Remuneration: Where We've Been, How We Got to Here, What are the Problems, and How to Fix Them

Currently, we are in the midst of a reexamination of chief executive officer (CEO) remuneration that has more than the usual amount of energy and substance. While much of the fury over CEO pay has been aimed at executives associated with accounting scandals and collapses in the prices of their company's shares, the controversies over GE CEO Jack Welch and NYSE CEO Richard Grasso signal a watershed. In their cases the competence and performance of both men were unquestioned: the issue seems to be the perception that they received "too much" and that there was inadequate disclosure. We provide, history, analysis and over three dozen recommendations for reforming the system surrounding executive compensation. Section I introduces a conceptual framework for analyzing remuneration and incentives in organizations. We then analyze the agency problems between managers and shareholders and between board members and shareholders, and discuss how well designed pay packages can mitigate the former while well designed corporate governance policies and processes can mitigate the latter. We say "mitigate" because no solutions will eliminate these agency problems completely. Since bad governance can easily lead to value destroying pay practices our discussion includes analyses of corporate governance as well as pay design. Because optimal remuneration policies cannot be designed and managed without consideration of the powerful relations and interactions between the financial markets and the firm, its top-level executives and the board, we devote significant space to these factors. Section II offers a brief history of executive remuneration from 1970 to the present. Section III examines and explains the forces behind the US-led escalation in share options. We argue that boards and managers falsely perceive stock options to be inexpensive because of accounting and cash-flow considerations and, as a result, too many options have been awarded to too many people. Section IV defines and discusses the agency costs of overvalued equity as the source of recent corporate scandals. Agency problems associated with overvalued equity are aggravated when managers have large holdings of stock or options. Because neither the market for corporate control or the usual incentive compensation systems can solve the agency problems of overvalued equity, they must be resolved by corporate governance systems. And few governance systems were strong enough to solve the problems. As the overvalued equity problem illustrates, while remuneration can be a solution to agency problems, it can also be a source of agency problems. Section V discusses several widespread problems with pay processes and practices, and suggests changes in both corporate governance and pay design to mitigate such problems: including problems with the appointment and pay-setting process, problems with equity-based pay plans, and problems with the design of traditional bonus plans. We show how traditional plans encourage managers to ignore the cost of capital, manage earnings in ways that destroy value, and take actions to deceive investors and capital markets. Section VI defines and analyzes a new concept: what we call the Strategic Value Accountability issue. This is the accountability for making the link between strategy formulation and choice and the value consequences of those choices - basically the link between internal managers and external capital markets. The critical importance of this accountability, its assignment, and its implications for performance measurement and remuneration have long been unrecognized and therefore ignored in most organizations. Section VII analyzes the complex relationships between managers, analysts, and the capital market, the incentives firms have to manage earnings to meet or beat analyst forecasts, and shows how managers playing the earnings-management game systematically erode the integrity of their organization and destroy organizational value. We highlight the puzzling equilibrium in this market that seems to suggest collusion between analysts and managers at the expense of investors - an area that is ripe for further research.