Too Much Is Not Enough: Incentives in Executive Compensation

Too Much Is Not Enough: Incentives in Executive Compensation

Too Much Is Not Enough: Incentives in Executive Compensation

Too Much Is Not Enough: Incentives in Executive Compensation

Synopsis

The scholarly literature on executive compensation is vast. As such, this literature provides an unparalleled resource for studying the interaction between the setting of incentives (or the attempted setting of incentives) and the behavior that is actually adduced. From this literature, there are several reasons for believing that one can set incentives in executive compensation with a high rate of success in guiding CEO behavior, and one might expect CEO compensation to be a textbook example of the successful use of incentives. Also, as executive compensation has been studied intensively in the academic literature, we might also expect the success of incentive compensation to be well-documented. Historically, however, this has been very far from the case.

In Too Much Is Not Enough, Robert W. Kolb studies the performance of incentives in executive compensation across many dimensions of CEO performance. The book begins with an overview of incentives and unintended consequences. Then it focuses on the theory of incentives as applied to compensation generally, and as applied to executive compensation particularly. Subsequent chapters explore different facets of executive compensation and assess the evidence on how well incentive compensation performs in each arena. The book concludes with a final chapter that provides an overall assessment of the value of incentives in guiding executive behavior. In it, Kolb argues that incentive compensation for executives is so problematic and so prone to error that the social value of giving huge incentive compensation packages is likely to be negative on balance. In focusing on incentives, the book provides a much sought-after resource, for while there are a number of books on executive compensation, none focuses specifically on incentives. Given the recent fervor over executive compensation, this unique but logical perspective will garner much interest. And while the literature being considered and evaluated is technical, the book is written in a non-mathematical way accessible to any college-educated reader.

Excerpt

For the typical citizen of the United States, there is nothing more inexplicable and infuriating about corporate America than the high level of executive compensation, particularly that received by the leaders of corporations, the chief executive officers, or CEOs. In many cases, the response is visceral— “It can’t be that a CEO deserves four hundred times as much as I make. No one is worth that much!” Merely because the outrage over executive compensation is visceral, it is not necessarily mistaken. One might more charitably characterize the damning of high executive pay as an intuitive one. But these assessments, whether visceral or intuitive, whether entirely mistaken or exactly on target, are not built on solid economic understanding. While the economics of executive compensation is complex, any ultimate judgment about the level and structure of executive compensation should be based on an informed understanding. This book provides that understanding for the educated layperson.

Incentives lie at the heart of the executive-compensation system that dominates corporate America and which increasingly finds favor throughout the world. In the main, corporations act to establish compensation systems that provide their executives with behavior-guiding incentives. However, some executives find their own, often perverse, incentives in the established pay systems. That is, they find their compensation program rife with incentives that they can exploit for personal gain at the expense of the firm and society.

Two main ways of controlling behavior are through monitoring and command, on the one hand, and providing incentives on the other. Monitoring and commanding an individual who is supposed to lead an organization has proven to have severe limitations; although, we will see that effective monitoring can play an important role. This leaves incentives as the chief way to establish a framework within which a corporate leader can direct the firm toward increasing profits, building firm value, and benefiting society. Reflecting this line of thought, corporations build executive-pay schemes around incentive compensation, which they deliver mainly in the form of pay related to the value of the firm’s shares. The two principal vehicles for providing share-based pay are restricted stock and executive stock options (ESOs).

Perhaps surprisingly, firms provide these incentives mainly to induce CEOs to increase the risk level of the firm beyond what they would otherwise choose. The incentive compensation should encourage the CEO to increase . . .

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