Answering Executive Compensation

Executive compensation has been highlighted lately because of Obama's cap of $500,000 for executives who receive TARP funds. Although I understand the sentiment behind it, my gut reaction is that a government ceiling can't be the best way to go about it.

In terms of salary, supply and demand still exists for executives at the top level. Let's say, for instance, you were one of the best corporate turnaround artists in the world, and you got a call from Citigroup. Would you really want to go work for $500k/year in the public spotlight with regulators breathing down your neck? Or would you go work for a private equity firm where you'd get paid millions? I think this cap only further weakens TARP companies' ability to recruit top talent.

Additionally, the TARP executives can only gain their restricted stock if the company pay back all TARP loans to the government first. BusinessWeek had a great decision tree (to the right) that showed that this hurdle to receive the restricted stock would lead executives to take greater risks in order to get the returns needed to get the restricted stock.

The HBR Editor's Blog wrote about a potential solution to tie executive pay to performance relative to competitors:

There is a smarter way to pay top executives. Former Kellogg Professor Al Rappaport wrote an article about it, back in March of 1999.

Rappaport argued that the proper way to reward CEOs was through granting them options whose strike prices were tied to an index of peer group of companies. If the company outperformed competitors, the manager got rewarded. If the company didn't outperform or did worse, there was no reward...

Unfortunately...when the economy heats up again, the war for talent will warm up with it. One of the easy ways for companies to compete in that war is by offering easy dollars. In that case, companies that stick to virtuous indexing may end up losing the best executives.

So the question we should be asking ourselves is not how we should be paying bosses - we've lots of good ideas about that-but rather how can we make fair pay schemes stick.

I think that this compensation structure is more in-line with market forces than the restricted stock reward structure that they have now. If a TARP execuitve can provide better returns than competitors, even though it doesn't reach the full amount of the TARP loan, the TARP executive should be rewarded for that performance because they delivered more repayment on the debt than any competitor did. Compensation should be incremental to performance - not a 1 or a 0.