For years I have believed the massively unjust executive compensation packages have been doing great harm to American businesses. As an investor, one of the big risks that has to be evaluated is how much of the business profits executives will divert to their personal bank accounts. And investors also have to worry about the risks executives take to reach huge incentives which then greatly damage your investment.
In 2007, I added two of my own deadly diseases to Dr. Deming’s list. These deadly diseases have emerged since Dr. Deming created the list of 7 deadly diseases (which started out at 5 deadly diseases- he added 2 more later). Excessive executive compensation is one of those new deadly diseases. Our outdated and harmful laws, regulation and tolerated behavior relating to patents, copyright and “intellectual property” is the other.
The Incentive Bubble by Mihir Desai, Harvard Business Review
Mature corporations without large shareholders may become bloated with perquisites or preoccupied by empire building that satisfies managers rather than shareholdersâ€”the classic principal-agent problem.
In order for these pay mechanisms to be successful, managers and investors should be rewarded only for success beyond what would normally be generated. Said another way, there are returns that one can generate by doing little, and managers and investors shouldnâ€™t be compensated for those returns.
A very important point to consider in calculating “excess” returns is an understanding of variation. This core component of Dr. Deming’s management system is not understood by most executives today and leads to mis-assigning credit and blame. In addition, an appreciation of systems thinking shows the fallacy of assigning individual causal credit or blame when in reality much of the result is systemic in nature (result of the system with little ability to sensibly assign individual cause – not that those wishing to have huge transfers of corporate wealth deposited in their bank account won’t pay lots of money to people that will create fancy formulas to try and justify such payments).
The rapid spread of stock options over the past two decades resulted in large windfalls for managers because no effort was made to subtract average performance during a period of remarkable returns in asset markets. Moreover, wide varieties of misbehavior have been traced to incentives created by the â€œcliffsâ€ in most compensation packages: strike prices and vesting dates. Reaching for extra earnings by cutting small corners when such large amounts were at stake was inevitable. The corporate governance crises of the past 15 years had many roots; large stock option grants and the distorted incentives they provide loom large among them.
Absent regulators, irresponsible intermediaries, and oblivious homeowners were all important agents in creating the financial crisis, but the transformation of investment banks into risk-hungry institutions was central to itâ€”and that transformation is connected to the growth of financial-markets-based compensation. At a basic level, the appetite for risk by managers of investment banks can be linked to the rise of compensation structures that provided them with highly asymmetrical incentives
Second, it is tempting to diminish the role of the skewed incentives identified above and reorient the debate toward ethics and morality: If only we hadnâ€™t lost our sense of right and wrong. Such complaints may be well-grounded, but they obscure just how important these high-powered incentives are. More can be achieved by understanding incentive structures and the ideas that underpin them than by bemoaning a decline in character or promoting the virtues of professionalism. And moving away from shareholder-centered capitalism toward stakeholder capitalism risks overcorrecting the excesses of the past three decades. Indeed, capitalism appears to be serving managers and investment managers at the expense of shareholders.
Well said. From a Deming management perspective I see the huge problems created by the deadly disease of unjustly outsized executive compensation. And as an investor I see great risk in executives destroying investment returns as they try and extract hugely excessive amounts of the profits the organization makes to their personal treasuries.
Related: Taking What You Donâ€™t Deserve, CEO Style – Obscene CEO Pay, 2005 data – Executives Again Treating Corporate Treasuries as Their Money – â€œToo often, executive compensation in the U.S. is ridiculously out of line with performanceâ€ Warren Buffett – Leverage, Complex Deals and Mania – The soaring executive pay in the 1990’s turned Drucker into a leading critic of unjust pay (and those levels were tiny compared to what executives are taking from treasuries today) – No Excessive Senior Executive Pay at Toyota – Brooks Brother Bureaucrats – Losses Covered Up to Protect Bonuses