Last weekend, while hanging out in San Francisco with some friends from my job last summer, we got to discussing the issue of executive compensation, which has been a hot topic lately to say the least. This question divides the people I come into contact with in my various travels perhaps more sharply than any other. My business school colleagues and the free-market believers in my RSS reader will defend executive compensation to the death. I was disappointed recently to hear a well-known Yale professor who I otherwise respect very much oppose any attempt to limit the bonuses of companies in the financial sector receiving federal assistance, using the same old argument for a rationale: that “the best” employees will flee to other firms, resulting in a talent drain at the organization at a time when talent is more important than ever.

I’m sorry, but after the failure of a number of companies this past fall led by some of the most well-compensated individuals in history, can’t we retire once and for all this notion that “the best” employees are the ones who command the highest salaries? When financial professionals justify their enormous pay packages by pointing to gains by their companies in the market, and then still take home enormous pay packages when their companies lose billions of dollars in that same market, isn’t there something wrong with this picture?

As I see it, the argument for current executive compensation practices rests on three separate faulty assumptions:

  • They’re worth it. Simply not true, according to academic research on the subject. (h/t FiveThirtyEight) Furthermore, with any new hire there’s a level of uncertainty, a risk factor if you will, about their effectiveness in a new environment. Past performance is no guarantee of future results, after all. Automatically offering to pay a candidate more than what he made at his last job ignores this risk factor.
  • If you didn’t pay them that much, they’d go somewhere else. Sure, this will be true so long as other companies participate in the same conspiracy of self-deception with regard to the other assumptions. However, many companies, particularly well-established ones, fail to properly value the non-monetary benefits that they provide to top employees, including connections, influence, prestige, and the enhancement of future career prospects. In fact, a study by former Yale SOM Dean Joel Podolny found that workers in the financial industry will actually demand more compensation to work at lower-status (i.e., non-bulge-bracket) firms, with the corollary that higher-status firms—which are invariably firms that can pay more—can actually offer lower compensation and still get the same-quality employee.
  • No one else could possibly do this job. Any executive position at a reputable company will have hundreds, maybe thousands of quality applicants. Is the difference in performance between the person eventually hired and someone a bit farther down the pack so vast as to be worth a 30, 40, 50% premium? Do you seriously mean to say that there are people who would have done worse for their companies than the recently departed CEOs of Bear Stearns, AIG, and Merrill Lynch? Isn’t it at least possible that a less experienced candidate with fewer external credentials but more integrity and intellectual honesty would have produced far better results?

The reality is that the highest-compensated executives in a given industry are not necessarily the best or most talented leaders of companies in that industry. The people who are in the best-compensated positions are merely the people who are the best at securing compensation for themselves. Should they perceive an opportunity to secure even more compensation somewhere else, leaving their current company in the lurch, they will not hesitate for an instant to make it so. It’s a classic agency problem.

A lot of this confusion stems from a narrow-minded focus on salary as the single axis of measurement for the worth of a job to employer and employee alike. Seth Godin addressed this issue recently and put it like this:

Law firms went through this cycle twenty years ago. The top firms competed with each other to recruit a too-small pool of talent from the top law schools. Unable to muster up even a mite of marketing insight, they chose to compete on only one axis: salary. So, 24 year olds were given jobs at $120,000 a year, when their peers from college were making 20% of that. The firms could have found great people at half the price, except that with only one axis, they had to be at the top if their peers were.

If you were a law student, the choice was easy. Either you got a job at a firm that proved its worth by paying a lot or you didn’t. You didn’t have to know anything about the firm, apparently, other than the fact that they were top tier, and the way you knew that was because they paid a lot.

Workers make choices about jobs based on a number of factors, with compensation being only one. Location, industry, function, challenge, work environment, relationship to the firm, the firm’s reputation, and the prestige of the position are all major factors that prospective employees consider. In Negotiation class we learn about distributive versus integrative negotiations. Distributive negotiations are the kind we usually think about: tugs-of-war in which any change in conditions will result in a win for one party and a loss for the other. Pure salary negotiation can only be distributive, assuming both parties like to have money. An integrative negotiation adds a third element: conditions that result in the improvement or worsening of the situation for both parties. A company’s location or a job’s responsibility level, for example, could play a role in an integrative negotiation, if what the company prefers is in the interests of the employee as well.

Wouldn’t we all be better off if companies pursued salary negotiations with executives in integrative rather than distributive fashion? Sure, they might get paid more if they went elsewhere, but they wouldn’t have the same experience. Call their bluff. They might have to endure a few more months of unemployment or stay in a job that they find unfulfilling. Or things might work out for them. But ultimately, don’t you want to avoid hired guns who are more interested achieving results for themselves than they are for your company? Don’t you want talented people working for you who want to be there? Don’t you want people who have an emotional or intellectual attachment to their work with you and want to make it as effective as possible? Isn’t that kind of a skill, really, that makes the employee more valuable?

I’ve been talking about these things in the context of the for-profit sector, but to my mind, they are just as if not more relevant in the nonprofit sector. A lot of people complain that compensation in the nonprofit sector is too low. In the aggregate, I agree (more on this in another post), but when it comes to executives, someone who would leave an organization over a few hundred thousand dollars that he doesn’t need is someone that probably doesn’t belong in the nonprofit sector anyway. Every incremental dollar that goes to an executive’s salary is another dollar that doesn’t get spent on programs that are the central focus of the nonprofit’s mission. Given the cash-starved state of most nonprofits, unless an organization can clearly justify that incremental expense over hiring a supposedly lesser candidate in terms of concrete outcomes for its constituents, its decision to pay that salary is both strategically and morally questionable in my view.

So how do we fix this situation? It’s a classic market failure scenario in which a suboptimal equilibrium has been reached because individual players perceive a strong disincentive to make the first move. If Bank of America takes a stand tomorrow and decides to pay all of its employees $100k or less, it probably will lose the best ones to other companies. But it doesn’t have to be this complicated, and that’s because of the third assumption I mentioned above. My advice to any reasonably-sized organization looking to get better bang for its executive compensation buck is this:

Hire from within.

Right now, most organizations recruit people from outside the company for executive positions—typically people who already have high-paying, high-profile jobs in their field. These people have all the leverage in a negotiation, because they can easily stay put in their attractive position where they know they can be successful. They will likely only leave for a big raise. By contrast, non-executive staff in the organization have no such alternative. They already know the organization and would have a shorter learning curve than a comparable candidate brought in from the outside. If the staff has benefited from professional or leadership development initiatives during their time at the organization, why let some other organization benefit from that investment? Consider this as well: the true capabilities of your organization’s staff are known much better internally than they are externally. This represents a competitive advantage: you have insider information on your own employees. Why not use it? Why go through the trouble of identifying outstanding candidates for junior positions if you’re not going to take advantage of their talents over the long term?

  • Adam Huttler

    It seems to me the devil is in the proverbial details on this one…

    Is there a number you have in mind that, once crossed, makes compensation unreasonable? How much does an organization’s budget size matter? Is performance completely irrelevant, or are you more tolerant of high compensation when the long-term performance seems to justify it? Should we consider whether someone has grown an organization or merely stewarded it?

    I do strongly agree with your aside about aggregate compensation levels (looking forward to that future post). I’ve done a fair amount of hiring in the NFP sector, and I can assure you it’s a problem when compensation levels are wildly uncompetitive with our FP peers. That’s especially true when you’re looking for folks with serious business training and skills, rather than just content/industry expertise. I’d love to do some recruiting from your MBA program, but I’d have a very hard time matching what folks could get on Wall St or Madison Ave. That’s despite the fact that I could offer a more interesting, rewarding position.

  • Adam Huttler

    Another thought occurred to me…

    What about compensation for specialists at NFP orgs? For example, the Chief Investment Officer at the Ford Foundation makes nearly $1M/year (see Guidestar). But that person is responsible for investing over $12B in assets. That’s pretty important! And the specialized skills involved would be in demand at any Wall St firm, so there’s real competition from the FP sector.

    I don’t think it serves the sector to be skimping on some of this stuff.

  • tonyjwang

    Loved the post Ian – good analysis on the compensation issue on a lot of fronts. What do you think of nonprofits doing something to what corporations have been doing for a long time – paying their employees to go to business school? I think you’re right that there is an underinvestment in human capital (which I find to be a recurring theme in the nonprofit and education markets and the developing world).

  • Will

    Ok, fair enough. But there’s one kink that plays to the negative in this scenario. It’s well known that, when an employee is promoted to a supervisory level, it’s that much harder to be an effective manager over one’s former peers due to the peer relationships based on equality built up over time. It takes considerable energy to change that dynamic, and some find themselves unable or even unwilling to make it stick.

  • Ian David Moss

    Wow, lots of interesting and great comments on this one! I’ll try to address them one by one.

    @Adam – You raise a number of important points, so much so that I’ve decided to respond to them in a separate post.

    @tonywang – I think paying employees to go to b-school could potentially be a very beneficial strategy, though a lot of complicated details would have to be worked out. Business schools are very expensive, after all. Perhaps some deal could be reached with schools that offer loan forgiveness programs, like mine, so that the nonprofit wouldn’t have to bear all of the burden. Or, they could pay for basic business training through a lower-tier business school, though that might shortchange their most talented employees. A lot to think about there.

    @Will – a very fair point, though I think that the situation you describe can be mitigated via good management and picking the right employee. Obviously, though, hiring internally won’t always be the right decision for a given organization.