Monday, January 10, 2005

Merely Golden Parachutes Are So '90s

by Tom Bozzo

The headline "Mayday? Payday! Hit the Silk!," shouting at me from just above the NYT Sunday Business fold, reminds me that Brayden King has another post that ties into his ongoing series on executive compensation practices.

Here is the least believable quote from yesterday's Times article:
Some specialists say that criticism of pay practices is unwarranted. "There is a tendency now to take a more democratic [he means "egalitarian" -- ed.] approach and give senior management severance based on the same formula as everyone else in the company," said Doug Matthews, an executive vice president at Right Management Consultants, a Philadelphia firm that advises clients on pay issues.

We'll cycle back to this later.

Brayden discusses recent sociological research indicating that while large firms pay equally qualified candidates better than small firms, the firm-size effect has been diminishing, as
Employees are less likely to be promoted internally and are also less likely to work for the same company for years as they once did. As larger firms usually had the most integrated and rewarding ILMs [Internal Labor Markets], the decline of ILMs has led to a diminishment of the [firm size wage effect].

I have a couple of on-point anecdotes from my immediate family (neither of which I'm at liberty to blog, sorry) that makes me inclined to believe elements of this story, though I do wonder about confounding effects. What would be slick, though just about impossible, would be to control for productivity of the firms somehow. Brayden then asks a very good question:
I wonder what the overall effect this has on employee wages - something [the author] doesn't address directly in this article. Economists might say that highly qualified employees can actually boost their wages by playing the external labor market. Unfortunately, the opposite may hold for low skill workers. Perhaps this is another contributing factor to the increasing inequality in wage compensation we've seen in recent years.

As a matter of fact, I would say something like that, and I think Brayden has the effects basically right. An interesting follow-up question is how often it actually happens.

To some extent, the external labor market comes to the qualified employees. As far as I can tell from my own social network, practically every private sector professional gets calls from 'headhunters' from time to time. When the recipients of such calls aren't interested in what's on offer, recruiters invariably ask to be referred onward to other potentially qualified candidates.

Still, to actually capture the rewards of the external labor market, employees can't be too risk-averse. There is, of course, no shortage of tales from the tech and telecom bust of professionals recruited by unsustainable dot-coms out of relatively stable jobs with "real" firms with the lure of large pay packages that evaporated after a few months. Dot-com implosion risk is just an extreme example of the risks and uncertianties involved in capturing the external market rewards, which often (usually?) involves a job change and at a minimum requires a credible threat of one.

Providing greater rewards to less income-risk-averse employees could well be efficient in the sense that price discrimination is efficient. (Whether these efficiencies outweigh the transaction and other costs related to perennially losing qualified employees to more lucrative outside opportunities is unclear.) Like any price discrimination, risk aversion-based wages would result in income inequality and perhaps also increased income uncertainty.

As Brayden suggests, the lower ranks — increasingly comprising contractors and otherwise arguably the first targets of force reductions — get income uncertainty without conspicuous rewards.

This leaves the executive class. A common thread to "abusive" executive pay contracts is the grant of extraordinary income security — against the vagaries of the business cycle, the termination of employment (with or without cause), and even death. This implies, contrary to myth, that at least some corporate executives are not drawn from risk-loving entrepreneurial stock. If executives are no more income risk-loving than the rest of us, part of the contract theory rationale for their incentive pay arrangements is undercut. Corporate pay arrangments then should be more egalitarian. But will they? Also from yesterday's Times:
Despite the brouhaha surrounding [outgoing Fannie Mae CEO] Mr. Raines, it is unclear whether corporate compensation committees plan to push for greater retirement disclosure and more modest payouts. Warren E. Buffett, the billionaire investor who is a longtime critic of corporate compensation practices, has said that getting clubby boards to question enormous executive paydays is like expecting well-behaved guests to start "belching at the dinner table."
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