In the latest issue of Harvard Business Review, Mihir Desai, a professor at HBS, argues that stock-based pay and high-powered incentives contracts have evolved in a pathological direction. Rather than reward performance as such, Desai argues that compensation pegged to the financial markets has rewarded luck and encouraged a short-term focus.
[T]he idea of market-based compensation is both remarkably alluring and deeply flawed. The result has been the creation of perhaps the largest and most pernicious bubble of all: a giant financial-incentive bubble, or FIB. (“Bubble” acknowledges the unsustainability of market-based compensation, and the acronym reminds us of the intellectual flaws underlying this idea.) These changed incentives and rewards have contributed significantly to the twin crises of modern American capitalism: repeated governance failures, which lead many to question the stewardship abilities of American managers and investors, and rising income inequality.
The allure of financial-markets-based compensation stems from its connection to powerful narratives about entrepreneurship and the virtues of “sweat equity.” The translation of this intuition to managerial and investor compensation has proceeded without consideration of the differences in settings and the potential for distorted incentives. Moreover, those that monitor managers (boards of directors) and investors (largely state and corporate pensions funds) have readily outsourced performance evaluation and compensation to markets in order to avoid their obligation to make tough decisions and in order to rationalize the excessively optimistic assumptions undergirding the solvency of their funds. The combination of a foundational myth and absent monitors over the past two decades gave rise to harmful incentives, asymmetrical payoffs, and windfall compensation levels.
Remedying these distorted incentives and restoring faith in the fairness of American capitalism will require that we pop the financial-incentive bubble by exposing the intellectual flaws behind it, restructuring compensation contracts and separating legitimate investment activities from systemically important financial institutions.
Desai’s article has attracted considerable attention, as it captures the intuitions of many observers of the corporate compensation landscape. Interestingly, Desai counsels against a regulatory solution to the (alleged) financial incentive bubble, which he traces to the great difficulty of differentiating between the role of skill and luck in financial performance.
Three superficially attractive responses to these developments should be resisted. First, it is tempting to rely on regulation and taxes to reverse these practices. But such policy instruments are extremely blunt and will have unforeseen consequences. For example, limits on the deductibility of executive pay in the early 1990s provided a rationale for further explosion in equity-based compensation. Tax policy should be guided by fiscal needs and the imperatives of long-run growth rather than by vengeance or myopic considerations. The one area where policy may be helpful is in remedying the mischaracterization of labor income as capital income—widespread in the alternative-assets industry via the use of carried interest and currently condoned in tax policy.
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.
Third, it is tempting to respond that markets will self-correct against these excesses, so little action is required. Such complacency overlooks the profound conflicts of interest that characterize modern capitalism. Competition will not solve the problem of pension funds that fail to monitor the investment managers they hire, given the monopolistic position of those funds. Similarly, competition from new alternative-assets managers will not solve the problem, because self-interested managers will happily adopt the incentive schemes that provide their brethren with windfall gains. Markets are powerful, but they are not a panacea when monopolies are present and when agents aren’t serving their captive principals.
Desai argues instead that “monitors must begin to wrest control back from managers and investors to rectify the skewed incentives and rewards of the financial-incentive bubble.” While Desai’s arguments will appeal to those scandalized by income dispersion, Desai tries to stake out a distinctive position:
The fraying of the compact of American capitalism by rising income inequality and repeated governance crises is disturbing. But misallocations of financial, real, and human capital arising from the financial-incentive bubble are much more worrisome to those concerned with the competitiveness of the American economy.
That is, Desai maintains that fixing the “financial incentive bubble” will be growth-enhancing.
I asked Steven Kaplan of the University of Chicago’s Booth School of Business for his thoughts. Kaplan is one of the leading experts on corporate governance, and he is very skeptical of Desai’s conclusions. On the question of skill vs. luck, or Alpha vs. Beta, Kaplan argued that we may well see an increase in the use of relative performance metrics over time, as more firms embrace them of their own volition — yet this might actually increase compensation as some managers are rewarded for strongly outperforming the market. Moreover, he observed that there are in some cases good reasons to use absolute rather than relative performance as the appropriate metric for determining compensation, e.g., some shareholders might balk at the prospect of paying a CEO a significant bonus as the stock price goes down by 20% while the broader sector goes down by 40%.
This raises an important question. Would Desai object if an emphasis on long-term performance and relative performance actually led to a sharp increase in compensation for top executives? Given that Desai is primarily concerned with allocative efficiency, one gets the impression that he would be indifferent. And if that is true, at least some of the people who’ve embraced his arguments on grounds of outrage over high CEO pay might want to rethink their position.
Nicholas Bloom of Stanford, who has done a great deal of work on the diffusion of effective managerial practices and how the quality of managements impacts economic performance, is more sympathetic to Desai, e.g., he suspects that a shift to five-year bonuses would be more likely to emphasize skill over luck. Like Desai, he is reluctant to embrace regulatory or legislative solutions, instead arguing that boards should devote more time and attention to building internal metrics to evaluate performance.
Interestingly, there is agreement across Desai, Kaplan, and Bloom on at least one issue: it is best to leave regulators and tax authorities out of decisions regarding the structure of executive compensation.