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Pay without Performance

December 11th, 2004

I’ve been reading


“Pay without Performance : The Unfulfilled Promise of Executive Compensation” by Bebchuk and Fried)

For anyone who still believes that executive pay is based on rewarding performance, and encouraging risk-taking, this book should disabuse them. There are loads of studies pointing out, not surprisingly to anyone who reads the papers, that top executives and boards look after each other in a way that rewards failure.

The most telling detail for me is the observation p98, that every single CEO in the S&P Execucomp Database has a defined benefit pension plan. This, while bosses everywhere have been shifting their employees onto defined contribution plans, where they, and not the company, bear all the risk, and while the Republicans in the US are trying to do the same with Social Security.

One thing I would have liked more of is quantitative information about the aggregate magnitude of payments to executive pay, considered in relation to corporate profits. There’s only a little of this in the book, though the authors say here

Aggregate top-five compensation was equal to 10 percent of aggregate corporate earnings in 1998-2002, up from 6 percent of aggregate corporate earnings during 1993-1997.

Given that this excludes various kinds of hidden transfers[1], that non-executive board members extract substantial rents (mostly through favorable corporate decisions rather than in cash) and considering senior managers, rather than merely top-5 executives, as a class, it’s apparent that the total rents income flowing to this group could easily be between 25 and 50 per cent of aggregate corporate profits. If this is correct, it ought to have profound implications for the way in which we model corporations, and the way in which we think about the class structure of modern capitalism.

fn1. It’s not clear whether retirement benefits are counted, for example, and these are as large, in present value terms, as direct compensation. Then there is the observation that executive insiders do remarkably well in trading the shares of their own companies.

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  1. derrida derider
    December 11th, 2004 at 17:53 | #1

    it’s apparent that the total rents flowing to this group could easily be between 25 and 50 per cent of aggregate corporate profits.

    This guesstimate assumes that all of senior management’s earnings are rents. I agree that some – perhaps even most – of it is (though don’t forget that we’re talking about all ‘senior management’, not just ‘top management’, here), but you don’t help a good case by making unjustified assumptions.

  2. John Quiggin
    December 11th, 2004 at 19:01 | #2

    A good point. I didn’t mean to make the implied assertion, and have changed the post accordingly.

  3. December 11th, 2004 at 19:50 | #3

    Speaking personally, I prefer that all such corrections to original posts be in the form of annotated clarifying additions rather than amendments, since the former obscure the dialogue being brought out by comments.

    What I found significant ever since my MBA days was the concept of agency costs, and how those can never be analysed properly by comparing firms with “best practice”. Most of all, I found that the agency costs idea has a clear relevance to the workings of representative (indirect) democracy, and shows how so many things do not truly reflect popular wishes. In particular, agency costs always favour “electing a new people”, here and now in the form of immigration and in the nineteenth century in the form of widening the franchise (read: “diluting the equity”).

    Any replies in the form “but these are good things because…” or “do you seriously mean that you disapprove of … and …” are missing the point. I’m just pointing out that what drives these things has precious little to do with the “will of the people” and a great deal to do with gaming the system, driven by what will happen if any one group fails to do so. Evolution of the system favours groups that do these things, even sincerely; it does not require any hypocritical deliberate gaming the system.

  4. Uncle Milton
    December 11th, 2004 at 20:33 | #4

    If it’s rents, why do the shareholders put up with it? One possible answer is that the executives of the investing institutions, like the big pension funds, that are supposed to represent the shareholders interests are on the same gravy train, so it’s not in their interests to rock the boat.

    That answer seems a bit facile, but I haven’t got a better one!

  5. John Quiggin
    December 11th, 2004 at 20:49 | #5

    As Bebchuk and Fried point out (Galbraith was way before them on this one), the shareholders don’t have much choice, other than selling. Voting out an incumbent management is just about impossible, so you have to wait for a takeover. And US law allows takeover defences strong enough to make buying off the incumbent management the most sensible option.

  6. December 11th, 2004 at 21:05 | #6

    Uncle Milton, it’s even worse than JQ outlined because of those damned agency costs again. Even if you get rid of the current crop, all that’s on offer is somebody else from the same stable (the political analogue is when something becomes “bipartisan” in the worst sense, i.e. off the agenda).

    For a case history, see what happened when Bernie Cornfeld got squeezed out of his investment funds. Look what hands the salvage operation fell into.

  7. Uncle Milton
    December 11th, 2004 at 21:37 | #7

    “the shareholders interests are on the same gravy train, so it’s not in their interests to rock the boat.”

    I’m going to fisk myself and apologise for that awful mixed metaphor.

    John & P.M, if it’s systemic throughout the whole of American capitalism, you might think that investors would desert US companies as a whole and go instead to other assets where the mangement doesn’t appropriate so much of the returns for themselves. Maybe it’s a feature of US capitalism that the returns are so high that the management can cream off such a large slice for themselves and still leave enough tp keep the investors satisfied.

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