THE BLOG
01/28/2013 01:45 pm ET Updated Mar 30, 2013

Time Is Ripe for Board Leadership on Executive Pay

The board of JPMorgan Chase took a bold step last week when it slashed CEO Jamie Dimon's bonus in half in the wake of management's failure to rein in excessive risk taking. Reducing the CEO's pay by $10 million may hardly matter against $6.2 billion in trading losses, nor does it address the swing for the fences incentives that underpin the loss. But it was still refreshing to see a board reduce pay for cause, even if the CEO has spoken in favor of clawbacks and seems to respect their decision.

Could this action signal a new opening to the dialogue about executive pay? There are reasons to suggest we are at a turning point. For starters, how corporate executives are paid looms large in the public consciousness, and is strongly linked to distrust in business institutions. The issues of inequality and fairness in pay are also getting a new hearing at Davos and beyond.

The issues are complex. Businesses operate in a competitive environment; pay is central to attracting and retaining talent, and in spite of the predictable hue and cry when a CEO is paid stratospheric amounts amid a crisis, we are wary of the unintended consequences when government interferes. Yet, with investor votes on pay packages a reality and a tiny but growing percentage of companies earning a no vote last year, thoughtful boards will be need to spend more time on this issue in the future.

That means tackling three issues.

The first one is about the direction and power of incentives -- what behavior does the structure of the pay package reward, mostly? The second is transparency -- is it easy to tell what the executive actually earns -- delayed compensation, incentives, perks and all? Is the package designed to illuminate or obfuscate how much the CEO actually takes home? Finally, we have the third rail issue of fairness -- is the pay level is appropriate and who decides?

This is America: no one is asking corporate execs to don a hairshirt. But, the numbers and trends are still troubling. Last year, according to the Hay Group, and perhaps as a result of the say-on-pay law, pay leveled off, and greater emphasis was placed on long-term incentives aligned to stock price. But with the average pay of S&P 500 executives dancing around 400 times that of the average worker, the issue of pay isn't going away any time soon.

There are winners and losers in this game. In addition to the CEO, the clear winners, today, are the short term shareholders. Institutional Shareholder Services (ISS), which influences some 30 percent of the vote when it recommends against a pay package, puts its emphasis on the "disconnect" between pay and so-called "performance," euphemism in ISS parlance for share price. Total Shareholder Return is the primary metric used, and they measure against a peer group of companies. By this system, we are pretty much assured that boards, first and foremost, will pay their CEO to boost the short-term share price. Some, but not all, would argue that is the CEO's job anyway.

Who loses under this game? In one example, documented by Bloomberg, the employees take the hit. The CEO of McDonald's earned $8.75 million in 2011. That is roughly 500 times the wage of a front line workers at a McDonald's store, assuming he or she makes minimum wage and can log in 40 hours, which doesn't always happen. In 1980, the year CEO compensation began to skyrocket, the average S&P 500 chief executive was paid only 42 times the typical worker. Another piece of data is equally important: Last year McDonald's bought back enough shares to pay each company-owned store worker an additional $14,000. That's easily enough to get every last worker off of food stamps.

Who else loses? In a system that is designed to ratchet up share price in the near term, it's going to be nearly anyone or anything that involves a longer term bet or payoff. Except in the most confident and disciplined companies, it comes at the expense of R&D, employee development, customer service and other forms of investment that fall short in comparison with a share repurchase.

I will not be surprised if Dimon's pay package jumps back up over $20 million next year, after all, JPM reported $5.7 billion in profits for Q4 2012, so why would we not reward the leader? We can hope, however, that the Boards of high visibility institutions like JPM take this ripe opportunity to consider the tone and direction and examples they set, including connecting pay to long-term objectives that minimize the fixation on the movements of stock.

The system is perfectly designed for the results we have now. Can boards lead us to a better place?