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Agency and compensation

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Agency and compensation

Executive compensation has been in the spotlight for many years. Structuring the compensation package for senior management of public companies, where there is separation between ownership and control, is an example of the agency problem. Senior management, the agents, have to be offered the right set of incentives to align their interests with those of the shareholders, the principals, or so the theory goes. Left to compensation consultants, the solution to this agency problem has lead to profit-related bonuses and so-called, long-term incentives in the form of stock options and share grants.

But the agency problem is quite pervasive, and it is interesting to examine some other examples in order to compare their compensation structures with those employed by compensation consultants for senior management.

Compensation consultants are another example of agency – they are the agents of companies (boards of directors) who retain them. How are they paid? Generally they are paid a fee for service, where somehow the fee tends to be positively correlated to the aggregate value of the compensation package for the CEO and one or two other key members of senior management. The fees are not contingent on how effective the proposed compensation package is in motivating senior management, and/or in producing superior results for the shareholders (whom boards of directors represent).

Executive search firms provide a further example of agency. They are hired to find the “right” people to fill senior management vacancies. They too are paid a fee for service, with the fee correlated to the aggregate value of the compensation packages of the executives they recruit. The fees are not contingent on the performance/success of the people whom they recruit.

These two examples raise the following questions. If these agents receive no performance-based compensation, why should CEOs and other members of the senior management team receive any such compensation? On the other hand, if performance-based compensation is necessary to align the interests of agents and principals, why don’t these agents receive most of their fees contingent on the success of the advice they offer?

Management consultants are another example. Most often they receive a flat fee regardless of whether their advice is used, or if used, regardless of whether it creates any value. There have been some cases where part of the fees paid to management consultants have been contingent on the value of their advice.

Investment advisors, generally investment bankers, are yet another example. They are usually paid a monthly work fee, independent of outcomes, and a “success”-based fee. However, the success-based fee rarely has anything to do with whether their advice enhances the values of the clients’ companies over time. Rather, the fee is tied to doing a deal, regardless of its longer-term merits.

One might believe that reputation would compel investment bankers to strive to provide advice which truly is in the long-term interests of their clients and shareholders. (One might similarly believe that reputation might be sufficient to motivate CEOs to create value for their shareholders.) But what matters more for their reputation are the annual rankings in the number of deals, the total value of the deals and the total fees generated. The long-term value/success is largely irrelevant because senior management always can be blamed, as with management consultants as well, for poor execution.

In most cases of agency (lawyers, advertising agencies, public relations consultants, auditors, credit rating agencies), compensation is rarely linked to performance. So why should CEOs’ compensation be linked to performance? Why not just pay them a fixed annual amount, and let shareholders decide whether their contracts should be renewed? The real super-stars, and there are very few, will be richly rewarded when they test the free agency market for their services. The mediocre will not be overpaid and will join the unemployment lines much more frequently than they do at this time.

Or, if performance-based compensation is critical for solving the agency problem, then why are not all agents paid most of their fees contingent on the longer-term value of their advice? Would Goldman Sachs have given Greece different advice if their compensation were linked to the long-term financial stability of the Greece?

The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.


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