Recession. Health care. Crime. Drugs. Homelessness. Education. The deficit. These are just a few of America's problems, topics that should dominate the political debate this election year. But what's the newest hot-button among Presidential candidates and on Capitol Hill? Executive pay. Thanks to all the commotion surrounding the generously paid chief executives who accompanied President Bush on his trip to Japan, what had been an annual springtime flashpoint for activist shareholders has flared into a national issue. Now, obscure congressional proposals, such as capping the tax deductions a company may take for executive pay, are gaining support.
Unfortunately, what may sound good to a recession-stung population makes for bad policy. The way Corporate America pays its executives does need revamping: It's not right that the compensation of most CEOs rises each year, as predictably as the sun comes up every day, even if their performance hurts a company's returns and imperils its future. But turning CEO pay into a political issue is pure folly. Since virtually all pay schemes can be manipulated, the solution lies in exposing the process to shareholders and thus to the market.
EVER UPWARD. U.S. executives can blame two pay gaps for moving the issue to the fore: On average, they take home 160 times the pay of their employees and three to six times that of their European and Japanese counterparts. But that's not the nub of the problem. What counts is whether each individual earns his or her pay. Usually, an executive's pay is determined by a board committee that is guided by pay consultants hired by the company. To ensure that pay is good enough to lure and keep talent, companies usually tell the adviser that they want to set pay levels at a certain industry percentile--often 75% or more. That directive itself leads to an upward spiral in pay.
Worse, pay committees increasingly have handed out bonuses, stock options, and other incentives keyed to financial results or stock performance, all in the name of aligning management interests with those of shareholders. Trouble is, the inducements have been mainly add-ons, with little downside if an executive doesn't perform--certainly none that materially affects lifestyle. Again, pay only goes up.
Consider, though, what might happen if Congress tried to limit executive pay to a multiple of the average worker's pay. A CEO could get a raise only if he gave a lot of raises. "The implications for the economy would be disastrous," says Kevin J. Murphy of the Harvard Business School. "Executive pay is a drop in the bucket compared to giving workers a raise--think of the rise in labor costs. And it would completely get rid of pay-for-performance." Other proposals have drawbacks, too.
What can be done? Boards, specifically compensation panels, must feel the pressure for change. Potential new accounting rules, requiring companies to deduct the cost of stock options from income, may add discipline. Shareholders, meanwhile, should make sure compensation committees consist entirely of independent directors who hire their own consultants. Next, "expose the whole thing to sunlight," says attorney Ira M. Millstein, a corporate-governance expert at Weil, Gotshal & Manges. The Securities & Exchange Commission can do that simply by adding a twist to reporting requirements: Compel pay panels to explain in the annual report or proxy statement what a CEO's compensation really is--in all its components--and why it's reasonable.
Washington may indeed have a role in righting the executive compensation mess. It's just a lot simpler, less glamorous, and less political than the one it's playing now.