Forget the Magic Compensation Bullet

The debate raging today over executive compensation misses a basic truth: an executive can’t have two masters.

In the case of the proposed compensation reformers, those masters would be economic growth and risk management. A fine article in today’s Wall Street Journal describes the conundrum:

Treasury Secretary Timothy Geithner Wednesday recommended companies assess pay packages to discourage “imprudent risk-taking.” Soon after, Securities and Exchange Commission Chairman Mary Schapiro said the agency is considering requiring companies to disclose “how compensation impacts risk-taking” in annual proxy statements.

Yet, at the same time, “appropriate risk-taking is still something you want to do in business,” as one person put it in the article.

Let’s put ourselves in the shoes of the average executive. On the one hand, its shareholders are saying, “make me money.” Meanwhile, this concept of “appropriate risk” has to be taken into account. So which gets compensated, because I don’t see how both get into an employment contract? Can you incentivize an executive to make money, but not by way of risk?

Compensation doesn’t seem like the channel for risk management; it’s no magic bullet. Look, this whole effort to reform compensation is mainly based on the bonuses paid out to executives in AIG Financial Products, despite the billions of dollars of losses in the unit. But rather than try to make compensation into an incentive and a risk management tool, there should be more of an emphasis on creating a counterbalancing enterprise risk management infrastructure that compensates its workers for doing what they should be doing: minimizing risk. The incentive to minimize risk will counterbalance the incentive to make money by those charged with doing so.

Still, all employees should be subject to an overriding condition: that the company not lose a substantial amount of money relative to the company’s size. Those AIG FP execs should have had a clause that said, “If AIG FP loses $1 billion in a year, it doesn’t matter what you have done personally; you can’t get a bonus.” There has been too much distance between corporate performance and personal compensation plans on Wall Street. Keep that in line, and give executives only one master at a time, and executive compensation will do what it is supposed to — compensate for good results; not any result.