(The opinions expressed here are those of the author, a
columnist for Reuters)
By James Saft
April 7 There are only two problems with the way
incentive-based executive pay works: neither the incentives nor
the people who are supposed to be motivated by them work
Norway’s $915 billion sovereign wealth fund, the world’s
biggest, took a stand on Friday against executive long-term
incentive plans which attempt, with little success, to align the
aims of company owners with those hired to manage.
"For us, long-term incentive plans should be removed from
pay packages. The packages we want in the future are very
different from what they are now. They are too complicated," the
fund’s Yngve Slyngstad said following release of annual results.
"We want simplicity.”
Long-term compensation now accounts for about 60 percent of
executive pay in the U.S. and Britain. Slyngstad, whose fund
owns more than 1 percent of global market capitalization, is
right to have doubts. As they now stand LTIPs are often an
overly complex matrix which bestow windfall gains on executives
for events largely outside their control while failing to
properly bind them to their employers’ bests interests.
Slyngstad’s call for simplicity is correct, but tinkering
with the existing system won’t help much. The typical web of
goals in an LTIP is a bad joke for those who know Goodhart’s
law, the economist’s axiom which states that “When a measure
becomes a target, it ceases to be a good measure.”
In specific, the system fails because our whole executive
pay edifice is built on two ideas; the efficient market
hypothesis (EMH) and the existence of Economic Man, a mythic
figure who always does what will make him the most cash.
The former idea misunderstands how markets work and the
latter what makes people tick.
Other than that, the system, which has pushed executive pay
in the U.S. to a bloated 276 times that of the typical worker
while delivering historically poor shareholder returns and
economic growth, is just grand.
EMH AND SHAREHOLDER VALUE MAXIMIZATION
That the majority of executive compensation comes in the
form of shares in the company has its roots in the adoption by
management gurus of the 1970s of the efficient market
hypothesis, the idea the current market price of a stock is the
best single predictor of the future cashflows it represents, and
thus of the success of the company. (here
If you lived through the past two decades and believe that,
I have some dotcom stocks and a collateralized debt obligation
to sell you.
EMH found itself betrothed to the allied idea of shareholder
value maximization, that companies exist solely to enrich their
owners and that the market is the guiding north star in
navigating how best that can be done. The result: pay executives
in shares and they will do what’s needed to make the shares more
There are huge problems with that but just to name one: the
average investor is saving for the distant future and the
average executive, seeing as how they only hold the job for a
few years, doesn’t have one. Companies began to live quarter by
quarter, investment and innovation in publicly held companies
fell and a huge transfer of wealth to executives ensued.
That the market is largely driven by another set of agents,
fund managers, who tend to feed bubbles in highly priced stocks
in order to feather their own nests and protect their own jobs
just makes matters worse, or, if you will, less efficient.
ECONOMIC MAN IS JUST A BIG APE
This brings us to Economic Man, the guy who always maximizes
his own rational self-interest. For economists, naturally, this
became synonymous with maximizing his financial utility, a
useful idea if you want to pretend that your social science is
something akin to physics but an idea which, put into practice
in the boardroom, quickly turns to farce.
But since Economic Man exists, the management theory went,
the more we pay him not only the better he will behave but the
better an example of his type we will recruit. This attempt to
deal with the inherent conflicts between principals, who own the
company, and the agents they hire to manage it has been largely
“What agency theory fails to account for is the real
psychology of incentives,” Alexander Pepper, a management
professor at the London School of Economics and former longtime
employee of accountants and consultants PwC wrote last year.
“Research conducted over the past 35 years has found little
evidence of a significant link between executive pay and
performance. Many executives I encountered during my years with
PwC raised similar concerns; they found incentive packages too
complex, too long drawn-out, and they didn’t properly appreciate
the value of the rewards on offer.” (here)
The executive pay system needs more than a reworking of
long-term incentives, it needs a complete reboot.
(Editing by James Dalgleish)