03/12/2015 08:53 am ET | Updated Mar 12, 2015

Here's How To Fix The CEO Pay Problem

We’re doing CEO pay wrong.

Incentive pay -- compensation based on verifiable performance measures like stock price -- is on the rise. It’s supposed to help align executives’ interests with those of shareholders. Instead, it leads corporate boards to pay executives more than necessary, and ultimately hurts shareholders and workers.

With incentive pay, the company could end up paying the CEO for something over which he had no real influence. Or the company could end up not paying the CEO for actions that were good for the company, but for some reason didn’t raise the stock price. Most likely, the CEO will single-mindedly pursue actions that will boost the metric he’s paid on, even if they only succeed in the short term. Over the longer term, paying your CEO a fantastic amount can hurt stock performance.

The solution, according to a new paper by Peter Cebon, of the Melbourne Business School, and Benjamin Hermalin, a finance professor at the University of California’s Haas School of Business, is for the government to limit performance-based executive contracts and make informal pay agreements more attractive.

An informal contract, in its broadest and perhaps too-simple but illustrative sense, is like a board telling a CEO: “We will pay you for being a good CEO. The better a CEO you are, the more we’ll pay you.” It is, Hermalin said, really just a “series of promises” that aren’t legally enforceable.

Alluding to Odysseus’ escape from the Sirens, the paper's authors write that corporate boards setting executive pay need be to “lashed to the mast” with restrictions on the size of formal executive pay packages, which are the sorts of contracts that tie pay to objective, verifiable outcomes like the company's stock price or specific accounting metrics.

But boards can’t actually tie themselves to a mast, Hermalin noted to The Huffington Post. That’s why they need the government to restrict their options. This could be done, he said, by boosting taxes on all performance-based pay, by dramatically increasing taxes on incentive pay above a certain level, or simply putting a cap on total formal incentive-based pay.

Such regulation would encourage boards to enter into more efficient informal contracts, or what economists call relational contracts.

Having an informal contract for an executive may seem like a strange arrangement, but it's quite common for other workers. The vast majority of white-collar workers have a type of informal contract: a series of objectives established and shared between manager and employee. If and how those objectives are met is how salary and continued employment are decided. These objectives may be very well understood by the worker and his manager (hopefully, they are), and there are things the manager cannot fire the worker for or use to determine the worker's pay (see: discrimination, etc); but someone looking in from the outside with no experience in the worker's field would not be a very good judge of his informal contract.

For an informal contract to work at the executive level, there has to be mutual trust between the board and the CEO. The board also has to know a lot about its company and the CEO’s actions. That forces boards to be more engaged in, and informed about, the companies they oversee. That’s good, because when corporate directors are stretched too thin, the company’s performance suffers.

The problem with formally tying pay to stock price, Hermalin said, is that “stock performance is incredibly noisy, and a lot of that noise has nothing to do with what an executive actually did.”

The solution to that problem is for executive pay to be set on an informal basis by people who know the company and can directly observe the CEO. And if it takes government intervention in the market to achieve that, Hermalin is not too worried. There’s no “economic theorem,” he says, “that just letting boards write whatever contracts they want with their executives has to be the right course of action.”