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Why Exec Pay Curbs Won't Work

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

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.

By Gustavo Manso
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