Paying executives on performance

Internationally, executive remuneration has become the most important and contentious aspect of contemporary corporate governance. As legal scholar Iman Anabtawi has recently written, “Few recent issues … have drawn more ire from the public or more bewilderment from scholars than the compensation of public company CEOs”. What has been of particular concern is the “decoupling” of executive pay from company performance. That is, CEO pay packets continue to skyrocket, while the companies they manage enjoy modest growth, no growth, or negative growth.

In Pay without Performance: The Unfulfilled Promise of Executive Compensation, prominent law professors Lucian Bebchuk and Jesse Fried point out that in the US, between 1991 and 2003, the average large company CEO’s total remuneration increased from 140 times the pay of an average worker to 500 times average pay. Similarly, in Australia, between 1992 and 2002 CEO remuneration increased from approximately 22 times average weekly earnings, to 74 times average earnings.

Bebchuk and Fried’s Pay without Performance has produced a great deal of debate concerning executive compensation, particularly in relation to the “managerial power” thesis put forward by Bebchuk and Fried to explain the decoupling of pay from performance that we have witnessed. Under this thesis, senior executives are considered to be overwhelmingly motivated and guided by their own self-interest, with their self-interest directly connected to their pay packet. These self-interested executives are considered to have enormous influence over the board of directors who determine executive pay (principally due to having a say over which directors will be nominated by the company for re-appointment) and therefore structure remuneration arrangements with the interests of the CEO as the primary concern.

Bebchuk and Fried do not in any way question the legitimacy of using “pay for performance” as the principal methodology for determining executive pay and indeed contend that appealing to the hip pocket of executives is the best way to motivate executives to perform and to satisfy their personal objectives. Pay executives as much as they can possibly dream of, Bebchuk and Fried contend, so long as there is a proven correlation between higher pay and improved company performance.

In a new book, The False Promise of Pay for Performance: Embracing a Positive Model of the Company Executive, to be released this month by Sandstone Academic Press, I directly respond to the “managerial power” thesis outlined by Bebchuk and Fried in Pay without Performance and in particular the very negative model of the company executive they put forward.

In The False Promise of Pay for Performance, I draw upon an extensive amount of literature from a wide range (including psychology, sociology and the emerging science of happiness), to explain why the emphasis on remuneration and “pay for performance” is misguided. This literature makes it very clear that the overriding motivation of executives in terms of their relationship with the company is not the promise of high salaries and lucrative options packages, but rather the desire to do good and be part of a successful and respectable company.

Furthermore, rather than more and more money being the key to greater and long-lasting happiness, studies in the emerging science of happiness suggest otherwise. It is not money per se that makes people happy, but rather the enhancement of one’s “relative position” (i.e. being objectively more successful than one’s neighbour or colleague). One's relative position could be enhanced by, among other things, high income and a luxurious lifestyle - so explaining our drive for material wealth.

As I explain in the book, based on this emerging literature on real human motivation and behaviour, it is time for a fundamental change in our approach to executive remuneration in particular (and corporate governance in general). Rather than waiting for the promise of “pay for performance” to deliver, and continuing to focus on “improving” disclosure requirements for remuneration arrangements that generally do not work, it is time to embrace a positive model of the company executive. The evidence on executive motivation and the natural competitive instinct of executives can be used in more productive ways.

Adopting this positive approach to corporate governance, the emphasis would be less on the ability to say “my options are bigger than yours” and instead on the ability to say “my company is more respected, or bigger, has happier employees or better products than yours”. This is surely better for shareholders and executives.