FIXING Executive Compensation: Right Time, Wrong Approach

By Lawler, Edward E., III | Chief Executive (U.S.), June 1, 2009 | Go to article overview

FIXING Executive Compensation: Right Time, Wrong Approach

Lawler, Edward E., III, Chief Executive (U.S.)

As a result ofthe executive pay cap in companies taking TARP funding, the door has been opened for increased federal regulation of executive compensation. It is impos- sible at this point to predict how open the door is and whether or not it is just the first step in an effort by the fed- eral government to control executive compensation in the U.S. It could be the only action taken or the first of many actions that are triggered by growing public anger over the pay levels of senior executives.

This is not the first time that Congress has passed laws that attempt to regulate executive compensation. Indeed, perhaps the most comprehensive effort was the establishment of a wage and price control board during the inflation-ridden 1970s. This effort, like the ones that have followed, is generally considered to have been ineffective. No doubt they changed compensation practices and levels, but not necessarily in the intended way. Indeed, some have argued that past regulation efforts are partially responsible for the high levels of executive compensation that have resulted in today's demands for controls on executive compensation in the financial services industry and elsewhere.

In 1993, a change in the tax code limited the deductibility of CEO pay as a business expense. It means that corporations can treat only $1 million of salary as a business expense for each of its five top executives. Not covered by this provision are all kinds of incentive compensation (e.g., bonuses and stock). Most agree that the effect of this provision was to establish $1 million as the acceptable level of base salary for top executives. Further, it appears to have stimulated the development ofthe "pay for performance" plans that have contributed to the high level of executive compensation that exists today.

In 2006, the SEC issued a set of disclosure requirements for executive compensation that ordered companies to provide in "plain English" a view of their executive compensation plans. The result was to add long (often 30-plus pages) reports on compensation plans to proxy statements, but it did little if anything to change how and how much executives were paid.

Whenever regulations are proposed for executive compensation, the key question is whether they are likely to be effective. In order to answer this question we need to specify what we expect executive compensation to accomplish. Most research on executive compensation suggests that there are four ways an effective executive compensation plan can contribute to organizational effectiveness. It is important to look at each of these and examine whether government regulation of executive compensation is likely to increase the degree to which executive compensation plans support them.

The four are: control the cost of compensation, attract and retain the right executives, motivate the right executive performance and present the right optics concerning executive compensation to key organizational stakeholders. Each of these deserves separate attention, so let's look at them in turn.

Control the Cost of Executive Compensation

Executive compensation is a business expense, and as such it is appropriate to try to position it at a cost level that is "reasonable" and "competitive." There is good reason to believe that executive compensation in many U.S. corporations is too high by some reasonable standards. For example, there are some corporations that have pay levels that are out of line with the U.S. market for executive compensation and reduce corporate earnings accordingly. It is also true that executive pay levels in U. S. -based corporations are higher than those elsewhere in the world. This is particularly true in large corporations. As a result, U.S.-based corporations have higher executive salary costs than their offshore competitors.

It is highly likely that federal regulation of executive compensation could reduce the total compensation of executives. …

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