Compensation Overkill

When calamity strikes, Americans tend to look for a villain. This is how we regulate our industries, keep our government honest, and even how we go to war. Unfortunately, it means that many policies forged in haste end up being repealed years later, when it's clear that they were the result of overreaction.

Sander A. Flaum

Today, we stand on the cusp of another mistake that could sink American industry in the midst of a recession. Congress is toying with the idea of placing artificial caps on executive compensation.

The AIG Backlash

The latest battle in this crusade began on Wall Street. Several years ago, a handful of people in the finance arm of AIG began engaging in risky behavior that led to heavy losses. To prevent the firm's ruin, the US government bailed out AIG with cash infusions exceeding $180 billion. And just as the media was primed to report on every dollar spent by the company, public disclosures revealed that AIG had given out more than $218 million in 2008 bonuses—a hefty sum by most standards, but hardly a dot on the balance sheet of the firm's otherwise staggering losses.

Nevertheless, the backlash was harsh. A Gallup poll showed that 85 percent of Americans were bothered or outraged by the bonuses. Chief Executive Edward Liddy, who took office after the firm's most egregious recklessness, was subjected to a grilling on Capitol Hill.

Now Americans are demanding regulation of executive compensation. However, the call for broad caps on what executives can earn, without regard for their performance, is not the solution. In fact, such a blunt tool would ultimately hurt American interests and leave us at greater risk.

"We cannot attract and retain the best and the brightest talent if employees believe their compensation is subject to continued and arbitrary adjustment by the US Treasury," Liddy wrote in a letter to Treasury Secretary Timothy Geithner earlier this year.

Previous attempts to legislate limits on executive compensation have only escalated the arms race. In 1993, Section 163(m) of the Internal Revenue Code limited the deduction for executive compensation under the corporate income tax to $1 million; but corporate America not only found a way over the hurdle by turning to stock options, it used the hurdle as a jumping-off point for setting higher baseline salaries.

"The $1 million limitation on deductibility of senior executive compensation resulted in many companies increasing CEO salaries to $1 million," says Richard Floersch, executive vice president of McDonald's and chairman of the Center on Executive Compensation. "Earlier limitations on exit packages had the same effect—the ceiling became a floor."

Many Options for Reform

Lawmakers need to realize that they have more tools at their disposal than simply capping what key employees can earn. For example, it may be time to review the relationship between boards of directors and management. Because boards often set executive pay, a chief executive who also sits on the company's board can present a conflict of interest. A clearer separation of the CEO and chairman roles would go a long way toward ensuring the board's interests lie with the shareholders.

Another idea is to link executive pay more closely to performance. Federal Reserve Chairman Ben Bernanke supports new rules tying management's rewards to its accomplishments.

In a study conducted in 1999 at the University of Southern California's Marshall School of Business, Kevin Murphy found evidence that stock ownership and stock options are more effective drivers of performance than base salaries. One way to increase managers' stake in the company's health would be to place stricter limits on the length of time executives can hold onto stock options before cashing out.

Many firms are also instituting "Say on Pay" policies, in which shareholders are given the opportunity to cast votes on compensation. The vote is nonbinding, but it offers another voice in the boardroom that's difficult to ignore.

In sum, there are many options for reforming how companies go about rewarding their employees aside from setting arbitrary limits on what they take home. Simply writing down a number may quiet the crowds for now, but in the long run it will do the country a disservice.

Sander A. Flaum is managing partner of Flaum Partners and chairman, Fordham Graduate School of Business, Leadership Forum. He can be reached at sflaum@flaumpartners.com