Unintended Consequences on Executive Pay I: Golden Parachutes

Posted February 4th, 2009 at 4.12pm in Enterprise and Free Markets.

Policies premised more on class-warfare than sound economics, are not going to get us out of this recession. They may actually delay recovery.

A case in point: the executive pay guidelines released by Treasury today. Though the new rules seem to apply, at this point, to only the few corporations that have received “exceptional assistance,” such as AIG and Fannie Mae, they are clearly a template for more broadly applicable rules. It is worthwhile, then, to consider how they undermine incentives for performance and economic growth.

One particularly populist and dumb rule bans balloon severance payments to executives, known by the loaded term “golden parachutes.” The ban applies to the top 10 executives of a corporation, and the next twenty-five will be limited to severance payments greater than one year’s compensation.

The debate on golden parachutes has raged since the mid-1980s, with self-appointed “shareholder advocates,” supported by union affiliates seeking to embarrass executives, claiming that they’re nothing more than, well, golden parachutes–big and pointless payouts to executives on their way out the door.

While that may be the case in some instances, it’s far from the whole story.

Economists have identified three virtues of golden parachutes that actually serve to boost shareholder value. First and probably most important, they reduce executives’ natural resistance to takeovers. A top executive is a leader, and typically leaders don’t like to give up their position at the top of the pecking order, especially when that position comes with prestige and perks. But sometimes a change in leadership, such as through a takeover, leaves a corporation and its shareholders better off. When a takeover is in the cards, shareholder and executive interests diverge: shareholders may stand to benefit but the executive may stand to lose his job and prestige. In this kind of situation, golden parachutes help to align the interests of executives with those of other corporate stakeholders, like shareholders and employees, by encouraging executives to make a deal, rather than doing everything possible to stay put, to the detriment of everyone else.

Second, golden parachutes encourage executives to put their talent on the market and invest in firm-specific human capital, especially in corporations and industries where changes in management are routine. A good manager can add a lot to a corporation’s bottom line, but the most skilled managers are understandably wary of giving up their current positions or industries for new ones, where things may not work out for them. In this case, golden parachutes are a sort of insurance policy against both the risk that taking a new job may work out worse than other options at their disposal and the risk that focusing on company-specific matters won’t translate into better career opportunities down the line. As a result, the market for executive talent is stronger, and executives are willing to delve more into the businesses that they run.

Third, in some industries, golden parachutes may actually be a preferred means of compensation from shareholders’ point of view. Severance pay is, at core, just deferred compensation, so executives slated to receive higher severance pay should be willing to accept lower current compensation, in general. The costs of golden parachutes are reflected in firm’s takeover prices–the bigger the parachutes, the higher the price. In this way, they shift compensation expenses from current shareholders to acquiring shareholders, boosting current shareholders returns. So in this very direct way, golden parachutes for executives can actually leave shareholders better off, too.

All this suggests that Treasury–surprise, surprise–got things exactly backwards when it placed greater limits on golden parachutes for top executives than lower-ranking executives. It’s actually much more important, and more beneficial to shareholders and workers, to use large severance payments to give top executives the right incentives.

If the Treasury prevents this, however, expect the best corporate talent to be increasingly reluctant to work for corporations covered by the new rule, at exactly the time that such talent is needed most. And expect those who do take the reins to be more reluctant, if and when the time comes, to give them up, even when doing so is the best course of action. That means fewer consolidations–a strange outcome when the economy (as well as the government) is pushing many companies to partner up just to persevere.

A better solution is to give up government meddling in pay decisions as hopelessly impractical. Too bad, however, that the (largely) economically illiterate press is willing to give the President a pass–even praise–when he says things like “We’re taking the air out of golden parachutes.” It’s a good soundbite, but terrible, counterproductive policy.

7 Comments

February 4, 2009 Ozzy6900, CT writes:

Well, I was waiting for this! This is mostly due to crybabies that cannot keep their mind in their own jobs. People are whining about the CEO’s pay well so what? Everyone is entitled to earn as much as possible in this Country! For example, I am an employee of AT&T. I earn under $100k per year. I was not hired as a CEO or Management, I am a worker. I am concerned about my pay not that of my CEO. If he is making too much as opposed to the business, then it is up to the business to handle that. People are being moved about and some laid off but that is the way business works. Sometimes times are good (and they have been good for over 30 years) and sometimes they are bad.

Now, some people say that a bank will loan you money but stipulate how you should use it. Maybe that is okay for a bank but it is not for Government! Government has no business or RIGHT to tell anyone…. ANYONE what they can and cannot earn! “Oh, but the Government is handing out taxpayer money for a bail-out so they have that right.” NO THEY DO NOT!

First of all, the Government is not a bank. Second, the Government has no business acting like a bank. Third, if the Government didn’t act like a bank, they would not have to make such stipulations, now would they?

Mark my words, once the Government gets away with telling ANYONE how much they can and cannot earn, it will never stop. The Government will soon tell the common worker (such as myself) what the limit of their salary is. And why not, if the Government gives the company money to keep operational, it then has a right to protect it’s investment. DON’T LET THIS HAPPEN!

In conclusion, the biggest and best Golden Parachutes do not occur in business or on Wall Street. The biggest Golden Parachutes are awarded to Government officials (Senators, Congressmen, Cabinet Members, etc.). But if course, they can do what they want because not many people know of this….. at least until now!

February 5, 2009 Marshall Hill-Michigan writes:

Well America how do you spell Divide and Conquer!

Socialism has no Free Markets,just Messiahs and
Czars that report to him!

February 5, 2009 Joseph L. Krumenacker, Doylestown, PA writes:

As a shareholder, am I to sit back and let the government takeover and run a company? I thought this was the job of the CEO reporting to the Board of Director who set the CEO’s salary and made the decision on where the CEO takes the Company.

Oh, and, isn’t the Board elected by the Shareholders?

Now, I would agree, as a shareholder, trying to get a Board to do something, (i.e. firing the CEO or reduce the CEO’s salary), can be difficult. However, how are the shareholders ever going to remove the federal government from running the company?.

Let’s see, the government reports to, “We the People,” (hereafter “WE”) and on behalf of WE, the government assume control of the WE Company owned by WE (because they tell We the CEO makes too much money, etc.). Can WE tell the government to leave the WE company alone? Why not? After all, the government reports to We, the shareholders of the government, aka, the government’s boss?

Should the government have to buy the WE company, or a portion of it, from the WE shareholders, based on an agreeable price? And, if the WE Company doesn’t like the offer, can the WE shareholders tell the government to, “take a hike?”

What’s wrong here? If We own the Company, why does the government, that works for WE want to buy it from WE?

Sound a little confusing? Well, just wait until the government takes over the WE company. That’s when the confusion begins.

Therefore, I, as a shareholder of the USA, want to now place my vote to have the government sell the US Postal Service, AMTRACK, NASA, Fanny May, Freddy Mack (well, we can just close Fanny and Freddy), and all other business entities run by the WE the People government.

If others will vote along with me, then WE will have a nice sum of money to pay down some debt and WE will be able to reduce our spending. Also, the shareholder run companies who buy the government entities will no doubt run the US Postal Service, AMTRACK, NASA, Fanny May, Freddy Mack, and all other business entities run by the WE the People government more efficiently and produce more jobs. : ) : ) : )

February 5, 2009 RWineland, CA writes:

The President is a known socialist so his actions regarding business and the economy are completely consistent and predictable. He is governing according to his avowed beliefs and his life-long associations. It is going to be a challenging four (hopefully) years.

February 5, 2009 Jamie writes:

Please remember that CEOs do not work for themselves. They also don’t work for “the company,” as if that entity existed unto itself. Executives work for the shareholders — the OWNERS of the corporations.

Outlandish executive pay is perfectly fine when corporations are making money. But the myth of the ‘heroic CEO’ is one that has led us to where we are now: the executives get paid lavishly, cannot be removed except by Boards populated by their cronies, run the company into the ground, and then pick up their so-called ‘deferred compensation’ on their way out the door. Who gets screwed by this deal? The shareholders — the OWNERS.

In the United States, the Boards of Directors are completely unequal to the task of setting executive pay. Why? Because they cannot be replaced by shareholders in a single election cycle! It takes three cycles to vote out an entire board; that means that it takes TWO cycles to get a majority. In the interim, the OWNERS can neither fire the CEO nor change his pay.

While mandatory government caps on pay might therefore be unwarranted, therefore, what is NOT unwarranted is a regulation that requires direct SHAREHOLDER approval of executive compensation.

As for capping pay offered to executives who head companies that receive taxpayer money as their primary funding — I don’t mean local banks that get a million or two, but corporations like General Motors, AIG, and Citigroup that would have been LIQUIDATED were it not for the taxpayer cash given them — OF COURSE that makes sense. Pay is based on performance; these corporations are where they are because performance was poor.

And y’know what makes it all so funny? Most if not all of you probably have piddly net worth, sustaining your standards of living on excessive borrowing just like these banks. The day will come when your job also disappears, and you’ll find out just how hard it is. Then you’ll understand why we have public services.

February 5, 2009 Tristan, Orange County, California writes:

This is amusing, to say the least.

I have been living off of $8.75 per hour for the past two years, and have been quite comfortable. This tells me that for every person in a household, an employee should be entitled to $8.75 per hour. For instance, in a home with two parents and a child, each parent should receive $26.25 per hour, and they will live quite comfortably.

These CEO’s do absolutely nothing for the company that a group of lower paid individuals couldn’t do more efficiently. The problem with NOT allowing government to control their pay is that the shareholders that have voting power are all friends with the CEO’s, so they won’t vote to decrease pay based on horrible performance.

I’m tired of CEO’s driving companies into the ground and STILL receiving humongous severance packages. This practice needs to stop. Also, high pay doesn’t guarantee good work. High pay just guarantees high pay. Good work can only be guaranteed by making pay dependent on results. If the company earns good profits, pay the executive more. If the Company loses money, pay them equal to what the average employee of that company receives, because the CEO obviously only did average work.

October 25, 2009 Wage Controls Don’t Work | Conservative Principles Now writes:

[...] we’ve argued before, economists have identified multiple reasons that golden parachutes are beneficial. Most [...]

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