
90 Cents of Every 'Pay-For-Performance' Dollar for CEOs Are Paid for Luck - ikeboy
https://corpgov.law.harvard.edu/2016/09/29/90-cents-of-every-pay-for-performance-dollar-are-paid-for-luck/
======
woopwoop
I remember an interesting theory about golden parachutes in Steven Landsburg's
"The Armchair Economist". In a typical publicly traded company, the CEO is
actually much more heavily invested in the company than the shareholders. His
salary, and probably the major part of his assets, are dependent on the
performance of the company. On the other hand, the average share holder is
well diversified. Therefore, a CEO will be incentivized to pursue a highly
conservative strategy, while the shareholders may wish that he takes more
risk. To offset this, the shareholders may make it known that a generous
severance package, as well as generous benefits if the company does
exceptionally well, are on the table, to simultaneously soften the blow if he
takes a bad risk, and sweeten the deal if he takes a good risk.

In other words, the point of executive compensation may not be to produce
better results on average, but rather to increase the variance of the results.

~~~
amluto
> Therefore, a CEO will be incentivized to pursue a highly conservative
> strategy

I _strongly_ disagree. A CEO is probably highly personally invested in the
company, but that investment almost always has an unusual structure: it
resembles a call option, not equity. If a CEO generates a large gain over the
course of a few years, the CEO makes a lot of money. In contrast, if the CEO
generates a large loss over the course of a few years, the CEO loses very
little. This can give a CEO an incentive to make extremely risky decisions
because the CEO doesn't personally suffer much more from a huge loss to the
company than from a small loss to the company.

This problem exists for investment managers. In a hedge fund that charges a
performance fee on investment gains, managers have a perverse incentive to
take large risks. It gets more pronounced if the fund is already down for the
year: if, say, the fund has taken a 40% loss, it can look very attractive to
the manager to bet all of the remaining assets on a coin flip. Heads, they get
their bonus. Tails, they now have a 90% loss, but they weren't getting their
bonus either way and they lose nothing.

Edit: At least the coin flip is neutral on expectation. But the same issue
exists for a bet with negative expected value: the manager gets some benefit
if they get very lucky, so the manager has positive expected value even if the
fund has very negative expected value from their decision.

~~~
supster
Actually hedge fund managers tend have a large portion of their net worth
invested in the fund also.

~~~
amluto
Even when this is true, it doesn't necessarily solve the problem. Say you're
28 years old and you're running your first fund. You have a net worth of $500k
(because you worked 100-hour weeks as a banker for a few years, paid your
student loans, and saved up). You put $400k into your fund and raise $50M. You
charge a 25% performance fee.

If you get 10% returns, that's $1.25M for you (at a possibly low tax rate,
too) plus $40k on your own investment. If you lose 20%, you're out $80k.
What's your incentive here?

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mpdehaan2
Excellent points in this article - another factor is they are often paid
outrageous base salaries (plus options) for the success of a company, when the
success of that company can often be in spite of the CEO, coming from within,
and embodied equally by all of the collective employees.

Executive comp is a major racket, enforced by the standard that this is "what
the market average is". Which is set by executives overpaying themselves.

Ask yourself if your CEO is really working 100x as hard as you, or 100x
smarter than you. The answer is usually a definite no. I'd really like to see
more fair pay in this area and a culture that treats contributions of all
employees more equally.

~~~
MattRogish
A _general case_ CEO/exec job is far, far riskier than a IC software
developer. If you're a fantastic (heck, halfway decent) developer, you can be
fired, laid-off, or simply quit and find a new job relatively quickly. And
yes, you're generally paid a lot of money (compared to the rest of America).

As an executive in a _general case_ (sure, we can all find outliers) company,
there are comparatively far fewer jobs for you to go to. If you fail, you fail
spectacularly/publicly and may not be employable for _years_. The high
compensation is in exchange for the risk of the job and the low probability of
finding a new one.

Semi-related (not what you said - of course): "I deliver $1M in value to the
company so I should be paid $1m" is a thing I see every now and again. That's
not even remotely how any of this works.

~~~
djb_hackernews
The general case is CEOs are part of the management club, a club that protects
itself much like a trade union.

CEOs fail all the time, and they aren't shunned but rewarded with golden
parachutes and positions on boards of other companies, biding their time until
they can "come off the bench".

The management club is something to be admired and I wish engineers would try
to adopt some of its behaviors instead of viewing ourselves as mercenaries.

~~~
Spooky23
It's divide and conquer.

Engineers are too impressed by their own intelligence.

~~~
javajosh
No, it's that we are too idealistic and are turned off by the messy, immoral
greater world in which the management club makes their money. We want things
to be beautiful and fair and so we spend our time constructing abstract
fantasy lands in miniature.

The great irony, of course, is that the messy and immoral world intrudes even
there because rational idealists can't find consensus and are subject to the
biases that require conventions, institutions, politics and regulation just
like the legal and business worlds.

If we were rational you might say we chose "playing with fun toys" over
"controlling thousands of people and millions of dollars, and influencing
millions of people and billions of dollars". Perhaps, for some people, that is
indeed the rational choice if you don't really trust yourself.

------
ransom1538
From my years of startup experience: luck determines basically everything.
What company you end up picking, what team you get placed on, how your
interviews goes (remember merge sort)?, what problems you need to work on, who
your boss is... even if your company survives. Your entire company can lose
funding because of an argument on a golf course or Apple TOS change (sigh). At
larger companies what team you are on is well.. everything. How were you
picked for that team? Because the boss of the other department was on holiday
that day.

I smile when I hear people actually think they can control their own luck.
That is how religion started. Whatever makes you happy.

"I am going to pick my OWN boss, I am going to join the start up I want to
join with MY purpose." No, you will pick the boss from a super small subset
that has a position open and you are going to find a company that needs you
'currently'.

Who gets promoted? Generally, lucky loud people. Who makes sales quota? People
given the best accounts (luck). Who goes IPO? People that bumped into an
untapped market.

Do what you want. People's evaluation of you is just based on luck.

~~~
rm_-rf_slash
Everything is based on luck. 99.9% of humans in history were born into what
the average American today would consider extreme, abject poverty.

I did not choose to be born into a family of upper-middle class American
academics. I did not choose to be born on time with excellent health any more
than my uncle's fetus chose to be exposed to lead paint, get born 3 months
early, and become severely developmentally disabled for the rest of his life.

Even if spmeone came from literal rags and made literal riches, they still
benefited from a civil society, rule of law, access to education, and so on.

I am fully convinced that the only healthy and ethical approach to live is to
be grateful for everything you have, and empathetic for others whose needs are
unmet.

~~~
lutusp
> Everything is based on luck.

ITYM _chance_ , not _luck_. Luck describes a supernatural force. Chance
describes simple randomness.

~~~
rm_-rf_slash
The way I see it, chance is what is out there, luck is getting what you didn't
know you had.

------
AndrewKemendo
I don't think it's possible to reliably link pay to performance for anything
other than measurable immediate production - like manual labor. Forget
reliably doing it for executives. The reason is, because long term price
impacts of individual performance are not knowable, so they cannot be priced
effectively.

The executive compensation system right now is built on social proof and
positioning, not on auditable causal decision chains. Too many dependencies to
make causal connections.

------
jbb555
Bonuses are not to be considered to be pay for performance.

They are to be considered as a part of pay that can be withdrawn if either the
company does badly and can't afford it, or if the employee does visibly badly.

They are a good thing for the company because they can decide not to pay it,
except in as much as they allow the company to pay more because they can
withdraw it if necessary

~~~
sidlls
Bonuses for executives or bonuses for regular employees? Every bonus item in
any employment package I've had has always been tied to the company's
performance and my individual performance. I have never once worked anywhere
with an automatic, performance-independent bonus, from tiny shops working as
government contractors to large and well-known corporations. This is
anecdotal, obviously, but I'm talking about myself and literally hundreds of
thousands of other employees across all the organizations I've worked for. I
am not denying such bonus structures exist in some places, but I'm skeptical
that it's common or not considered an extreme aberration.

~~~
TeMPOraL
I don't know if it's common, but I'm currently employed in such a company.
Basically, at the interview I asked for $X / month after benefits[0] and
taxes, and what I'm being paid is ($X - benefits - taxes) / month base, +
performance bonus equal to the amount that went to the government in my name.
I get the bonus by default, but they can suspend it if I perform visibly
badly.

[0] - don't know the right English vocabulary for that; in Poland, if your
employer pays you X directly, then he actually costs you Y, where Y > X, and
the difference is what he pays as a contribution to your social security and
health insurance.

EDIT I was misremembering things, so I doublechecked my payslip and fixed the
comment to reflect "real reality".

~~~
lutorm
Interesting arrangement. If your tax rate goes up, does your pay go up too?

~~~
TeMPOraL
It probably will, though most likely only after renegotiation of contract. The
bonus amount was calculated off the $X I asked for and is "hardcoded", not
computed dynamically from the taxes and social/health payments.

AFAIK we didn't have the (income) tax rate changes since at least 2009, so I
don't know for sure.

------
johnhess
I love this very honest appraisal of how pay-for-performance incentives ought
to work, and I wish more companies would step back and ask themselves if their
"traditional" incentive structures have the motivational factor they're
"traditionally" assumed to have.

While _startup_ performance is less correlated to market performance than an
established firm, the concept of setting the bar as outperforming the
industry/market is brilliant, and I wonder if there's a good analog in the
startup space, particularly for employees.

Bonuses and stock options are all well and good, but they incentivize the
firm's survival and success. A single employee may be unable to change that,
even if they perform exceptionally. Those incentives are great for "share the
wealth" and "all for one, one for all" camaraderie, but they don't incentivize
individual performance.

------
calinet6
True at all levels; statistics are rarely taken into account in _any_
performance review or measurement process. It is always assumed that the
individual is responsible for his or her own performance. However, the
opposite is largely true: the system and environment the person is in accounts
for a disproportionate level of the end result.

It's an uncomfortable truth because it mucks with our sense of free will and
control, but it is a well known phenomenon (attribution bias) with countless
examples. This CEO incentive pay version is simply the most extreme.

------
neximo64
Or you know, 'luck' is just what couldn't be mathematically described in the
model, attributing it to randomness.

------
pitchups
A while back I came to the following conclusion : "We often attribute our
success to our skills and talent and failure to luck - while quite often it is
the other way around." :)

------
Tharre
As much as I'd like to believe that CEOs are basically payed for chance, this
research is deeply flawed. As in, it's literally trying to measure the
(practically) immeasurable.

More specifically, it's this assumption:

> We model the impact of a manager on her firm’s performance by assuming that
> a manager who exerts effort and manifests her talent increase the firm’s
> expected return by the magnitude of her talent.

that is simply not true. The performance of every CEO is amplified by the
amount of people he's affecting. And that is made even worse by the fact that
companies are competing against each other, meaning that usually it's not
their total performance that matters, but the difference to the next best
company. You end up with so much noise in your data that yes, the result looks
random. But is it? We don't know.

The only accurate measure of performance (that we know of) is performance
itself.

------
hbt
On a related note, is there any successful pay for performance scheme for
engineers?

Pay-per-performance is well established in sales and marketing. Even when the
sales/marketing strategy requires a large team to implement, the spoils go to
the top.

It seems the only time engineers get properly compensated for the value they
create is when it is so obvious and the owners can't get away with stiffing
them.

Startups are well known for stiffing engineers because the teams are small,
there are no repercussions and the founders don't have much of reputation to
begin with. It's harder in bigger companies since it sends the wrong message
to others in the company and destroys your reputation.

Maybe there is no such thing as fair compensation. Just get leverage and
negotiate or obtain a position of power (authority) within the company.

~~~
jimbokun
Patrick McKenzie has written about this extensively.

~~~
hbt
He wrote on salary negotiation and creating value as a consultant + boosting
his rate.

Is that what you are referring to by pay-per-performance for engineers?

~~~
jimbokun
Yes.

------
pierrebai
"I've met very few good plumbers, it takes a special person of talent to be a
great plumber."

"I've met very few good truck drivers, it takes a special person of talent to
be a great truck drivers."

...

There is a whole premise in many post about this story that it's somehow a
very rare thing to be able to run a company well and that the person filling
the role of the CEO is the main driving factor of success. (Instead of
economic factors, outside forces, performance of other employees... oh! I
know! The other employees performs solely because the great CEO makes them do
so.) I think there's a lot of egotism being expressed in this thread...

(Especially by VCs who basically say they're impervious to misjudging
someone's abilities and its true influence on success.)

------
milesskorpen
They found a way of structuring bonuses that works nearly twice as well — too
bad it was a bit buried in the summary: "Indexing the option, and setting the
strike price much higher than the granting-day price almost doubles the
option’s motivational power"

------
smallnamespace
It's well worth it to remember than equity is just a call option on the value
of the firm.

Therefore, it's often in the equity-holder's interest to do two things:

1\. _increase_ the volatility of the underlier (by making riskier investments,
etc.)

2\. Re-strike the option to be closer to at-the-money, by loading up with more
debt or paying out cash as dividends

Both actions increase the odds that the firm goes bankrupt, but also increases
the expected payout to equity holders.

When you increase equity compensation to executives, you basically encourage
them to do riskier things.

------
gravypod
I think this video, by Louis Rossmann, is very important to this discussion.

[https://www.youtube.com/watch?v=-q6hpsGjcIo](https://www.youtube.com/watch?v=-q6hpsGjcIo)

I don't think you can ever accurately account for what is "luck" and that it
is actually harmful to our own abilities to call something luck and write off
whatever was actually done by the CEO. I think this is a good watch and I look
forward to hearing what others think about the video.

------
lefstathiou
I think there is a simple and rationale explanation for this...

I believe founders that step away from the role of CEO seek to put in place
someone who prioritizes the business as (close to) as much as they do (ie
before family, friends, life etc). The problem is how do you find someone to
love (yes love or at least pretend to) the business without them owning a
meaningful piece of it (the equity that is)? When granting sixeable equity is
not an option (most founders I know who built successful companies are highly
protective of it) the solution is you buy it. Mark Zuckerberg owns 30% of
Facebook. The professional CEO that one day replaces him will own 0.0000001%
of it. That's not very motivating for entrepreneurial CEO types who are ideal
for these roles. Mark isn't going to go to sleep easy at night unless he knows
the person running the show eats sleeps and breathes Facebook the way he has
for the last 30 years. That person is buying his dream, he's buying their
loyalty and commitment (and great judgment, etc etc).

------
gnicholas
The article seems to assume that CEOs are believe that they have very little
impact on a company's success, and that they calculate how much effort to
exert accordingly.

My understanding is that CEOs tend toward hubris and that this assumption is
false in most cases. If so, then it might be more efficient to up the strike
price, but the current situation isn't as inefficient as it seems (thanks to
hubris).

Relatedly, if CEOs were granted deeply-underwater options, wouldn't they
demand much more in base pay, to compensate? I'm not saying they "deserve"
higher base pay—just that if a board wanted to institute this change, they'd
get push back from the individual. Otherwise it would look like a disguised
pay cut (imagine if your boss came to you and said that to incentivize
employees to work harder, all options were going to be issued underwater).

------
mcguire
People keep talking about "shareholders" in the comments here. Where, exactly,
do shareholders come into the picture?

C*O compensation is set by the board of directors. The board is determined by
the executives' recommendations. The only shareholder who matters is Carl
Icahn; the only power most shareholders have is to sell shares. And I'd be
willing to bet something that their willingness to do that is only related to
short term performance.

------
lutusp
> ... Paid for Luck

I wish academics would have the sense to avoid the word "luck" when "chance"
is the principle at work. These people should know better.

------
jernfrost
Michael B. Dorff wrote a book about this called "Indispensable and Other
Myths":
[http://blog.translusion.com/posts/CEO%20Salaries/](http://blog.translusion.com/posts/CEO%20Salaries/)

His conclusions were that CEOs don't really matter all that much. Exceptional
ones like Elon Musk or Steve Jobs are quite rare.

------
musgrove
Not sure how one would control for "luck" in a (legitimate) academic study.
The definition of it is broad, to say the least.

------
chatmasta
Does overpaying the top executives of a company, regardless of performance,
increase motivation of all the other employees of the company? After all, the
underlines want to become the CEO one day. The higher the reward for the CEO,
the more tantalizing the carrot dangled in front of his underlings.

------
simon_
Analyses on this topic are always so bad. Some counterpoints:

(1) CEOs are intentionally aligned with shareholders, for good reason.
Shareholders often make money due to luck, so eliminating luck from CEO
compensation without breaking alignment is a very hard problem.

(2) Going in, a CEO (or a shareholder) needs to lock down a big future payday
in the upside case, in order to compensate them for the risk of the downside
case. Yes, the upside case usually involves some luck, but the "optionality"
to get paid in a lucky outcome is a valuable part of the deal.

(3) CEOs are also paid to be trustworthy agents for shareholders/boards.
Like... if I am a billionaire looking for you to oversee a big part of my
capital, I may pay a lot just because I know you are a good/smart/reasonable
person who will be autonomous but raise the right issues to me if needed,
reliably. I might know all that just because we have been buddies for years,
and even though there are lots of objectively more talented people out there
who would do the job for less, paying you more would not be irrational for me.

~~~
c3534l
(1) The study specifically talks about the motivational effect of performance
pay and finds that the component of luck means that performance pay must be
more difficult to achieve in order to motivate the executive officers to align
their interests with the company.

(2) You could reduce the financial risk of executive officers by paying them a
fixed salary. In fact, different companies offer very different compensation
plans. This was a review of those plans to see what did and did not work.
Generous performance pay does not work.

(3) This is an issue of whether executive officers should be paid well in
general, not the value of performance pay. And at any rate seems to be a
justification for nepotism in an area of business that is already
dysfunctionally nepotistic.

------
JamesBarney
Is this 90% a upper or lower bound?

I mean did they try to measure luck and found that it accounted for 90% of
returns?(lower bound because their measure of luck was probably imperfect)

Or did they measure talent and were able to account for 10% of the
returns(upper bound).

------
aisofteng
Replace the definition of T with "the number of unicorns helping" and nothing
changes. The author's T does not represent anything tangible or measurable.
These conclusions are meaningless in any practical sense.

------
jwatte
Now consider that whether you end up born in an industrialized country into
circumstances that will let you become a CEO in the first place requires a lot
of luck...

------
tmpdude01
This is a profound misunderstanding of corporate governance, and the fact that
so many people here somehow agree with the assertion that CEOs are paid for
luck is astounding.

~~~
wstrange
It would help if you could add some more substance to that assertion.

CxOs clearly require some competence- I don't think that is in dispute. It is
the 200x + salary differential that is in question and the subject of the
article.

Can you cite some other studies that contradict this?

------
draw_down
Sounds like a good racket.

------
whack
Please update the headline to reflect the fact that this study is focused
purely on CEOs, and stock-price-based-performance. The vast majority of people
who are paid-for-performance are not CEOs, and are not graded based on stock-
price movements.

------
hammock
CEOs are primarily paid to bear risk, so this makes perfect sense to me.

~~~
cmurf
What risk are they bearing in comparison to the company itself, or separately
even its shareholders? Or heck, even its bond holders? About the last person
whose shouldering risk is an officer of the company, that's the whole point of
officers vs boards vs shareholders.

~~~
retube
Officers are increasingly taking on more and more legal liabilities. There's
definitely a growing need for danger money in some industries.

Would you be a bank CEO if it meant jail if one of your 100,000 employees was
caught laundering cash or passing on insider information?

~~~
jaynos
>Would you be a bank CEO if it meant jail if one of your 100,000 employees was
caught laundering cash or passing on insider information?

IF that was actually a risk, I might consider it, but thanks to the Holder
Memo, we have "Too big to jail".

"Kareem Serageldin was an executive at Credit Suisse who was described by
friends as an “investment-banking monk.”[1] As of April 30, 2014, Serageldin
was also the “only Wall Street executive prosecuted as a result of the
financial crisis” that triggered the Great Recession.[2] On Friday, November
22, 2013, Serageldin—the former Managing Director/Global Head of Structured
Credit in the Investment Banking Division of Credit Suisse Group—was sentenced
to 30 months in prison in connection with a scheme to hide more than $100
million in losses in a mortgage-backed securities trading book at Credit
Suisse.[3] Serageldin also agreed to give back $25.6 million in compensation
to Credit Suisse, and was later ordered to pay more than $1 million to settle
an SEC lawsuit." [1]

[1]
[https://en.wikipedia.org/wiki/Kareem_Serageldin](https://en.wikipedia.org/wiki/Kareem_Serageldin)

