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Unintended Consequences on Executive Pay I: Golden Parachutes

Posted By Andrew M. Grossman On February 4, 2009 @ 4:12 pm In Economics | Comments Disabled

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 [1]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 [2]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 [2]things like “We’re taking the air out of golden parachutes.” It’s a good soundbite, but terrible, counterproductive policy.


Article printed from The Foundry: Conservative Policy News from The Heritage Foundation: http://blog.heritage.org

URL to article: http://blog.heritage.org/2009/02/04/unintended-consequences-on-executive-pay-i-golden-parachutes/

URLs in this post:

[1] executive pay guidelines : http://clusterstock.alleyinsider.com/2009/2/the-fives-the-limit-treasury-departments-statement-on-pay-caps

[2] clearly a template : http://news.yahoo.com/s/ap/bailout_executive_pay

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