.....

Bank Manager A makes good loans gets paid back, makes money, everyones happy.

" " B makes terrible loans, does not get paid back, loses money, shareholders cry, manager gets no bonus.

AntiAntiCamper

This is a very sensible analysis. But what to do if Taleb is correct and there is no mathematically reasonable way to accurately measure "risk"?

MikeM

Since when do people not complain about pro athletes compensation?

Andrew

Unless we abolish markets and capitalism, radical reform of Wall Street compensation will take one of two forms: 1) complete economic collapse and world-wide war 2) violent revolution. These are not of course mutually exclusive possibilities.

It is not a question of calculating the probability density of guessing on inherently stochastic processes. The market system left to its own devices will quickly destroy itself. The latest crisis is more evidence for what many largely ignored thinkers have been arguing for centuries. Even Adam Smith wrote that markets can function only if there is "relative equality".

michael

indeed, there isn't an clever guy currently

Chris

Interesting piece. Discouraging, too, because nobody in power these days seems to think along these lines. You're right, it'd be good for all of us if the financial sector could gauge performance more accurately. But that's not going to happen just because the government sets some arbitrary cap on bonuses. In fact, it hinders the process.

ScotterOtter

I'm against any sort of regulation of execute pay rates. BUT, if I were to enact some sort of law, I would require equal pay scale amongst all company employees. If the CEO gets a 10% raise, all employees should get a 10% raise. If the CEO has a golden parachute, all employees should get the same severance as a percentage of their pay rate and so on. Layoffs could also be used as a factor to require pay cuts amongst executives.

br

I guess I missed it when Tom Brady's focus on short term profits brought the country to its knees and required a trillion dollar bailout. I also missed the golden parachute he got as a reward for the damage done.

Also, sorry to state the obvious but MikeM is right.

I really like this section and think it should be extended to include taxpayers, not just shareholders:

Far too often, sophisticated risk/reward computations have been used to justify enormous payouts to those who happened to be in charge when good outcomes occurred, only to leave shareholders holding the bag when the bad outcomes came along — a case of “Heads I win, tails you lose”.

Joe

I don't see what's so complicated. If the company makes money while they're in charge (or even loses less money than the year before), they're entitled to a bonus tied to the profit (or performance increase).

What boggles my mind is when the company loses millions, and yet the executives all get bonus packages that normal people could retire on, and then get a nice fat bailout courtesy of my taxes.

Sandy Raymond

I am not sure wheat we should be aiming for "pay for performance" but rather paying for "our common good". Let CEO's be paid only a percentage of their lowest paid worker, let Congress be stripped of all benefits not afforded a single voter, force corporations to match dollar for dollar what they pay on lobbyists and political campaigns in charitable gifts,etc. Only when each of us have a vested interested in the well being of the lowest common denominator in any given system, will see see meaningful reform

Sandy Raymond

I am not sure that we should be aiming for "pay for performance" but rather paying for "our common good". Let CEO's be paid only a percentage of their lowest paid worker, let Congress be stripped of all benefits not afforded a single voter, force corporations to match dollar for dollar what they pay on lobbyists and political campaigns in charitable gifts,etc. Only when each of us have a vested interested in the well being of the lowest common denominator in any given system, will see see meaningful reform

Joe

I don't buy the comparison. Part of the reason that pro sports pay is more "reasonable" is because the employees (the athletes) are not also the employers (the team owners and managers). In the financial industry, and corporate America in general, the problem is a direct principal-agent problem. The people who effectively run the show are the ones who set the compensation (yes, in theory Boards have independent compensation committees, but these in most cases have turned out to be a joke, and even in well-functioning would have trouble keeping pay down if the CEO is able to set pay levels for other senior executives).

A simple solution might be to have constraints, set by vote of the shareholders, on overall executive pay (total executive pay could be limited to a certain percentage of company revenue, for example) -- but this would require a more direct process for restoring power to the owners of corporations (the shareholders) and taking it away from the management.

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Steve in Pennsylvania

Let management choose between these options:
They can pay themselves what they want, but the company has to be a partnership. That way if it goes belly up, the partner's personal wealth is at stake. This will limit risk-taking to prudent opportunities.
The partner must remain a partner for five years after stopping work for the company. This will keep the culture of prudence strong.
If they are a public company they are paid in cash, but 20 percent of the cash is deferred for five and only five years. Company goes bankrupt, this pool of deferred compensation is the first asset assigned to creditors.

Gary

Alignment of risk from a shareholder (or systemic) perspective can't happen without addressing the level of compensation in the first place. We're deluding ourself if we think manipulating structures (making them more complex? hardly!) is going to address the problem. And shareholders/auditors shouldn't have to bear the brunt of education ... boards of directors should be the front lines on this, which they obviously have not been.

The compensation system resembles the tournament system that has led to high athlete salaries - get the brass ring, win a lot of money. In some cases these salaries might even be higher than the marginal value the recipient adds to the team - but the tournament also provides incentives for higher performance further down the line.

I am not sure that compensation for corporate executives is a place where that tournament system should prevail. The tournament not only provides perverse incentives for the man (or woman) at the top - roll the dice and make the score - but it also pollutes the pool down the line by attracting people who are after the score. These are precisely the people most subject to the what the behavioralists tell us - subject to overestimating their own capabilities, willing to embrace risks, especially asymmetrical risks with other people's money.

Lower the level of compensation and maybe you get people who are attracted by building and/or maintaining a business, managing risk properly, and not making the score - not only at the top, but throughout the organization.

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mark cuban

Very poor example. The differences between a pro athlete and a financial executive are significant.

1. The financial exec, with only rare exceptions, is not using their own money. So the propensity for risk taking is far higher. They have little to lose beyond their job.

The pro athlete puts their physical well being on the line every game. THeir professional career can end on any play. The financial exec might have a spotted resume, but has the opportunity to get another job.

2. When the athletes career is over, for any reason, its over. THe skill rarely translates to another profession. So the athlete has to maximize their earning power over an estimated life span of their career.

The financial exec using someone elses money, can and should take every risk possible to hit the jackpot whenever they can.

which is exactly what happens

Michael

I would add that to make anyone feel better about the outlandish pay and benefits top managers in the financial products world, would also require some way to think you are effectively being heard. SOme one making a 100 million dollar bonus will not pay attention if I move my paltry 6 figure 401K somewhere. Even if I and 1000 of my cohorts were to do it, the boards who pay them will not act in our best interests.

Rick

How about this.

Shareholders (not cozy little boards) must approve all compensation packages annually for upper level management. Large portfolio holders (like mutual funds) want to see their investments and dividends grow. Too much compensation lowers their returns, too little lets talented managers get away. My guess is that these large holders will really be the deciders on this (thought I confess I don't know for sure). Oh yes, any contact from executives and individual stockholders discussing this compensation is prohibited. Trading individual favors for votes results in automatic termination.

Maybe the market just might have the solution to this (wouldn't that be refreshing).

dd

Andy Lo clearly explains why it is difficult to measure skill, and why executive pay has a large component of luck.

But he didn't explain why there should be regulation. Isn't this just a contracting problem between firms and employees? Why should I care if some banker gets paid too much?

I can see two possible answers:

1) The agency conflict between firms and its shareholders.
2) The public good component of banks that leads to bailouts or other subsidies from taxpayers.

I don't think there is any hope of correcting problems in pay until we explicitly identify what the problem is and build a framework based on the market imperfection that we would like to correct.

kevin

Key seems to be the transparency. Would love to see that throughout the corporate ladder: all compensations known. People who see what they , their peers, and their bosses make, may be a little more demanding. Thus, the outrageous pays could be held in check.