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Unpacking the Golden Parachute

by Carlos Uribe, MBA ’12

At the Rady School of Management, certain professors tend to answer crucial questions with the response, “It depends.” This is an interesting approach, as it basically says, “Well, there’s no one cookie-cutter solution to any issue; no one answer solves all problems; and many factors have to be considered, weighed and accounted for.” It also implies that we should draw our optimal strategy from the goals and resources we have at hand. Different approaches to those two factors — goals and resources, that is — will render varying conclusions.

As an example, dissatisfaction with the exorbitant salaries of certain executives compared to levels of performance is an issue that the business world could confront using the pragmatic approach described above. But is the solution as simple as paying CEOs less? Well… it depends.

Goals of Executive Compensation

The main goal of executive-compensation packages is to assure that a company is able to attract and retain the kind of talent that will grow the firm’s profitability and overall value. This is achieved by offering a package appealing enough to bring in the market’s prime candidates.

Corporations, which act on the decisions made by their boards of directors, also attempt to keep the firm’s costs at a reasonable level. Their aim is to provide a structure that aligns the interests of shareholders with that of the company as a whole. Such structures reward the CEO when performance matches or surpasses expectations, but penalizes the executive when this goal is not met. Boards of directors expect this carrot-and-stick process to inspire executives to work as diligently as reasonably possible and to tailor one’s risk preference to the level preferred by shareholders.

However, boards do not always find it easy to achieve optimal objectives. Michael J. Berthelot, former CEO of TransTechnology, current director of Fresh Del Monte Produce and Pro-Dex and professor at the Rady School of Management, said, “The main problem is that objectives are established with foresights and then they are judged in hindsight.” Therefore, boards need to find a system that allows them to create compensation packages that offer rewards from a hindsight perspective, even if they have to create the plan early on — that is, with foresight.

Rather complicated incentive systems are currently in place in the corporate environment. Such systems claim to divide the pie into different slices, making parts of it grow or shrink based on a firm’s performance. This creates a link between pay and performance, while bulletproofing a minimum amount of compensation from the external and unmanageable fluctuations of the market.

Business Circumstances

Currently, boards of directors in various industries have been selecting the goals and bonus-triggering thresholds based on their best possible estimates of what good performance should look like. To do so, boards use all the information available to them, including hiring outside consultants. This process is usually a priority for the board, since a goal that is not finely tuned will result in either overwhelmingly challenging tasks… or the converse. The issues that will likely arise if incentives are not in alignment with expectations is that CEOs will be either pushed toward risk, taking chances in an attempt to reach unrealistic goals, or they will take the easy way out with respect to what their boards have requested without having to invest themselves fully in the success of the firm.

Evidently, the entire incentive system must be instituted before different compensation levels are put into place relating to a CEO’s performance. However, an area of concern would be that the information the board is using to create the system is based on events and circumstances that occurred in the past, that is, they are using this information to build a scenario for how the future will look.

Even if no one likes to admit it, most individuals — and those involved in high-level business are no exception — do not particularly excel at forecasting the future, as Nassim Nicholas Taleb (a professor of risk engineering at New York University) explained in his popular book “The Black Swan.” Therefore, it would be reasonable to expect that the actual level of task difficulty assigned to the executive by the board will not exactly be the intended one. Increasing market volatility and specific industry fluctuations will shift this difficulty level, either raising the bar to unreasonable levels of hardship, or lowering it enough so that corporations end up compensating CEOs for mediocrity.

Proposed Solution

A proposed solution to improve overall performance would be to set compensation as a function of living indicators, which would track the difficulty of the task assigned to the executive and adjust the goals set up for him/her so that they are both realistic and challenging. By doing so, it would allow for a reasonable creation of the compensation amount to improve the expectancy (the belief that one’s effort will result in attainment of desired performance goals) and instrumentalities (the belief that a person will receive a reward if the performance expectation is met) of the executive. This approach would ultimately support the desired level of risk taking and effort expressed by management, since the executive’s performance would be paired to an accurate picture of the world, rather than a projection that could be outdated.

A determination needs to be made with respect to what is deemed to be an optimal level of complexity in the compensation-setting system (economically or any other kind) for any given individual, not just high-level executives. Different industries will have different operational priorities, business environments and availability of market/competitive information; therefore, executives should be compensated accordingly. However, the overall idea of tailoring the goals to a reality as it occurs should always be considered.

As Ken Weschler, an expert in executive compensation for the Radford Group, said, companies across the board are working toward matching task difficulty with compensation-triggering goals. “Everything [in the world of executive compensation] is becoming relative to your peers. . . sometimes just not losing money is good enough.” If a company is operating in a market where heavy losses are being witnessed all around, it would make sense not to demand high profit growth; maybe a zero net income at the end of the year is a reason to celebrate.

Even if, in many cases, the performance of a defined peer group is a fairly acceptable proxy for difficulty at the CEO level, what about when it is not? There are more than a few circumstances that can make an observer restless about this simple metric. What happens if the company has no similar competitors to measure against? What about firms trailblazing through new market opportunities? Which peers should be considered when evaluating a zero-revenue firm (typically in some scientific field)? What about the case of mediocrity, or simple failure to execute properly on the competitor side? Wouldn’t this make it easier for the company in question to reach predetermined goals? If so, shouldn’t these goals be updated, that is, increased, and not reduced by the competitor’s failure to succeed?

If it is believed that peer groups can be used to track task difficulty, but is not quite enough, we need to find other variables to complete an equation that determines our objectives. The nondefinitive answer will once again be “it depends.” But what is certain is that the level of performance that would earn bonuses for CEOs and other executives can be better defined as a factor of a few observable relevant variables. Comparisons to peers can seemingly be a very helpful approximation, but they don’t tell the whole story. Potentially relevant factors may include technological or scientific developments (or failures), market conditions, regulatory frameworks, performance of substitute products, capitalization of acquired competitive advantages and distribution of revenue (weighing down especially lucky or unlucky segments or divisions).