Why Exec Pay Curbs Won't Work

Guest Column: How Exec Pay Curbs Could Stifle Innovation

(CBS)  This column was written by Gustavo Manso, Assistant Professor of Finance at the MIT Sloan School of Management

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With the plunge in the economy has come a rising public outcry over executive pay and perks. The federal government banned golden parachutes and capped pay for leaders of companies receiving bailout money. At firms not getting government aid, shareholders are clamoring for similar measures.

While this outrage is understandable, it is important to understand that certain curbs on compensation can stifle the very innovation that companies desperately need today. Carefully crafted incentive programs, which encourage experimentation and creativity, are what the economy needs to recover, not knee-jerk, across-the-board limits on executive benefits and pay.

A growing body of research in economics and finance has discovered that the best way to encourage innovation is by tolerating early failure while rewarding long-term success. The lessons can be applied to executives, entrepreneurs, and scientists.

For breakthrough discoveries, long time horizons are necessary. Life sciences researchers who receive five-or seven-year grants tend to do more ground-breaking research and come up with more important discoveries than similarly accomplished scientists whose grants have to be renewed every three years. With more time, researchers have the freedom to explore, which tends to produce to important advances.

Last year, a colleague and I at MIT's Sloan School of Management conducted an experiment in entrepreneurship by creating a "virtual lemonade stand." Subjects were divided into three groups. The first was paid a flat wage to manage the lemonade stand; the second, a flat percentage of the profits. The third group was not paid anything at first but was told to expect 50 percent of the profits in the second half of the experiment. Subjects in the third group were far more likely to find the best location for the lemonade stand and generate higher profits.

We introduced the notion of golden parachutes by offering different deals to two groups of subjects. Both were told to expect to receive 50 percent of the profits in the second half of the experiment, and both also were informed that the experiment would be called off early if they were not generating profits. But only one group was told that a termination bonus would be provided if the experiment ended early. The other was not offered a bonus. The group offered the bonus was significantly more likely to find the best business strategy for the lemonade stand.

The experiment demonstrates that having the right combination of incentives is important for successful innovation. Tolerance for early failure allows individuals to experiment. Reward for long-term success combined with job security motivates people to find the best ways of doing things. Applying these lessons, one can see the value of tenure for academics, leniency in bankruptcy laws, and offers of golden parachutes or stock options for executives.

Of course, there are many situations in which innovation is not desirable, and in those instances, other incentive schemes should be used. For workers assigned routine tasks, the best approach is often "pay-for-performance," which rewards employees consistently for productivity.

What went wrong in corporate America is unclear. Executive compensation schemes may have been weighted too heavily toward short-term profit. A golden parachute plus a bonus for early success is precisely the wrong combination. Long-term incentives are needed to encourage individuals to find innovative solutions.

The public is understandably angry about high paid executives getting bonuses at failing companies, and remedies for some of the injustices are no doubt warranted. But while we curb abuses, we must not create conditions that in the long run will only encourage more failure of companies and more hardship in the economy.

[Razzl]

I honestly don't think that curbing executive compensation at the highest levels is going to have even the slightest effect on compensation policies at the levels Prof. Manso is dealing with. I'm no MIT professor, nor even an economist, but it seems clear to me that when compensation exceeds a level where it truly means the difference between enhancing someone's lifestyle or sense of security then we're on a different playing field of human psychology which has its own rules.

In our society and economy there is a level of compensation at which all possible material wants can be met. At that point one can own the best homes in the best locations, the best cars and clothes, eat the best food, travel without limit to the poshest resorts anywhere, and never have to worry about retirement or medical costs or even alimony. We can argue about whether that level is $2 million or $20 million dollars, but the question could be studied and an answer would be found. Once one reaches that level of compensation, all further compensation is just score-keeping and ego-stroking, or a power trip over controlling resources. Job security is not even an issue when one makes enough in the 90-day trial period to retire on in comfort should they be let go.

We now have a system where the CEO's and many of their related officers in large companies are being compensated multiple times more than the minimum needed to meet all material wants, typically tens to hundreds of millions of dollars. If we change the compensation landscape and ratchet back those compensation levels because they are unfair to the shareholders, who ought to be getting more of that money, does anyone believe the executives are going to stop working hard or quit? In spite of their cluelessness about some things, these men certainly know for a fact that there's no better deal to be had elsewhere. They will continue to play the game under the new rules and keep the ego score by what they make in relation to other execs who are also making less. At the highest levels money is not the motivator it is to lower levels, but threat of failure to qualify for big bonuses would be. By taking away the failure penalty the bonus system got broken...

[k9insky]

Gustavo must be lining up a CEO job with Bank of America

[didserve]

Run away greed in EXecutives and Unions have killed American Industry

[A_Statistician]

I am a professional statistician. I have conducted experiments at leading companies.

I am shocked that work this shoddy originated from a reputable institution like MIT's Sloan School of Management.

This article has three inexcusable errors:
1) The conclusion is not supported by the experiment results.
2) Scalability--what is true for small amounts in not necesarily true for large amounts.
3) the study is not relevant to the large corporations where compensation is being limited.

Unsupported Conclusion: The author's conclusion that limits on executive benefits and pay is not needed is simply not supported by his study. The incentive package that was the most successful in his study was subjects were paid NOTHING then 50% of the profits. The author does not recommend the most successful compensation scheme in his study.

Scalability: What is true for small amount is not always true for large amounts. Was this the only income the subjects earned? Did they need this income from the study to pay their mortgage, car payments? Most likely not.

Ask yourself. "Would any exec sign a 20 year contract where they earn NOTHING for ten years then 50% of the profits for the next ten years?" Highly unlikely. This study does not scale to real world conditions.

Poor simulation: a virtual lemonade stand is not like a 100 year old bank or auto company. These companies have tradition and bureaucracy. It generally accepted that start-ups and small companies are more agile and are innovative than the large established companies.

The proper conclusion is: "a fixed length contract with no pay or benefit for half the term and then a percentage of profit for second half of term was the most successful incentive program for (whatever time period) for a small virtual company."

I welcome Mr. Manso's response to my critique.

[itgranny]

sorry, i inserted stuff in the wrong place.

[itgranny]

No wonder we're in so much trouble. This is the drivel that's being taught to our young people.

We're led to believe that the people installing the seatbelts and airbags are making too much money when they receive $50 and hour ($104,000 a year and maybe they are). We certainly can't pay the farm worker or more than $10 an hour so that he doesn't contaminate our food supply. They lay off air traffic controllers because they make too much at ~$110,000. Fire fighter salaries start at about $40,000 a year top out at about $60,000 a year. Gosh, our food prices would go up (and of course we don't want to lower the pay of the top 10% of management to improve the circumstances of the bottom 90%.

These people at the top have led everyone to believe they are more important than they are. It serves them well. See how even the college professors are teaching it. Maybe they're in bed together, after all, has any one noticed the increase in what it costs to go to college?

[johnb8888]

Management is mostly made up of yes-men with good a$$-kissing and golf-playing skills. They know the way ahead is to give the Billionaire elite what they want, and screw everything else.

Management buys off egg-head professors to tell them what they want to hear with grants, glittering prizes of awards and titles.

It's feudalism all over again.

[enriquecaliente]

So wait, what is being said here is that. An executive, who is being paid say $975.000.00 a year needs to be paid even more money to do a job that he's already being paid handsomely for.?

How come that's not the rule for every working person in the US.?

Maybe I should go to my management and say, hey I know that you pay me 80k a year, but if you want even more out of me, then you should do the following for me.

Besides my Salary.
Give me a big Bonus.
Give me Stock awards.
Give me Options awards.
Give me a Company car and driver.
Give me use of the corporate aircraft.
Pay for my financial planing service.
Pay for my personal automobile and related expenses.
Pay for my Club memberships.
Pay for my Parking.
Pay for my Home security.
Pay Contributions to my defined contribution plans.
Pay my insurance premiums.
And last but not least, pay me a TAX reimbursement for all of the personal perks and such listed above.

That way my salary can stretch a little further and I won't be stressed and do a good job.

The above listing is from a statement released by a finance company showing what they pay their CEO. His salary is $975.000.00 with all of the above perks this total amount for last year was $20.1 Million. And he didn't have to pay any taxes, because the company paid it for him. And you thought the union people have it good.

[notafan49]

You know if all corporations were required to play by the same rules, where would these golden boys go? They would retire and some of them would have to take their ill-gotten gains to one of their homes that we paid for.

[notafan49]

You know if all corporations were required to play by the same rules, where would these golden boys go? They would retire and some of them would have to take their ill-gotten gains to one of their homes that we paid for.