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Pay Me If I Perform

By: Jim Helik

An activity which always generates discussion in my classes at Ryerson comes when I ask my students to produce a system which links my performance as a teacher with the pay that I receive. The students end up with various plans, none of which ever quite work out.

One will suggest that class size be used as an indicator of my performance, the implication being that more students will seek out a good instructor. I counter that with all that I need to do is change the title of my course from ‘Management Finance’ to ‘Sex, Money, and Management Finance’ to get a bigger audience.

Or another student will come up with a plan that my pay be tied to the increase in the grade performance of the overall students. I, in turn, announce that I will immediately fail them all in their first test, then give them top marks in their final exam, with the change in their performance attributable solely to my wonderful teaching skills.

The end result of this exercise is that the students see the difficulty of actually implementing any system that ties performance with compensation. It is easy to see that the current arrangement where all instructors get the same level of pay isn’t great, but it may just be the best that people can devise.

This feeling of it-may-be-broke-but-what-do-we-do-next came up when I finished the current hot book in the compensation field: Pay Without Performance: The Unfulfilled Promise of Executive Compensation (Harvard University Press 2004) by Lucian Bebchuk and Jesse Fried.

Large Pay Package
There is no argument that executive pay packages are large, and have gotten larger in the past few decades, which the authors note on the first page. But a large pay package on its own is not proof that a chief executive officer is taking the shareholders for a ride. Neither are ratios of CEO payment compared to the lowest paid, or even average worker. As former GE CEO Jack Welsh (no slouch when it comes to large pay packages) has pointed out, this is a fairly meaningless ratio. Why should the salary of a football player be compared to the wages of somebody selling hot dogs in that same stadium. Each should be paid according to their worth and that’s the end of it.

Of course, this is really just the beginning and that’s why we have compensation committees, consultants, and human resource departments to help. According to Bebchuk and Fried, none of these players can be counted on to look after the shareholders’ interests. Instead, these same individuals are at the mercy of strong managers. Directors are unlikely to be turfed out by shareholders, and thus are beholden to CEOs. “Thus, sparring with the CEO over compensation can only hurt a director’s chances of being renominated,” say the authors.

Social Connection
Boards are also interlocked with executives through everything from related business dealings to charitable contributions. “Many independent directors have some prior social connection to the CEO,” they note. These same directors may not own a significant amount of the company’s shares, with the result being that directors will only bear a small fraction of the cost of a flawed compensation arrangement. Meanwhile, human resource departments and external compensation consultants will also want to avoid annoying a CEO who, ultimately, pays their salaries.

Well, maybe. The result of such a view is to question whether anybody, at any time, can be both independent and qualified to look at compensation matters. Bebchuk and Fried propose a system where shareholders are given increased power to replace directors and change corporate charters when necessary. This would produce a system of directors striving to serve shareholders, rather than a CEO, they argue.

Compensation Arrangements
Again, you get agreement from me, but this neatly sidesteps the issue of determining compensation arrangements. These freshly independent directors are still going to be faced with the question of how best to reward executives. Making sure that they are free of biases is important, as is ensuring that their decisions are made on behalf of shareholders for the long-run (however that is defined). But this still doesn’t answer the question of how to link pay with performance, it just makes sure that the decisionmakers are more independent

Sorry, there is still going to be a role for consultants and HR departments. And, at the end of the day, we still won’t be absolutely sure that I shouldn’t be rebating some cash to my former students.

Jim Helik is co-author of ‘Energy Markets Risk Management,’a textbook published by the Canadian Securities Institute. He also teaches at the School of Business, Ryerson University in Toronto.

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