A Smarter Model for Paying CEOs

By Covering Business     March 14, 2012

At most publically traded companies, executive compensation is linked in some way to financial performance – experienced or expected. A board pays a chief executive based on how the company has done or how the board believes it will do under the CEO’s stewardship.

Although this model seems reasonable in theory, in practice it has created what Mihir Desai, a finance professor at Harvard Business School, calls an “incentive bubble,” in which executive compensation has grown unchecked.

In an article in the March issue of the Harvard Business Review, Desai argues that CEO pay should not hinge solely on how a company performs because companies succeed or fail for a variety of reasons. They can soar because of management or in spite of it.

“Financial markets cannot be relied upon in simple ways to evaluate and compensate individuals because they can’t easily disentangle skill from luck,” Desai writes. “Widespread outsourcing of those functions to markets has skewed incentives and provided huge windfalls for individuals who now consider themselves entitled to such rewards.”

In the article, Desai lays out a framework for paying executives in a manner commensurate with the value they add.


Read the full article in the Harvard Business Review.


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