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CHAPTER ONE
Heresy
I started to question the standard CEO pay system in 2012 while I was a board member of a large family-owned business. The board accepted that CEO compensation must have three components: salary, short-term bonus, and long-term incentive. No board member asked why this trinity was holy. It would have been like asking why we worked in an office building or had an accounting department. It was how things were done.
The board was following a pay structure that expert compensation consultants had established ten years previously, along with a host of other pay practices, including peer groups, percentile ranking, compensation targets, performance measures, bonus targets, bonus ranges, and equity awards. The consultants argued that this system achieved "pay for performance" by linking CEO pay to the achievement of measurable goals. By 2012, virtually all large American companies used it to determine CEO pay.
The CEO pay process starts with the compensation ("comp") committee of the board. At this family company, the comp committee established annual performance measures and goals for both the short-term bonus and the long-term incentive and measured the CEO's performance against them. Two-thirds of his bonus was based on financial measures and one-third on the achievement of nonfinancial goals.
I began to find annual nonfinancial goals problematic because important initiatives rarely fell neatly into a calendar year. If turning around a money-losing subsidiary was going to be a three-year struggle, what should be the measurable achievement for the first year? Hiring a new president for the subsidiary? Achieving a smaller loss? Drafting a good turnaround plan? When another board member actually proposed this, I objected. "I can draft a good turnaround plan right now. My plan is to stop losing money. Do I get a bonus?" The response was, "Okay, wise guy, how would you measure the first year's progress on a three-year turnaround?" I had no good answer.
For the company's most important goals, what could be clearly defined and measured within a year was neither important nor revealing. One year, a major goal for the CEO was to hire a new chief financial officer (CFO). Offered a bonus for this achievement, should he get one for hiring his dog Buster as CFO? To prevent this, the board could specify that he get a bonus only if he hires a first-rate CFO, prompting the question: What is a first-rate CFO, and how can we tell if we have hired one?
Aggravating this lack of specificity, bonus measures were established before the start of the New Year, then often became obsolete after January 1 as the company faced unexpected opportunities or threats. One year, bonus goals were geared toward growth, but we suddenly had the chance to sell a large subsidiary at a great price and pay the shareholders a special dividend. The bonus goals now pushed in the wrong direction. Should we change goals? Perhaps, but unexpected events always happen. Should the company change bonus plans monthly? Daily?
I tried to imagine what would happen if the Pentagon drafted bonus plans in September 1942 for achievements in 1943. General George S. Patton's bonus might have depended on capturing particular towns in North Africa, while General Douglas MacArthur might have gotten one for protecting Australia from invasion. If we assume that bonuses influence behavior, MacArthur diverts resources from island-hopping to defending Australia, while Patton stays in North Africa and ignores the opportunity in Sicily. Or imagine structuring a set of bonus bogeys for General Dwight D. Eisenhower to motivate him to take the right actions when he was the Supreme Allied Commander.
If generals got bonuses for winning battles, they might be encouraged to fight easy, meaningless battles. To correct this, the military could award generals a bonus only after capturing at least a thousand enemy soldiers, but then generals might have an incentive to end the battle as soon as a thousand soldiers were captured, because they wouldn't get any extra pay for capturing more. But modifying the bonus criteria to remove these perverse incentives would inevitably introduce more unintended consequences.
"This is a ridiculous analogy," you may think. "Eisenhower was trying to win a war. He was concerned with soldiers' lives, not money. He would do the right thing regardless of any bonus."
You are probably correct. But then why have a bonus system? A bonus system makes sense only if it changes people's actions, decisions, and behavior. A bonus system that does not change behavior is a complete waste of money.
We recognize the absurdity of an annual bonus system for generals, but generals and CEOs face many of the same challenges. They command but must also lead and persuade. They face enemies (competitors), battle over territories (markets), introduce new weapons (products), coordinate their divisions, and make strategic decisions under conditions of uncertainty. Then why are annual bonuses absurd for a general but necessary for a CEO? Perhaps because the military trusts its officers, and in a strange way, corporations do not.
"Duty, honor, country," MacArthur told the Corps of Cadets at West Point, "those three hallowed words reverently dictate what you ought to be, what you can be, what you will be." The military believes that the strength of this commitment will guide officers to make the right decisions and take the proper actions without the financial reinforcement of duty bonuses, honor bonuses, and country bonuses. Corporate America implicitly fears that if CEOs are paid only a salary, they will neglect their responsibilities to shareholders. Therefore, a bonus system is necessary to animate CEOs actions, decisions, and behavior.
Remember that bonus systems are indefensible unless they change people's actions. A company cannot justify a bonus for actions that would have occurred without it. The great irony is that CEO bonuses do change actions and decisions: they make CEOs more selfish and less aligned with the interests of the shareholders.
Corporate directors would bristle at the suggestion that they don't trust their CEOs and argue that they are "paying for performance" and therefore "aligning the CEO and shareholders." But paying for performance assumes that the performance bonus will cause the CEO to act differently. In crude terms, the board holds that the CEO will make the shareholders more money only if he pockets his share of the loot. To get him to do the right thing, the board must bribe him. This does not exhibit a high level of trust.
While I was always happy to pocket one, an annual cash bonus is a dumb idea and almost always counterproductive. A cash bonus-money-is a powerful tool. Too powerful. I've seen CEOs neglect what I thought were more important issues to achieve their bonus goals. I can't blame them. When a board specifies certain goals as deserving a bonus, the CEO will naturally pursue these even if it means neglecting other initiatives. This is what the bonus system inevitably produces as the CEO rationalizes that he is pursuing the board's priorities.
In 2012, the board chair of the family company asked me to join the comp committee and help negotiate a new compensation plan with our CEO. This was something of a demotion. I had been chairing the audit committee, and in the corporate hierarchy, the saying goes that the second dumbest director chairs audit. The dumbest gets comp.
The comp committee comprised three independent directors, meaning that they did no business with the company and were not large shareholders. No member of the committee was an expert in executive compensation. This is normal in corporate America, where directors are usually generalists.
At that time (and this continues today), the newspapers overflowed with outrage, as the pay for CEOs running large companies in 2012 had increased 12.7 percent over 2011 and 37.4 percent since 2009. The New York Times asked, "Is any C.E.O. worth $1 million a day?" and ran stories about shareholder revolts over CEO compensation at Citigroup, Barclays, Chesapeake Energy, Morgan Stanley, Bank of America, and elsewhere.
This reporting encouraged me to pursue heretical thoughts. According to compensation consultants affirmed that our CEO pay system was well designed and effective. But the CEO always did better than the shareholders. The shareholders had mostly good years, but some bad years. The CEO had only good years. Year after year, he surpassed his goals and made more than 100 percent of his target bonus.
I could not blame the CEO, whom I will call Brad. He was honorable, hardworking, and very effective. He acted precisely as the system told him to act. He focused on the tasks the board designated as the most important when they attached a bonus to them.
I had no problem with Brad's total compensation, which was orders of magnitude below that of Fortune 500 CEOs, but I concluded the bonus system was misguided: It encouraged him to concentrate on short-term objectives that could be accomplished within a calendar year and to pay less attention to creative innovations and unexpected opportunities.
It seemed to me that either we were doing a bad job of applying the pay-for-performance model or there was something profoundly wrong with it, so I did some research. After reading academic studies on performance pay and surveying the business press, I reached a stunning conclusion: The emperor had no clothes. No matter how one defined pay for performance, no company had figured out how to make it work well. It always seemed to make things worse.
Brad had done an outstanding job. The board wanted him to stay for seven more years, until he retired. He was agreeable but wanted a fair contract. As a comp committee member, I wanted a pay plan that would keep him both satisfied and focused on what was truly important. The plan would also need to be explained to the satisfaction of the four hundred family members who were shareholders.
Brad did not need a bonus to be motivated. The compensation system needed only to channel this motivation. It would do so ineffectively if we offered a bonus for specific achievements such as increasing next year's earnings, gaining market share in one product line, or improving customer satisfaction at a subsidiary.
The company was best served if his motivation was directed toward his own satisfaction in a job well done with an economic incentive to always act in the long-term best interests of the shareholders.
This produced a radical proposal: THE CEO SHOULD RECEIVE ONLY SALARY AND RESTRICTED STOCK, NEITHER OF WHICH SHOULD BE SUBJECT TO ANY PERFORMANCE CRITERIA. The only exception was that he would forfeit a portion of the restricted stock when he retired if the shareholders had not achieved a satisfactory return over the entire period of his contract. If appreciation of shares plus dividends had not exceeded a fixed rate of return, the CEO would forfeit a large part of his restricted share grants.
The dean of one of America's better business schools chaired our comp committee. Like me, he had become disillusioned with the standard CEO pay system, which produced insane pay levels and dysfunctional incentives, and was tired of reading about the outrage at CEO pay. "Why does everyone use this convoluted pay process?" he asked me one day on the phone, and then answered his own question. "They do it because everyone else does it. I'm ready to try something new."
He liked my idea of jettisoning the annual bonus and relying only on restricted stock. "If we want him to think like a shareholder, we need to make him a shareholder." He suggested I meet with Brad to see if we could reach an agreement on the principles of my proposal.
Like most business executives, Brad valued money and understood that more was better than less. While he saw some advantages in this proposal, he raised practical concerns: What is the salary? What about future salary increases? How many shares of restricted stock would be granted each year? What portion of these would be subject to forfeit? How would a target for a fair shareholder return be established?
I told him I would talk with the committee, the board chair, and the other directors. If they agreed, Brad and I could negotiate the numbers. Most of this group, including the chair, a woman who was elected recently, were family members. She wanted a large portion of restricted stock subject to forfeit. But I argued that a significant amount should not be subject to forfeit. First, I was sure that Brad would not agree to have nearly everything at risk. Second, I wanted him to be a shareholder and think like one. In good times and bad, his economic interests should be aligned with the shareholders. If he received a fixed number of restricted shares each year, the best way for him to increase his wealth was to constantly increase the share price. However, if too large a portion was subject to forfeit and he was running below the return target, he might take large risks in his last years to beat the target.
Moreover, the portion subject to forfeit would depend on the ease or difficulty of hitting the seven-year return target. The lower the target, the higher the forfeit Brad would accept. So the board chair, the comp chair, and I agreed on the lowest acceptable return target; then I could negotiate for a higher forfeit and a higher target, trading off one against the other.
The comp committee then sent a memo to the board that said the following:
We have a simple proposal for Brad's compensation: Salary plus restricted stock. There will be no annual bonus and no performance measures save this one: Brad will forfeit a significant amount of his restricted stock if over the seven-year period shareholders receive less than a satisfactory return.
Our reasoning is:
The compensation system is not needed to motivate Brad. Brad is already highly motivated. The comp system should precisely align his interests with those of the shareholders. The only way to do this is to make him a shareholder and eschew additional bonuses beyond restricted stock that dilute this alignment.
Our current compensation system is too complex. It inevitably incorporates counterproductive incentives. For example, if we set return targets on investments and ignore leverage, the CEO will have an incentive to borrow too much. However, if we adjust for leverage, the CEO will have an incentive to borrow too little.
The CEO knows more about the company than the board. He will always have an advantage when negotiating bonus structures, goals, and payouts.
We and other boards cannot design methods to effectively measure and reward CEO performance.
All pay-for-performance systems cause more harm than good. They generate perverse incentives, undeserved and often absurdly high bonuses, and damage the companies that use them.
Salary plus restricted stock is simple and effective. We know that Brad is a highly capable executive with unquestioned integrity. We should pay him fairly and rid ourselves of the complexities and perversities of our present system.
