On Management

Dec. 21, 2004
Is there a way to achieve ethical fairness in compensation?

Michael Ovitz failed to accomplish much of anything in his year's tenure at the Walt Disney Co. His punishment? A walk-away package valued at $75 million to $125 million -- more than the total annual revenue of many companies. These days, it is not uncommon for CEOs to be awarded bonuses and stock options that reach eight digits. How can this happen? Can one person really be worth as much as all of a company's middle managers or hourly workers combined? Having been an executive, I know most of the rationales given for executive compensation packages -- and many of them are legitimate and reasonable. The seminal work on such compensation is Derek Bok's The Cost of Talent: How Executives and Professionals Are Paid and How It Affects America (1993, The Free Press). One of the primary reasons he cites for huge pay packages is that, as the economy becomes more complex, the demand for able, highly educated people takes on greater and greater importance -- and thus they command higher and higher pay. Bok also found that huge awards do little to motivate these top performers. Their big bonuses are more like "trophies" than compensation. What causes the entire system to grow out of control is the increasing number of "mega-star" deals: Michael Jordan's $35 million for one year; Tiger Woods' tens of millions for endorsements -- at age 21. The cause is quite simple. It is what the market will bear. They are "worth" millions because, in a competitive environment, someone is willing to pay that much for their services. The same principle holds for CEOs. Competition and scarcity make them worth that much. An unfortunate aspect of executive performance (compared with athletes) is that it takes much longer to measure accurately and it can be "faked" in the short term. Athletes either perform or they don't. Their performance is easily measured and highly visible. An executive's performance is often not very visible, and it can't really be measured until after several years -- and, even then, only by the most skilled observer or board of directors. What is appalling to many is the size of severance packages paid to underperforming executives. After talking to a friend recently about his new CEO job, one of his comments stuck in my mind: "If I do well, I'll make a whole lot of money. If I don't and they get rid of me, I'll still make a lot of money. It sort of changes my outlook about the job!" What he meant is that he is now working for the achievement, not the money. I know that he's a person of character and integrity. But what if he weren't? Think about the potential result. The form of compensation packages often aggravates the situation. Boards of directors can devise balanced pay and incentive plans, but if the plans are tied primarily to huge stock awards, CEOs can experience market-driven windfalls or disasters. Only when the CEO's compensation package has a balanced mix of components does it become fair. To pass the test of fiscal reasonableness, the package should include a modest fixed component (salary), combined with a mixture of short-term (one-year), medium-term (three-year), and long-term (five-year) results based on ROE comparisons against a broad group of similar companies -- in addition to any stock-based income. Ultimately, however, the test of ethical fairness demands a more radical approach. CEOs must find a way to share a part of their excessive compensation packages when they reach some upper limit -- like eight digits -- with the people who made it happen. Until CEOs find a better way to share some of the rewards of their success, the bitter taste of unfairness will remain in employees' mouths -- and none of these excessive pay packages will pass the test of ethical reasonableness. John Mariotti is president of The Enterprise Group, Knoxville, and author of The Shape Shifters: Continuous Change for Competitive Advantage. His e-mail address is: [email protected].

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