United States: Executive Compensation – Where Economic Policy and Politics Collide

America’s business executives have been transformed into the country’s political piñata. The media and an entire gaggle of Washington D.C. politicos would have us believe that it is these executives who are at the core of the nation’s economic woes. Never mind that these very executives are the only people with the potential to restore investor confidence and market growth, and that it is in their own best interest to do so. We all know what the problem is: executives make too much money

Fascinating. In a country where teenage basketball stars receive $90 million dollars in exchange for wearing a certain brand of sneakers, the executives who lead the companies that have created the richest nation on the planet make "too much money".

Okay, fine. So, how much should we allow them to make, comrade?

For a while it seemed that the dot-com kids were going to take the fall for our collective irrational exuberance that defined the last half of the 1990s. But then Enron became the metaphorical Titanic of its day, taking the "Star of Arthur Andersen" with it to its cold, watery grave and ‘corporate governance’ replaced ‘new economy’ as the buzzword of the new millennium.

It’s clear that Americans need someone to blame for their decimated 401(k) balances that resulted from that loud popping sound heard in April of 2000. It’s as if the music stopped and someone had taken our collective chair away. It’s humiliating to be the one who fails to find a seat when the music stops.

There are, of course, a handful of legitimate bad guys to point at as they are ushered up the courthouse steps from their limousines. These infamous defrauders who once led companies such as Enron, WorldCom, Tyco, Adelphia and a few others, broke the rules and will not escape both punishment and a lifetime of shame.

But does that mean the rest of corporate America should be embarrassed that its executives are handsomely compensated?

In a recent article, talk show political diva, Arianna Huffington, wrote that while senior executives are making off with undeserved millions, "the picture is far bleaker for those down on the factory floor or crammed inside an office cubicle…".

Really? You mean to tell us that the folks at the bottom don’t have it as good as those at the top, do you? Why that just isn’t right… assuming you live in communist China. But here in these United States, millions have fought and died to protect the free enterprise experiment that is America. Here we want it to be a whole lot better at the top than at the bottom. That’s what makes our country the land of opportunity. And that opportunity is what gives us hope. It fuels the American dream.

Now that Wall Street firms have been spanked and ordered to pay a $1.4 billion fine for recommending stocks that didn’t pan out, it makes one wonder if the media as a whole shouldn’t be next in line. Who do you suppose had more influence on the people who bought Pets.com? Was it the guy making cold calls at Merrill Lynch, or the people that publish Fortune, Fast Company or Forbes?

The cold harsh truth is that there is no one to blame for our declining stock market – no one is to blame and everyone is to blame. In a free market, capitalistic society, sometimes we win and sometimes we lose. But it’s the best system and best place to live in the world. If you don’t want risk, you buy T-Bills. If you want the potential for better than a 2% annual return, it can’t be had without increased risk being part of the equation.

Risk is what makes capitalism work. Our entire way of life has been built on the freedom to take risks in the hopes of reward. The forging of our entire nation was a huge risk. Going to war against the South or the movement West were risks of enormous proportion. The industrial revolution was really just a period in which a lot of risks, in somewhat of a chain reaction, all paid off. The automobile, airplane, telephone and computer – none was by any means a sure thing.

Throughout our history, our society has made risk taking something of which to be proud. The stock market itself, it should come as no surprise to anyone over 10 years old, is risk personified.

Business executives left their safe, lucrative positions with established companies and went off to pan for microchip-driven riches. College students were cheered as they dropped out of school, business plan on napkin in hand, and told us that everything we knew was about to change. And we believed them…because we wanted to believe.

To the ones who made it, we offered our praise. To the ones who didn’t, we said, "It’s okay. Try again." In the late 1990’s, if you weren’t taking any risks, you were seen by society as a dinosaur, certainly not in sync with what America was all about.

Back then, everyone was talking about early retirement. Not senior executives, but rather ordinary workers, teachers, bus drivers and others. Senior executives, on the other hand, weren’t retiring early. They were working harder than ever -- taking chances, competing globally and making us rich.

Then the boom turned to bust. A lot of companies failed. Our nest egg, which we had elected to invest in Yahoo! at 200 times earnings, fell like the smile on the face of a child who just dropped the scoop off his ice cream cone. We took the risks and didn’t get the reward. Someone must be at fault. In America, the willingness to take risks always pays off, doesn’t it?

Hardly. Our current anemic market conditions are, like the economy that spawned them, anything but new. That’s right, our country has gone through more ups and downs than anyone can remember. The ‘ups’ come along when we as a nation say that taking risks is good – the American thing to do. The ‘downs’ follow, the result of many of those risks ending in financial losses to those who took them.

If our country’s current attitude problem seems more severe than during the last down cycle, it’s because more people were involved this time around than ever before. In the late 1980’s when the bad guys were Milken, Boesky and Keating, we heard that their deeds would cause fiscal pain for generations to come. The "S&L Bailout", we were told, would bring the country to its knees where it would remain indefinitely.

Even for those who were there, it’s hard to remember what went on, and it’s only been a little over 10 years since it was front-page news. Americans get tired of sitting on their hands, and after the sting of risk gone bad has left our collective psyche, risk becomes admirable once again. And our nation’s economic growth quickly follows.

As compared with our current situation, the S&L debacle, as far reaching as it was, pales in comparison to the numbers of Americans who lost money when the bubble popped. Our markets don’t cycle -- we do. And now we are in a down-cycle because we’re still licking the wounds of our most recent failed risks.

When we lower interest rates, we are reducing the risk of capital to business. Business will generally respond to lower costs of capital and the economy will grow. Today, however, we are lowering interest rates with one hand and with the other, sending a message to the leaders of corporate America that any type of fiscal shortcoming is unacceptable. Go ahead. Take a risk. But miss earnings estimates by a penny and you can start writing your memoirs.

Executive Compensation has, in the court of public opinion, become an area in which you are presumed guilty as charged the moment your name appears in a business rag listing of "overpaid executives". The message sent to corporate America is heard loud and clear: we’re watching your every move. Don’t screw-up, or else.

The Sarbanes-Oxley Act of 2002 isn’t subtle when it states in so, so, so many words that there’s a new sheriff in town. The most salient impact of Sarbanes-Oxley has thus far been to increase the risk of doing business.

So, lowering rates to decrease risk while legislating heightened risk at the same time is our current public policy. If business is to lead us back to the land where our retirement savings grow, it must be free to take risks, without fear of becoming the next American Airlines executive compensation case study. Business must be free to compensate the human capital it needs most to achieve success.

Today, the pay-for-performance mantra is rolling off of our tongues like ‘B2C’ did just a couple of years back. The idea seems to be that executives should make money only if the company’s stock price went up during the year. That’s the same thinking that led to the use of stock options – to align the interests of management with the interests of shareholders.

Shareholder activist groups are the folks who pushed for stock option compensation schemes during the last half of the 1970s when our markets had been pretty much flat throughout the decade. Now we hear that these very options that shareholders wanted to be in the hands of senior managers lead to abuse because executives will do anything to raise the stock price for their personal gain. Some suggest executives receive too many options. "Too many options?" "Too much money?" Perhaps we should consider allowing voters to decide how much compensation is too much? Why stop there… Let’s just let the State decide.

Business executives are not baseball players. They do not play for a season that ends at the World Series and begins again fresh next spring. The stock market is not even close to being a rational indicator of a given management team’s success year to year. If a company’s stock price is the gauge by which an executive’s success is measured, does that mean that when the dot.coms had a high price per share they were well managed? Companies that sell products and services which are seen to be important to Homeland Security are on the rise. Does that have anything to do with the quality of their management teams? Conversely, our travel and hospitality industry has seen better times: bad management or September 11th?

Our business executives, if they are to receive their compensation based on the short-term performance of their company stock, will have been reduced to working as commissioned salespeople. Next thing we’ll hear is that they don’t take a long-term view in their decisions. How can we expect a CEO to make a decision that in the longer term will be positive for the company and its shareholders, if by making that decision he or she will be punished financially for doing so?

Ask yourself a question: if you were a 58-year old executive at American Airlines and your CEO asked you to spend the last seven years of your career working around the clock to turn around the company which is on the verge of bankruptcy, wouldn’t you want to know there’s a bonus involved? Without such a guaranteed bonus, why would you take a risk like that with the last seven years of your professional life? To do so would be irresponsible to your family. You’d find another job and so would anyone else.

Companies struggling to re-build their levels of profitability and growth need to compensate their executives even more so than would be required when times are flush. Microsoft has it much easier when it recruits executives than does American Airlines. Is it hard to see why that would be true?

The key to our future economic recovery is to remove the handcuffs that come with an atmosphere where any downside risk is too much. Executives are merely human beings who share the same fears and limitations, as do we all. They are not all saints or sinners. They perform because they are offered incentives to do so and their incentives involve far more than just money.

Executives have always been paid for performance. That’s how the free market works. No company wants to over-compensate or under-compensate, but the decisions regarding the amounts paid to executives certainly can’t be left to working Americans or labor unions.

The big issue on the tables of contents of all business publications is whether stock options should or should not be expensed. Some say yes, others no, but regardless of the outcome of this debate, it will not fundamentally alter America’s business realities. Companies will continue to do what they have to do to attract and retain the talent they want and need.

Deferred compensation, which unquestionably aligns the interests of executives with those of shareholders, has also come under fire of late. These plans are the most benign of all compensation methodologies. Their use causes no dilution in ownership, nor does it cost the company any significant dollars to provide the executive plan. In a deferred compensation arrangement, executives are offered the option of deferring their own compensation – that is to say, they don’t receive their own money until some future date, often at or near retirement. The monies deferred go into the company’s coffers and are subject to the claims of creditors should the company fail. Because they don’t receive the money deferred, executives are not taxed on these amounts until they withdraw.

It’s an arrangement similar to that provided by a 401(k) plan, except that there is no guarantee that when the money becomes due, it will be there. What sounds more risky than that?

Yet a number of politicians are proposing to restrict various aspects of deferred compensation programs because they say that Enron executives used their deferred compensation accounts to get away with riches while Rome burned.

What happened at Enron is not systemic – it is unique on an historical scale. Nothing like Enron has happened before and, like the real Titanic, we are not likely to see a repeat performance any time soon. Oh, there’ll be new corporate villains in our future, to be sure, but they’ll commit new fiscal atrocities of which we have yet to conceive.

To start legislating based on this type of event is political pandering at best. At worst it’s dangerous to our potential for economic growth as a nation.

As long as we possess the freedom to compete in a free-market economy, there will be those who will make us look stupid for allowing their particular scam to occur. It should not come as news that the markets dropped… it happens. But to blame the market’s losses on the business executives who run the companies that make up the US of A, well, that’s just bad business. Blame Ken Lay if you want, but try not to be too hard on the countless senior executives and CEOs who are guilty only of trying to run a company – at a profit – for a sustained period of time.

The CEO of a big company is trying everything possible to improve the company’s P&L and Balance Sheet. Decisions are made because the people closest to the situation believe they should be made. How in the world would a shareholder know whether a given decision is right or wrong unless, of course, it is obvious? How many options seem right to you? Do you think we should vote for a deferred compensation plan, or not? How much are you voting for to pay the CEO? Preposterous.

Senior executives at publicly traded companies live under the constant pressure to perform and have the greatest incentive possible to do so. They lost more than the average guy when the bull market ended and, in addition to their own investment balances, have the ultimate incentive of career advancement to consider. If senior executives succeed in their jobs, their returns consist of more than just money.

The newly approved NYSE rules regarding the need for shareholder approval of equity compensation plans are considered necessary to provide "checks and balances". But checks and balances are already in place. That’s what the Board of Directors is there for. When that system fails, when investors don’t like the way a company is being run, the harshest penalty is imposed – people sell the stock and the value of the company drops, often precipitously.

Next thing you know, the CEO is revisiting his or her resume and having lunch with someone from Korn/Ferry. And if that isn’t enough, Sarbanes-Oxley now provides for civil and criminal penalties for corporate malfeasance, and there’s a line of plaintiff’s attorneys stretching from New York City to Washington D.C. waiting to take up arms on behalf of one class or another.

Legislating even greater risk or otherwise handcuffing the executives who run America’s companies will do nothing to stop the tiny minority of corporate criminals. But it will place constraints on the 99% of well-run companies and lead to risk-averse decision making at a time when we need to remember that taking risk in business is what makes our economy grow.

When a large company hires a new CEO or other senior executives, there are dozens of experts involved in the negotiation, just like when Michael Jordan is recruited to play on another team. The company’s Board, Compensation Committee, external compensation consultants, CFO, head of HR, Corporate Counsel and many others are involved in the negotiation. In the end, the CEO’s compensation is set by what the market will bear, as is true for his "airness".

With the current life expectancy of a Fortune 500 CEO less than five years by all accounts, there isn’t much time for a newly appointed chief executive to perform, and there’s no shortage of interested parties waiting to call a foul.

In point of fact, when you compare CEOs with professional athletes, a very different picture comes into focus. Harvard Business School professor and Chair of Doctoral Programs, Jay Lorsch, explored such a comparison and found that although CEO pay has risen much faster than that of the average American worker, it has not risen as much as the compensation paid to other "scarce talent", such as professional athletes.

Professor Lorsch, in his paper titled, "CEO Pay – Facts and Fallacies", points out that CEOs are much more easily compared to professional athletes than to the "average worker". Their talent is "scarce" and they only receive their high levels of pay for a short time. According to Lorsch, most CEOs reach their position in their 50s and retire at age 60.

The numbers support Professor Lorsch’s views:

If you don’t accept that CEOs possess talent that is "scarce", ask yourself this question: how many people do you suppose there are in the country today who would be qualified to run American Airlines? Are there two… three… five… a dozen? And how many of them want the job, would you guess? Don McCarty was the best choice – even the unions had agreed, as evidenced by their willingness to make concessions in order to support his plan to turn the battered industry giant around. He cut his own salary, told the union he needed the freedom to compensate his executive management team and then made the best deal he could with the executives he knew would be needed to get the job done.

If he didn’t communicate the results of his negotiations in the optimal fashion, if his public relations acumen left much to be desired, none of that diminishes his being the best man for the job at hand. Yet he was forced to resign for doing what he believed to be in the best interests of American Airlines and its stakeholders.

Now we have a new CEO at American Airlines. Not anyone’s first choice, of course, but when you’ve only got a week or two to find someone to run the largest airline in America, you take what’s available. The new guy is from Sears. Perfect – credit cards, washing machines, tools – all of the things you need to run an airline.

Will American’s new CEO do a better job than the ousted Donald? We’ll never know, but that isn’t really the point. The point is that we have allowed union and political pressure to force out the best man for the job because his public relations skills were not up to snuff. That’s quite a reason to gamble with the future of an airline that employs hundreds of thousands and whose collapse could create a devastating domino effect.

Delta is now in the hot seat. It seems the senior management there, along with the Board of Directors, thinks that since the executives have stuck it out since 9/11 and outperformed the battered industry as a whole, they deserve a bonus. Imagine that. Not very American of them, is it. After all, since 9/11 is the cause, shouldn’t these guys stop thinking about money? Why they’re nothing but a bunch of capitalist pigs.

The retired Delta CEO even wrote a letter to the Board opposing the idea of giving bonuses to executives, what with the company’s 401(k) plan currently under-funded. "We’re in this together," he was quoted as saying.

In this together? Equally? The proletariat and bourgeoisie working arm-in-arm together for the good of the state… er um… the company? Memo to America: that approach has been tried. Did it work? Nyet. Corporate counsel at Delta responded with a voice that couldn’t hide at least a small amount of corporate anger, when he said that the airline was doing what it was doing to avoid the pain and suffering that would accompany bankruptcy. Now you might agree or you might not, but if the Board and senior managers think it’s important to compensate the executives at this time in order to avoid bankruptcy, why is anyone’s armchair opinion to be even considered? You have recourse if you don’t like the decisions being made at Delta – sell your stock. And, if you don’t own any Delta stock, then it’s none of your business what the senior management there does or does not do.

If we want to see the positive market returns we’ve come to love and depend on return once again, we must allow business to compensate the human capital that adds the most value to the cause. Business is not a democracy. All human capital is not created equal. Companies must discriminate, not based on race, religion, sexual orientation or creed, whatever creed is, but on the basis of value and scarcity.

Deferred compensation and other compensation arrangements that fall into the category of nonqualified plans are not "bad" because a handful of executives allegedly used them to make off with ill-gotten booty. They are valuable tools that align the interests of shareholders with those of management. The cost of offering a deferred compensation plan to executives is so low as to be considered negligible by any reasonable comparison. Yet, these plans provide executives with the advantage of tax-deferred saving and investment growth.

That’s "tax-deferred", not tax-free. The executive doesn’t have to pay current taxes on the money deferred because he or she doesn’t have the money, can’t control the money and may never receive the money. If the company fails, the dollars deferred are subject to the claims of creditors.

Offshore deferred compensation trusts… bad, most everyone agrees, but allowing an executive to forego receiving some portion of his or her compensation, in essence loaning it to the company where it is at risk… how is that a bad thing?

Nonqualified plans exist because qualified plans, such as the 401(k), discriminate against anyone who makes more than $100,000 a year. The reason is that the limits on 401(k) contributions, which are imposed under ERISA and IRS regulations, were designed for the masses, not for the relative few in management positions. These limits on annual contributions make it impossible for anyone earning more than $100,000 annually to view the 401(k) as "retirement savings". Even if a person were to contribute the maximum amount allowed each year for 30 years, the balance in the account would fail to come anywhere near to providing the guideline of having 60% of your final working year’s salary as annual retirement income.

The reason behind this limitation is simple: because the 401(k) is designed for tens of millions of American workers, it is expensive in terms of its tax advantages. Companies that contribute take an immediate deduction, as do the employees who participate. The result is a cost to the US Treasury and that cost must be limited.

Nonqualified plans, such as deferred compensation arrangements, arose to provide those earning more than $100,000 a year with a way to save on a tax-deferred basis. But deferred compensation plans are "not qualified" because they do not "qualify" for the favorable tax treatment allowed the qualified 401(k) plans. Participants defer their own compensation, so they don’t pay tax on that amount until they withdraw monies from their account. But companies are not permitted to take the salary expense deduction on the amounts deferred. When a participant in a deferred compensation plan receives the money from the plan, the taxes become due and the company can then take the corresponding salary expense deduction. The entire transaction is revenue neutral to the government, with the possible exception of a time-value-of-money calculation that is hardly worth doing.

In contrast to the 401(k) where the money is not allowed to be used by the company to fund operations, the money deferred into a deferred compensation plan cannot be placed outside the reach of a company’s creditors in the event of bankruptcy. It sits in the company’s coffers and there is no assurance beyond the company’s promise that it will ever be paid.

To give this unsecured promise a little more umphh, companies are permitted to utilize a Rabbi Trust – a "security" vehicle that has recently come under fire in the legislature. The Rabbi Trust does not place the money outside the reach of creditors; it merely protects the participant against the company – or its new management – in the case of a merger or acquisition – from changing its mind or otherwise deciding to break its promise to pay. Considering that the amounts deferred by the participant in a deferred compensation plan are "compensation" and therefore would otherwise be paid to that participant, doesn’t it seem eminently reasonable that the company not be allowed to merely change its mind and break its promise?

We’re not talking about offshore trusts, mind you. Neither are we talking about the type of trust that places the monies outside the reach of creditors. We’re simply describing a document that says if you make a promise and are financially able to keep it… then you should keep it. It seems that the "Mothers of America" would certainly agree with that tenet.

Yet deferred compensation plans, like stock options and anything else provided to "executives", are being looked at as a virus that must be cured before it claims any more innocent victims.

It’s worth mentioning that deferred compensation plans are made available to those considered "highly compensated" and by that we mean people earning over $100,000 a year. Although this group is unquestionably in the minority, it is hard to draw a comparison between Enron’s CEO and a guy making $150K who has a mortgage, two car payments and three kids to put through college. We, as a nation, cannot allow our mob mentality to harm the many because we are hopping mad at the relatively few.

Legislation in pursuit of public vengeance will not stop the occasional abuses of capitalism at work. The only effect of America’s misplaced anger will be to prolong the nation’s risk averse mindset and sluggish economic conditions. If we want to see our stock market accelerate, we must finish licking our wounds and get back on our free market horse, secure in the knowledge that we will fall off again, but further down the path to the national prosperity that knows no bounds.

We must not allow the victim of the latest round of corporate wrongdoing to be the capitalistic, free enterprise system that has served us so well for so long. We must not yell so loud as to drive our legislators to use a cleaver where a scalpel is required.

Just because our markets have seen better days is no fault of America’s business leaders or an indictment of our system overall. Just because Enron executives misused their deferred compensation plan is no reason to indict nonqualified deferred compensation as a whole. And just because we read a headline describing an executive who just cashed in a bucket of stock options, that’s no reason to believe that a link exists between that executive and the balance in our own 401(k) plans.

The faster we get over our troubled investment accounts, the faster they will recover. The more we restrict business’s appetite for risk, the longer we will have something to complain about. In this country we believe that "all men are created equal". It is a principle that has served to create a society envied by people everywhere. But, when those men and women go to work, they become human capital and all capital is not created equal… human or otherwise.

Business must be allowed to discriminate between different forms of capital. Capital derived from the public markets is preferable to venture capital, for example. As a result, the two forms of capital have different values to the company.

Human capital is no different. The executive qualified to manage 50,000 workers is of greater value to the company than any one of the workers themselves and should be rewarded accordingly. If a few of dozen slip through and receive "too much money" in your view, focus on the tens of thousands who dedicate their lives to making their companies the world’s leaders. They deserve to receive fame, fortune and glory.

Always remember that the race is long – very few in this country get away in the end. Today does not the whole story make. If you don’t like the way a stock performs, sell it. Give our system a chance to work and you won’t be disappointed. But, legislate our system to the point that it is afraid to reward those who make it work, and our disappointment will be profound and long-lasting.

What Enron did could have been done with pencil and eraser. Surely the USA can withstand a simple fraud. It cannot, however, withstand a fundamental shift in our attitude about risk and reward.

So, go ahead – build that microprocessor-driven digital mousetrap that is also an MP3 player and await the world’s beating a path to your door. Then compensate those who helped to make it happen, even if the animal rights protests against cruelty to rodents are causing your company’s stock to be undervalued.