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.


So how do you propose we compensate investment professionals?


Let's say that Bradley were paid 80 million a year or 180 million, would we still think that this is fair compensation for his efforts? Prof Lo's number low balls the wall street numbers by two order of magnitudes. When we get into three digit-million packages the number themselves start to look out of line and likely beyond anything that the agents could be doing to deserve it. There are a few outliers; Gates, Buffett, Brin, but then they did not earn this money by outsized compensation packages but in the old fashioned way; by risking their own money and talents.

L F File

If investment theory is correct then tying compensation to performance really means tying compensation to risk taking. The bigger the risk the bigger the payoff the bigger the compensation. The best compensated traders will be those that invest at the peak of the risk/return curve. Eventually this will catch up with any trader but only a few good years are required to be set for life.

Traders know their Keynes - in the long run they are dead (or maybe just fired).

Jitendra Desai

There may be simpler solution.Pay bonus every quarter, based on the performance.While he/she continues to draw " basic" salaries, his/her bonuses are determined every quarter based on performance of THAT segment of the business , that is being managed by him.

What about team rewards or penalties? An individual takes risks along with his/her core team.Entire team can be either rewarded or penalised.

As rightly stated, individuals always win the heads while we all loose our tails.Compensations must be coupled with penalties in case of failures." No Bonus" is not a penalty.

Broc Romanek

I think this CEO pay article misses the mark. There are plenty of atheletes who get paid for non-performance (ie. injury or just plain don't perform).

This mistake is commonly made among journalists - comparing CEO pay to those of entertainers and athletes. It's apples and oranges because the processes differ by how those amounts are set. Hiring athletes is a business decision just like obtaining any other asset (eg. factory)

In comparison, setting CEO pay is done through a series of board processes very much unlike those in hiring an athlete. Excessive CEO pay mainly is attributable to these poorly functioning board processes (eg. using peer group surveys where every board wants to pay their CEO in the top quartile - so that after 15 years, the peer group database is inflated). A few years back, I wrote this "Open Letter to Journalists" to try to stop the misinformation: http://www.compensationstandards.com/nonMember/files/letter.htm.

- Broc Romanek, Editor, CompensationStandards.com



@jeffreytg: this is the position that i believe should be debated, not the ancillary compensation issue. So long as a corp is allowed to implode, i would reluctantly agree. however, once the threshhold of gov't bailout hasbeen crossed, the good of the citizenry trumps all. in other words, play as a true free market, or cede to the will of the people if you request a bailout.

And for a bailout, i want personal payback of bailout from all execs from the highest tax bracket.

Blue Sun

There is a financial concept of 'rent' or 'economic rent' (which does not refer to property rent. The concept is simple. If a company can attract a specific talented executive for a given amount (say, $500,000 a year), then anything above that is referred to by economists as 'rent,' an unnecessary excess. If an executive would have taken a position for $500,000 and the company elects to pay him $20,000,000 then 95% of his salary is unnecessary rent.

In a free market, some increase in rent will occur when demand for, say, CEOs, grows and a small increase in salaries will attract people who can potentially make a large difference. But, again in a free market, the incremental increase in salaries will attract more qualified candidates to the positions and salaries will fall back to their market-regulated norm.

When this does not occur, and the rent percentage of CEO salaries continues to grow way out of proportion to the salaries necessary to attract top talent, this is evidence of extreme rent-seeking by executives. This is a red flag that the market in question (banks, financial institutions, health insurance companies, energy companies, et alia) is, in fact, not a competitive market and is increasingly unlikely to deliver efficient outcomes. The mechanism of the free market has been broken and the market now exists for the benefit of the few at the expense and exploitation of the many.

We have seen this very thing happen over the past three decades (not entirely coincidentally correlated to the economic policies of Ronald Reagan and the Conservative and Libertarian think tanks).

Today, there is no such thing in this country as a free market (if ever there was or could be), and we have arrived at a corporate oligarchy, where the power of the corporations now overrides the power of the people and of their representative bodies in the government. Though the quote is often credited directly to Mussolini, it was one of Mussolini's aides who said that "Fascism should more correctly be called Corporatism," since it the transfer of power to the private sector corporations and the active collaboration of the elected officials is the economic foundation of Fascism.

The process of converting America from a Representative Democracy to a corporate-ruled 'soft' Fascism (where the people go along willingly, without the need of brownshirts in the streets) was accelerated through the Reagan supply-side policies, and pretty much completed with the corporate/government marriage during the George W. Bush administration.

Now, both of the parties originally created to represent the interests of the people who elected them against the rapacity of greed and power-driven corporations and a wealthy elite concerned only with protecting is wealth and acquiring more, have become, instead, the handmaidens and defenders of the very corporate and wealthy forces we elected them to defend US from.

And so, as John Adams once admonished, "Remember, democracy never lasts long. It soon wastes, exhausts, and murders itself. There never was a democracy yet that did not commit suicide."

The only question left now is, "Is there still enough of a spark, a glowing ember of democracy left for the people to re-ignite our national democratic system?"



There will never be a politically acceptable and effective way to contain risk in the financial services industry via salary controls. I say let bankers make as much money as they can, but only on the condition that their trading and their firms never get big enough to bring down the whole system if they fail. Consolidation and deregulation of banking has concentrated power in the hand of too few - to a point where competition is too low - anti trust and pro market (not pro big business) reforms should be the priority in Washington.


If only the Wall Street players had their legs broken ala Montana (I think - who was that SF QB back in the day whose leg snapped?) a few years ago, the nation would not be gutted. Maybe if they lived with a constant sense that their physical well-being was threatened daily they would make better choices.

An executive is not equivalent to a pro athlete. The athlete has the best interest of his/her team in mind all the time. Executives have only their personal best interest in mind first, the stock price second, and their fellow citizens (ie, the team) never.

Why don't executives get rewarded for NOT being greedy parasitical thieving scum bags who actually better the lives of their employees and society? The less of a scum bag the higher the pay. Instead of the breed we have now.

Just a thought.


It seems to me the central problem is the disconnect between the shareholders and the executives: the shareholders are willing to tolerate obscene rates of pay as long as they are getting sufficient returns: but when there is utter implosion, as has happened recently, there's no taking it back.

If I were running such a firm, I would be paying a solid salary as a draw against commissions earned for long-term returns: perhaps with three year, seven year, and 10 year payouts, whether they are still with the firm or not. The key is that truly quantifying "performance" is only meaningful in the long term and there MUST be a way to link the employee's current paycheck with results that only happen years later. These amounts certainly ARE appropriate if the strategies employed result in healthy and sustainable long term profits.

Surely there is a way to accomplish this...


The crux of this argument is that risk/reward needs to be more carefully evaluated and accounted for in executive compensation contracts. This is not really what shareholders and the general public are so incensed with. There are way too many executive contracts with built in so called "golden parachute" clauses and other protections that reward executives with obscene amounts of money no matter what their performance. So the root issue here is the lack of correlation between performance and compensation, not the lack of understanding. The issue is that the way current contracts are written there is NO risk on the part of the executive who will earn 8 figures regardless of performance.

Boards are reticent to fire underperforming executives because of the tens of millions of dollars it will cost to buy out their contracts. All we are looking for here are compensation committees who don't give away the farm every time a whiz-bang I-got-lucky-once-with-XYZ-corp executive interviews for CEO.



"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."

On what basis are you making this claim?

The player is worth whatever the agent can get for them. That's not a valid comparison at all.

Jerry Goldstein

I dealt with traders' compensation for many years. We took the trader's earnings, deducted the direct costs like his Bloomberg, real estate etc., calculated how much capital he used on average and charged him for it, factored into each trade whether he put the firm at risk by taking securities onto the book or not, calculated how much he worked off the firms' position and used other variables as well. But there are two independent variables which are impossible to truly measure: how much was due to his performance and how much to the market ("in a strong wind even turkeys can fly") and how much was due to the fact that he worked for us and had access to our clients, and not some other firm. The third element in this calculation is just as difficult- what if the trader makes money but the firm eg., the shareholders over-all loses? The most important thing in my view, is to make sure all of the above is made transparent to everyone, and that compensation is not linked just to annual booked profits but to the performance over a longer time. As has been noted, the profit on a lot of deals is booked now, but the hedges and forwards take much longer to mature.


Kavan Wolfe

I object to pay for performance, unless the performance is curing cancer. I don't care how well some broker does, he or she does not deserve tens of millions of dollars. Can you name someone who deserves to be paid more than a million dollars per year? I can't. "U.S. President" only pays $400 000, last I looked.

Bob Cawley

Gary @ 15: Excellent post. Perhaps you should be the new guest blogger.

I also feel that pro athelete salaries are obscene so I must be nobody.

I have not read any of Mr. Lo's past contributions but, if this one is any indication, all I can say is this blog does not need anymore contributors in the mold of Daniel Hamermesh that dress up essentially superficial analysis with a smattering of math or economic principles.

A big question that Mr. Lo fails to ask is whether these people should be compensated at all for these activities. Their handsomely rewarded efforts brought the world economy to the brink of collapse but Mr. Lo's only metric is whether they were making money (for some period of time) for their shareholders.

I forgot: the market is always right. Nevermind.


Here is a simple, market-driven solution to this problem:

Compensation ultimately is about supply and demand of talent, so let's dramatically increase the supply. There are likely many people who possess the intellectual and other skills required to be successful in investment banking, trading, etc. And as these masters of the universe often cross into the seven-figure compensation range within five years out of business school, it can't be that difficult for someone of above average abilities to master these skills.

The government should take $10 billion and fund 50,000 positions with a starting salary of $200,000 in a variety of financial institutions. These folks would go through a three-year training program to do the sorts of things that overpaid Wall Streeters now do. You'd also recruit smart and driven people from all walks of life, not just 28 year olds exiting Harvard. There would be no lack of qualified applicants, and it would probably help to diversify the ranks in finance, to boot.

At the end of the program, you'd have many more qualified folks as jobs, so the compensation would like drop from the millions to the hundreds of thousands. As Wall Street compensation costs total well over $100 billion per year, you'd likely save at least 50% in comp costs -- that's $50 billion per year in either greater corporate profit, or more likely, lower fees. As this money serves little productive use other than trickle-down economics, the economy would deploy it into other higher return activities. The government could levy a tax on i-banks to recoup its initial investment in the program, although I'm sure that after 3-5 years of the program, it wouldn't be needed any more.

And no one had to mandate anything.

Incidentally, the same scheme would work well in bringing down physicians' compensation, which is the hidden driver of our spiral healthcare costs (when the average salary of a given specialist is inching closer to $1 million per year, incentives have gone amuck).

I'll provide an address where you all can send my economics Nobel.



@Christopher- I agree that if a corporation is going to dance with the devil then that corporation must dance to the devil's tune. But, ex post facto rule making is simply wrong. When the corporations took the bail out money, there was no rule in place that executive compensation would from that point forward be at the government's discretion. If the government wants to make such a rule going forward, so be it, then a corporation could enter into the bargain with full knowledge of the consequences. We don't allow a party to a contract to unilateral change contract terms after contract execution.

I still never heard anyone comment about privately held corporations.

Eric M. Jones

Here's the deal--A good argument can be made for paying people for superb performance. So I don't mind that Bill Gates, George Soros, Itzhak Perlman or Manny Ramirez makes the big bucks.

The problem appears when the reward is not fair. This is a plain and simple idea: We try not to reward criminals, conmen, charlatans, cheats, liars, crooks, etc....no matter how erudite and polite they appear, and no matter how "legal" they make their felonies look.

The fairness issue needs to be discussed. Too many deals straddle the line of fair dealing and honest brokering.

We need a whole lot more prosecutions and perp walks before we can begin to believe in our institutions.


I think it's so funny when people say that that the government shouldn't have any say in the functioning of corportations. In case any of you weren't paying attention during your business law courses:

Corporations are government created entities. Read the first paragraph of any C corporation's articles of incorporation and you will see that state governments grant corporate status.

Don't confuse businesses with corporations. Businesses are privately created. Corporations are merely a form of asigning ownership rights and liabilities among participants in a business venture. Businesses don't have to incorporate to operate.

It's simple, make grants of corporate charter, and the limited liabilities that accompany them, dependent on adoption of a more reasonable compensation spread among the employees - by the way, managers/executives are employees too.

If business owners - who also become managers in the IPO process - don't want to be bound by those compensation rules, don't incorporate. That way they can take all the risk and gain all the rewards for their risk.

This solves the moral hazard problem right there.

But since it would be nearly impossible to make all states adopt this rule simultaneously, make it an SEC rule for all securities traded on an SEC administered exchange. Once it becomes the de facto standard, it would make it easy for all states to follow suit in their charter granting authority.

And if this forces a split in the securities market between high rollers and speculators in the unregulated market and responsible corporate citizens in the regulated one, well all the better. The investing public will have a better idea of what they are buying and the tigers can fight it out amongst themselves.

I'm going to guess that a lot of large instututions like public pension funds will put their money where the business profits aren't being siphoned off in excessive executive compensation.


Clyde Kahrl

Check out the recent NYTimes story about the Simmons bedding company. This is just fleecing.
Bonuses never got out of hand in New York because the investment banking companies were not public companies and there was no rational reason to fork out that kind of money so they did not. But public companies do not have to disclose their compensation packages in LANGUAGE THAT CAN BE INTERPRETED by anyone.
And it is not just wall st. Carly Fiorina drove HP into the ground and walked away with $200million. After she left, HP recovered and is now doing great. I don't understand what made her so valuable.
Comparing Wall St execs to athletes is nuts. If you want to dig a ditch 5 times faster, you just hire more ditch diggers. So in the real world, if you wanted to win the super bowl, you don't pay your 11 players insane amounts--you go out and field a team with 200 players.
By they way--Tom Brady was drafted in the 6th round. He only got to play when the insanely overpaid star quarterback got injured.