How government must influence executive pay

Treasury Secretary Geithner is on the right track – mostly.

News item: Last year, compensation for the highest-ranking executives at America's 50 largest financial firms went skidding downhill right along with the economy. In 2007, the executives averaged $13 million a year; in 2008 they earned $9.8 million – a drop of 25 percent.

The decline, reported this week by Bloomberg, is unlikely to change views on Main Street that many of those on Wall Street are greedy – and not very good managers, either.

For three decades, CEO pay across America's major corporations has been racing ahead of what Joe and Jane Worker make. In 1980, chief executives made "only" 40 times the earnings of average workers. By 2007, it was 344 times.

Public outrage over executive compensation bubbled up during the Enron and Tyco scandals several years ago. But it reached full volcanic force earlier this year when bonuses at bailout-recipient AIG came to light.

Main Streeters, pitchforks in hand, rushed Wall Street – and Washington. Do something, the public demanded, and now, Washington is.

This week, Treasury Secretary Timothy Geithner announced a plan to limit compensation at companies receiving government help under the Troubled Asset Relief Program (TARP), as the administration was required to do by Congress. He also presented an outline for legislation that would increase transparency and lessen conflict of interest in setting corporate executive compensation.

With the exception of the TARP companies (more on that in a minute), Mr. Geithner is moving in the right direction. Admitting that pay "practices" were a factor in the financial crisis, he correctly identified the problem: "Incentives for short-term gains overwhelmed the checks and balances meant to mitigate against the risk of excessive leverage."

Note that he did not zero in on the amounts that executives are paid. As morally offensive as the totals may be, the far more important issue for the sake of the economy is pay "practices" – how pay is determined and doled out.

Is it done in a way that insulates America's businesses against excessive risk – or rather, that makes them more sensitive to it? Plain-old risk is not the concern here; it's the reckless kind that ignored mortgage borrowers' ability to pay that caused so much trouble.

In a capitalist system responsive to markets, the private sector – not the government – should determine pay and incentives. It was encouraging to hear Geithner say, flat-out, that the administration does not want to impose caps on pay.

But the government can play a useful role if it encourages compensation decisions that curb dangerous risk-taking and short-term thinking.

In a wisely hands-off way, Geithner proposes legislation that would shore up a corporation's checks and balances on compensation packages. He would give shareholders of publicly traded companies more of a "say on pay" – a yearly nonbinding vote on executive compensation. That would not only increase transparency of pay packages, it would also give those who have an ownership in these businesses more direct input. If shareholders actually use this leverage, they could have an impact.

The Treasury secretary also seeks greater independence of a corporate board's compensation committees that set CEO pay. These committees are typically loaded with friends of management or colleagues who do business with them. Just as the Securities and Exchange Commission insisted on independence for audit committees in the wake of the Enron scandal, so, too, should compensation committees be able to set salaries and incentives uninfluenced by personal or business connections.

It would be up to these committees to design packages that look more to the healthy long-term interest of the company and shareholders – stock options and bonuses that can only be exercised over years, for instance, as well as compensation consequences for bad performance.

This kind of approach can guide the private sector toward a healthier pay structure, but leaves it up to businesses to determine what's competitive pay and in the interest of long-term performance.

Unfortunately, that principle is not being applied to companies getting public aid. Geithner announced this week that a new "pay czar" will restrict executive compensation at seven of the TARP companies getting exceptional government assistance – including AIG and Citigroup, GM and Chrysler.

For years, government has had trouble recruiting and retaining talent because of low pay compared with the private sector. Now it needs the best and brightest to rescue companies in terrible straits – and it offers them less than their competitors at companies not getting government aid.

Clearly, Congress had the pitchfork-holders in mind when it gave the White House this order. Lawmakers are unlikely to reverse course on the TARP restrictions. What they should do is act on Geithner's proposed legislation just as quickly as possible to restore an even playing field for all of corporate America.

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