Massively Unjust Executive Compensation Damages Companies and Investments

Posted on March 13, 2012  Comments (4)

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 Our outdated and harmful laws, regulation and tolerated behavior relating to patents, copyright and “intellectual property” is the other.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 shareholders—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 shouldn’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 “cliffs” 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 it—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 hadn’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 Don’t Deserve, CEO StyleObscene CEO Pay, 2005 dataExecutives Again Treating Corporate Treasuries as Their Money“Too often, executive compensation in the U.S. is ridiculously out of line with performance” Warren BuffettLeverage, Complex Deals and ManiaThe 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 ToyotaBrooks Brother BureaucratsLosses Covered Up to Protect Bonuses

4 Responses to “Massively Unjust Executive Compensation Damages Companies and Investments”

  1. Jonathan Morena
    March 23rd, 2012 @ 1:54 am

    It is an unfortunate aspect of capitalism that greed is so highly rewarded, and the only way it will ever stop is if the average person stops putting so much value on the concept of ‘classes.’

    The only way a person is better that someone else, is because the ‘lower’ person views themselves that way.

  2. Corporate Social Responsibility » Curious Cat Management Improvement Blog
    January 16th, 2013 @ 7:58 pm

    [...] It is no wonder those people, that are suppose to be leading the organization, instead are just bleeding the organization for whatever they can get away with. That result is very likely when you fail to encourage systems thinking and respect for people [...]

  3. Leanpub Podcast on My Book – Management Matters: Building Enterprise Capability
    January 23rd, 2013 @ 5:45 am

    In the podcast we cover quite a bit of ground quickly, so the details are limited (transcript of the interview). These links provide more details on items I mention in the podcast…

  4. More Evidence of the Damage Done by Kleptocrat CEO Pay » Curious Cat Management Improvement Blog
    April 21st, 2014 @ 10:40 am

    I think it is a huge fallacy to believe there are not many many many qualified candidate who would be glad to lead companies with much less onerous terms than the current crop is taking…

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