Eliminating pay incentives for CEOs could remove incentive to innovate, study finds
It isn't easy sticking up for executive perks at a time when companies are lopping off workers and management blunders are blamed for the collapse of banks and the auto industry.
But that hasn't stopped Gustavo Manso, assistant finance professor at MIT's Sloan School of Management. In a research paper published in March, the Brazilian-born educator described a business experiment - involving that American entrepreneurial archetype, the lemonade stand - suggesting that a mix of long-term incentives and golden parachutes will best spark creativity and innovation.
"In a controlled laboratory experiment, we provide evidence that the combination of tolerance for failure and reward for long-term success is effective in motivating innovation," Manso wrote with his collaborator Florian Ederer, a PhD candidate in the MIT Department of Economics. "Subjects under such an incentive scheme explore more, and are more likely to discover a novel business strategy than subjects under fixed-wage and pay-for-performance incentive schemes."
The experiment took place last year at a Harvard Business School lab. Four hundred researchers, mostly students from Harvard and the Massachusetts Institute of Technology, played a software-based game replicating scenarios and decisions facing the operator of a lemonade stand seeking to expand.
The most successful were those given the optimal alignment of goals and incentives - that is, a pairing of stock options with golden parachutes, or huge payouts if the executive is terminated.
What this means, as a practical matter, is that much of the recent populist backlash against executive incentives, and the US government's move to cap executive perks at firms that receive federal bailout money under the Troubled Asset Relief Program may be misguided, Manso said in an interview.
"I understand the public clamor," Manso maintained. "But we need to be a little careful about what measures we want to take to regulate executive compensation. We need innovation to get out of the situation we're in now. And if you impose bans on the use of golden parachutes - as has already happened at companies that have taken TARP funds - it may be harder to design a compensation scheme that is going to motivate executives to take innovative action."
Manso's conclusions aren't popular among reformers working to tamp down corporate excess during the nation's steepest economic downturn since the Great Depression.
"I don't think there's a lot of evidence that these incentives have made executives smarter or more efficient," said Sarah Anderson, executive pay analyst for the Institute for Policy Studies, a think tank in Washington, D.C. "Stock options were sold as a way to tie pay to performance. But, in fact, executives have been able to get payouts from options that don't have anything to do with their brilliant vision."
As an example, Anderson cited stock option windfalls enjoyed by oil executives. The executives testified before Congress that they had no influence on rising oil prices but nonetheless profited as the higher prices pushed up their companies' stock.
"This myth of the genius in the corner office has been exploded by this crisis," she said, referring to the current recession and frozen credit markets.
Paul Hodgson, senior research associate for the Corporate Library, a governance research firm in Portland, Maine, that analyzes trends in executive compensation, echoed that view.
"For 20 years, we've been paying every single CEO in this country as though they are some kind of pioneering entrepreneur," Hodgson said. "In truth, only about 10 percent of them are really entrepreneurs. The rest of them are just managers."
Hodgson argued that executives at failing banks and industrial companies already have ample incentives from previously issued stock options that are now underwater.
Reviving their companies, and their share prices, will enable them to cash in on options that today are worthless, he said. Thus, he insisted there's no need for additional options.
As for golden parachutes, Hodgson said they should be far more modest.
Ideally, he said, they should be sufficient to encourage executives to take prudent risks on behalf of shareholders, such as selling their companies to an acquirer that might put them out of a job. But they shouldn't be generous enough to spur excessive risks, like investing in speculative financial products that could bankrupt their companies, by insulating executives from the consequences.
Manso's business gaming experiment divided researchers into five groups, giving each a separate set of compensation options: pay for performance, flat wage, long-term incentives but no golden parachutes, long-term incentives with no parachutes and the explicit threat of being fired, and long-term incentives with parachutes. Some of the options rewarded risk aversion, notably from the pay for performance team, while others rewarded only mild experimentation.
Each group was asked to devise a management strategy using different variables such as prices, ingredients, and locations. While the starting point was a lemonade stand in a business district charging high prices for low-sugar drinks heavy on lemon, there were multiple possible alternative scenarios.
The winning strategy was moving to a school district, charging lower prices but boosting sales volume, and selling drinks with more sugar and less lemon. The winning team had the golden parachutes, enabling them to experiment without fear of failing, and long-term incentives that promised they would be rewarded for success.
For Manso, the lesson is as clear as the adage about life giving you lemons: "If you cap compensation and reduce incentives, you discourage innovation and your most talented people will leave."
Robert Weisman can be reached at weisman@globe.com. 