My friend David Kirby passed along an interesting article from the Harvard Business School Web site proposing a novel method of executive compensation. A perennial problem for shareholders is that you want to give your CEO a personal incentive to improve performance by making her compensation dependent upon it in some way. The trick is how to prevent her from gaming the compensation setup in a variety of ways—say by making sure profits spike right before her options vest—in ways that help her bottom line, but not the long-term interests of shareholders.
The authors propose a Rawls-inspired strategy for preventing this: Let the new hire know the value of her compensation package, but not the mechanics of how it works. This is supposed to give the executive an incentive to maximize the performance of the company overall, rather than focusing myopically on whatever trigger metrics are built into the package. It’s clever on face, but there’s one big reason I’m inclined to think boards would be better off just tailoring their metrics better: The executive now faces the flipside of the problem that shareholders do under the status quo. That is, she knows the present value of her compensation, but can’t be sure whether it’s been rigged to peak at the time of her hiring, even if she does generally improve performance. They could, of course, give her quarterly updates of the package’s value, but this would presumably make it possible to reverse-engineer its mechanics, defeating the purpose of the scheme. And bar that, even if the executive trusts the board to set everything up fairly, she has to eat the risk of cashing out when the value of her compensation is unusually low for whatever reason. So the compensation probably has to be significantly higher to balance out this added risk. Maybe it’s still worth doing, because eliminating self-interested CEO gaming is worth more than the necessary increase, but it’s odd that the authors don’t seem to consider this factor at all.