Executive Compensation

By now, you've all heard about the AIG fiasco and those executives who still got their bonuses … even though the company needed to be bailed out. While some bonuses have been repaid, I have to wonder how much will be recovered in the end. This post isn't about AIG, but I'll just say that the company went broke! Had they not been bailed out they wouldn't have gotten anything … but I digress.

There is much talk that executives are overpaid and the amounts they receive don't reflect the true value to shareholders. I would say I agree – when I hear about CEO's making millions of dollars it kind of concerns me, especially if the company hasn't done that well. So, if a company underperforms, why do they still get paid so much?

TOURNAMENTS

On way to explain this is something called tournament theory. Quoting the article I link to, 'Workers are frequently ranked relative to each other and promoted not for being good at their jobs but for being better than their rivals.' It's not they provide more value to the company, it's simply that they were better than everyone else. In a way, office life (the rat race) is somewhat of a game – high salaries are a way to motivate employees to make it to the top, where a huge bucket of gold awaits.

There are several side effects of this theory:

• One way to win the game and get promoted is to sabotage your rivals – this could explain nasty office politics.
• Risk aversion – why take risks and do a great job, when it could lead to you being fired?
• The more luck that is involved in the process, the larger the pay gaps should be between the winners and the losers.

This goes a long way to explain why some highly paid executives are clueless, yet keep getting promoted – they're either good at the game or they got really lucky. High salaries are simply the lure to get employees to aspire to move up the ranks. It also explains why a CEO could do well and still have performed poorly – they still ended up doing better than everyone else.

STOCK OPTIONS

Some executives don't just get salaries – they also get paid in the form of stock options. If the company does really well, they have the option to buy the stock at a cheaper price and sell at the current market price, potentially making a killing. The theory is this should motivate the executive to increase shareholder value and in turn, increase their own earnings. This is why why some CEO's get millions of dollars in compensation – they happened to do very well that year and the stock price went up. There are problems with this kind of pay, though:

• It's short term oriented – a company could do well one year, but tank the next year; meanwhile the CEO already got paid millions of dollars while closing down plants.
• Possibility for unusual transactions – stock option backdating and other ways to defraud shareholders.

In theory stock options are a great idea because they're performance-based but they are not without their problems. Obviously, companies have to wrestle with these issues and there isn't always a clear solution – there has to be some happy medium but you're never going to keep everyone happy.

I have to be honest, if I were offered a high-level executive job, I wouldn't consider it unless the compensation package was fairly generous. There are just so many risks in the corporate environment and the days of job security are over. Stock markets and human are so short-term oriented, the pressure to perform well quarter after quarter is so great, the stress would be equally high. I'd want to be compensated for this stress and lack of job security.

I'd probably want a bit of a golden handshake at the end if I were suddenly terminated – this would go a long way to alleviating some of the worry of being fired and would allow me to focus on doing a better job. I'm sure people read about these payoffs and become furious.

I'm certainly not being an apologist because clearly, there are problems with executive pay. I'm not sure what the solution is, but hopefully, someone will come up with something in the future.

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