Rationalizing Compensation Systems for the Twenty-First Century

Critics of corporate board performance are increasingly advocating that directors be paid for their services to their companies in corporate stock. Some reformers go further, arguing that compensation should be solely in the form of stock, and that such holdings should be “restricted,” so that directors cannot easily sell out. Directors should, in the colorful phrase of Sarah Teslik, executive director of the Council of Institutional Investors, “eat their own cooking.” Adds Albert J. Dunlap, chairman and chief executive officer of Scott Paper Co., “If you don’t believe in the company you’re going to work for, why should anybody else believe in it?”‘ In line with this thinking, Scott Paper changed its director’s compensation rules in 1994 so that Scott directors are now paid solely in Scott Paper stock.

Advocates of equity-based compensation systems for directors and executives usually argue that tying compensation to stock performance aligns the incentives of directors and executives with those of shareholders. This is a valid and important rationale for such systems. But, from society’s standpoint there is another, perhaps more important reason for equity-based compensation schemes, a reason that applies not only to directors and executives, but to employees all the way down and back up the organization charts of most companies.

Properly structured equity-based compensation systems, used widely throughout companies, could have enormous social benefits because they would greatly improve the social efficiency of hiring and firing decisions throughout the organization. The reason is that most employees, in most companies, make substantial investments over time in skills, specialized knowledge, and personal and professional relationships whose value is very “firm-specific”—in other words, investments that are valuable to their employers, but less valuable, or in some cases utterly worthless to other employers. Those investments are at risk in a way very much like the way that equity capital contributed by outside shareholders is at risk. With standard, cash-based compensation systems, employees who invest in “firm-specific human capital” are paid salary and benefits based on their productivity with their current employer, a level which may be considerably higher than their short-run opportunity cost, which is determined by what their productivity would be in altemative employment.

Economists know this is true because studies of working people who have be-en laid off through no fault of their own (because of plant closings, for example) show that, on aver- age, such employees make 10 to 15 percent less on their next job. Employees who had been with the same employer for 10 to 20 years, make an average of 25 percent less on their next job, and employees who had been with the same employer for more than 20 years make more than 40 percent less on their next job.’

Why would that be true? Economists who have studied this problem argue that when individuals are laid off and forced to redeploy their skills elsewhere, they will be compensated only for their “generic” skills on their next job. Although they had earned higher pay over the years on their previous job, they cannot command such high pay on their next job because part of what they were earning on their previous job was a return on their “firm-specific” skills.

Why Downsize?

Companies have an incentive to lay off employees whose productivity, for whatever reason, falls below the value of their promised salary and benefits. When Dunlap took over as CEO at Scott Paper in early 1994, for example, he instituted a massive restructuring in which one-third of Scott employees have been laid off, including 71 percent of headquarters staff, 50 percent of management, and 20 percent of hourly people. Presumably such downsizing and cost-cutting was driven by an effort to get costs in line with actual productivity (and ultimately, to get productivity up). But if the laid-off Scott employees were typical of laid-off employees economy-wide, consider the impact that such layoffs had on society.

Consider, for example, a hypothetical laid-off Scott manager, who was being paid $80,000 (in total salary and benefits), but whose contribution to the firm was generating only $75,000 in revenues for Scott. (These numbers are meant only to illustrate the argument. As a general rule, it is probably impossible to break out the value that any one manager contributes this precisely.) This sort of thing could easily happen with fixed, cash-based compensation systems, and may help explain why Scott Paper got into trouble in the first place. Imagine, for example, that this manager had reached his current pay level several years earlier by working in a part of the business that, at that time, had very high margins. The manager’s net contribution might have been adding $85,000 per year in revenues in those days, or $90,000, or even more. But suppose that external market conditions changed, for reasons that were completely out of the control of the manager, so that his productivity declined to $75,000 per year.

Keeping that manager in place once his productivity declined would cost the shareholders about $5,000 per year. When these sorts of situations exist in large numbers in corporations, mass layoffs and restructuring can cause stock prices to rise. Firing this hypothetical manager, for example, would remove a liability whose (negative) value to the firm is something like $40,000. (The present value of a ten-year stream of losses of $5,000 per year, discounted at 5 percent, is $40,539.) If shareholders had access to all the necessary information, we would expect to see the equity value of the firm rise by about $40,000 when the manager was fired. If such savings for Scott Paper were typical of each of the 13,000 employees Scott Paper has laid off in the last few years, the layoffs alone would be expected to produce about a $500 million gain for Scott Paper shareholders. If the losses to the company per laid-off employee were higher, of course, the savings would have been even greater for firing them, and the stock price increase resulting from firing them even greater.

On the other hand, supose the manager’s next best opportunity outside Scott Paper allows him to earn only $60,000 (25 percent less than he was making at Scott, which as noted above, is the average for employees with 10 to 20 years of service with a single employer). While the shareholders gain $40,000 by firing the manager, the manager loses a stream of income worth something like $162,000 (the present value of a $20,000-per-year stream of income, discounted at 5 percent over 10 years). Thus there is a net loss, to society as a whole, of something like $122,000 resulting from Scott Paper’s decision to fire this manager. Multiply losses of this magnitude times the number of people laid off in corporate restructurings in the last few years, and the social costs of such decisions begin to loom rather large.

(Of course, if Scott Paper waited until our hypothetical manager’s productivity fell all the way to $60,000 before firing him, the gain to shareholders from fuing him would be $162,000, exactly equal to the loss to the manager. In such a case, the firing results in a transfer of value from the employee to shareholders, but the net loss to society from redeploying this manager would be zero. If the manager’s productivity at Scott Paper were even less than $60,000, shareholders gains would exceed the losses to the managers, and there would be a net social gain from redeploying the manager. The restructuring gains at Scott Paper—on the order of $4.5 billion as of mid-September—have been so large that this is arguably what happened at this company.)

Compensation Systems and Financial Incentives

So, what does any of this have to do with compensation systems? First of all, drastic cutbacks like those at Scott Paper require tough decisions. To the extent that the executives and directors who must make these decisions, or actually hand out the pink slips, are themselves significant shareholders, however, they have a powerful financial incentive to make the cutbacks and other necessary changes because they will share in the financial benefit from doing so. That incentive presumably helps to counteract (for the executives and board members, at least) the unpleasantness of the task of laying off large numbers of people. This is the standard story about why equity-based compensation systems for management and directors are supposed to be a good thing.

But imagine how much better off society as a whole would be right now if all of Scott Paper’s employees had been compensated significantly with stock all along. Suppose that, instead of making $80,000 in fixed, cash compensation and benefits, our hypothetical manager had been paid only $60,000 in fixed, cash compensation and benefits (his true, short-run opportunity cost), but that over the years, this employee was compensated for his firm-specific contributions with stock grants (in lieu of salary), such that his return on the stock, on average, made up the difference and gave him an average total income from his relationship with the company of $80,000. Under this scenario, the manager would have had a strong incentive to confront the problems at Scott Paper when the productivity of his operations first began to fall. Moreover, even if the decline in the value of the manager’s contribution was ultimately unavoidable, the company would not be eager to lay off this manager when his productivity first fell below $80,000, but rather, would want to keep him on as long as his productivity exceeded $60,000—his true social opportunity cost.

Since, under this plan, the fixed part of his compensation would reflect his true opportunity cost, the decision about when to lay him off and force him to redeploy his skills elsewhere would come much closer to being socially oplimal. In the meantime, the manager would still have a strong incentive to invest in the sort of firm-specific skills that make his productivity as high as possible at ScotL

In sum, there are two sets of problems that equity-based compensation schemes help to solve. The first is the motivation problem—aligning the incentives of decision-makers in the organization with those of shareholders. And the second is what might be called the “signalling problem.” Compensating employees—or executives or directors for that matter—with fixed, high salaries sends the wrong signal about the true social costs the company is incurring when those employees are on the payroll. Part of the salaries paid to those employees is not a cost in a social sense, but a return to those employees for their specialized contributions, a return that comes out of the economic surplus being generated by the enterprise. Under standard compensation systems, however, those salaries are treated as part of what executives scramble to reduce in times of trouble in order to increase shareholder value.

Equity-based compensation systems that pay directors, senior executives, mid-level managers, and rank and file employees fixed wages for the generic skills they bring to the organization, and pay them shares of equity for their firm-specific knowledge and skills, would motivate employees at all levels to work toward enhancing share value. Moreover, such systems would send the right economic signals about whether to lay off employees and force them to redeploy their skills elsewhere, or to hang on to their valuable human capital.

By contrast, systems that powerfully incentivize senior managers and directors to maximize share value, but fail to rationalize the compensation system throughout the organization, tend to encourage mass layoffs and cutbacks that enhance share value at the expense of employees who have made investments in f-irm-specific skills. In the short run, such layoffs can enrich shareholders, but may impose sizeable costs on laid-off employees, costs that may exceed the benefits to shareholders. The long-run social costs of such systems are even greater, however. Over time, working people will learn that the value that they create by their investments in firm-specific skills can be expropriated from them at any time by zealous executives, hell-bent on cutting “costs,” and they will be discouraged from making those investments in the first place.

What Do We Do Next?

Will it be easy to rationalize compensation systems throughout companies? Do we have good or obvious ways to measure the contributions that individual employees make, and parse them out into those that result from “generic” skills and those that result from “firm-specific” skills? Of course not. But, then, neither accountants nor compensation consultants have ever thought about the problem in this way or tried to devise better measurement systems based on this model. The few large companies that have avoided mass layoffs by negotiating wage cuts with employees in exchange for significant equity stakes (United Airlines, for exwnple), or that have implemented significant stock ownership plans deep into the ranks of employees, are moving in the right direction. But such actions by firms are rare and still somewhat tentative in nature. The issue of compensating directors, managers, and all employees in ways that foster, rather than punish, investments in firm-specific human capital are obviously most critical in firms where the human capital is the most important asset. In the knowledge-based economy of the coming century, however, it seems likely that such firms will become increasingly prevalent. If so, we may one day look back on the 1990s, when compensating directors with equity stakes seemed like a new and controversial idea, as the beginning of a massive transformation of the corporate sector in which not just execufives and directors, but employees at all levels, came to be significant stockholders. All employees, then, will share in the feast—or gruel—that they serve up to shareholders.