This paper looks upon traditional performance measurements and compensation philosophies and assesses their shortcomings in today’s competitive market. Paper suggests that new methodologies are needed in order to properly align the interest on the employees with that of the employer. It also recommends new methods of compensations that are more properly aligned with the employees’ productivity and effectiveness. In such a system both employees and employers can benefit from the system. Managing the value and tools to measure the added value are the main topics of discussion here. The paper first talks about the traditional and dominant compensation philosophies and then focuses the discussion on the topic of ownership versus pay and the effectiveness of each. The pros and cons of each method, equity ownership and pay for performance, are each debated. SHORTCOMINGS OF COMPENSATION PHILOSEPHIES 3 Performance Measurements and Their Effectiveness New talents enter the fast-changing economy and it is up to the old economy to modify itself into the new one. Performance measurements and reward schemes have always been the subject of discussion in finding proper compensation methods. Authors Pettit and Ahmad (2000) discuss the main methods of compensation and whether they need to be the subject of change or modifications to achieve a more efficient strategy that is more effectively aligned with employees’ productivity and efficiency. One may also state that in a system where the interest of the employee is aligned with the interest of the organization, the incentive compensation will benefit both the company and the employee. Managing the value and tools to measure the added value are the main topics of discussion here. Measures that are obtained from financial statements lack the sufficiency to indicate the added value. These numbers fail to consider the weighted cost of capital. The only cost item mentioned in financial statements is the cost of debt; however, the cost of equity capital is overlooked. Thus, the income statement profit does not properly illuminate the added value. This has been discussed as of the main deficiencies of accounting standards. Furthermore, the cost of equity is not the sole factor distorting the financial statements. Saeedi and Akbari (2010) state yet another factor distorting the balance sheet: Considering the issue that the economic value added is calculated using information produced from conventional historical cost accounts, inflation can distort information content and applications of the performance measurement criteria. Inflation can distort economic value added through three factors, i.e., the operating profit, the cost of capital, and capital base and these distortions potentially result in inefficient investment and compensation outcomes. SHORTCOMINGS OF COMPENSATION PHILOSEPHIES 4 Accordingly, many managers take on projects that make the balance sheet seem more attractive, but may ultimately fail to generate added value. Judging from the previously failed compensation philosophies, one may believe that a new compensation philosophy is called for. The Dominant Compensation Philosophy Competitive levels of compensation, pay-for-performance, and significant levels of pay at risk are currently the dominant compensation philosophies. “The primary focus of compensation committees seems to be determining an optimal level of competitive pay – reflecting widespread belief that their most difficult challenge is to find an optimal balance between competitive pay and total cost” (Pettit & Ahmad, 2000, p. 2). Management is often the sole decision making authority in determining the target capital structure and policies regarding pay distribution. This will ultimately lead to agency issues, which stems from the managerial team having the decision making authority affecting two parties with conflicting interest, the interest of managers with those of the shareholders. Pettit and Ahmad (2000) emphasize that pay-for-performance or incentive pay must avoid violating the existing balance among three competitive objectives, and furthermore, in compensation design for executives, one must take extra care to govern the balance between these factors: “align employee interest with value creation, limit retention risk – risk of losing good people during inevitable periods of poor or volatile performance, and to achieve this all at a reasonable total economic cost” (p. 2). However, the question remains and one may ask whether the existence of balance among all three elements is effective in the compensation design. “In a statistical regression analysis of thousands of executives, we found very little correlation between pay and performance” (Pettit & Ahmad, 2000, p. 2). Pettit and Ahmad (2000) go on to explain that the total shareholder return, TSR, explains only 1% of the SHORTCOMINGS OF COMPENSATION PHILOSEPHIES 5 variation in the CEO pay. This is yet further evidence that dominant compensation philosophies have not been very effective, if not futile. Despite the discouraging results of our regression analysis we did find that most CEO pay seems to be pay at risk – even more so for the New Economy CEOs. Base salary constitutes only about 30% of the Old Economy CEO pay at the 25 th percentile, and less than 20% of pay for 75 th percentile. Overall, more than 70-80% of total pay is typically “pay at risk.” For New Economy companies the proportion is even higher – overwhelmingly in equity. Yet, it’s not working (Pettit & Ahmad, 2000, p. 3). In practice, variable pay is based on the ex post or the actual return, as opposed to the fixed pay salary which disregards the actual returns. With a robust compensation system in place that can truly align the interest of the owners with the interest of employees, both employees and managers can benefit from the system, as owners can enjoy the value added and managers can enjoy their share of the resulting pie. With proper compensation design in place, both parties will enjoy the fruition of the company. Ownership versus Pay Failure in effectiveness in other forms of compensation has driven organizations to use equity stocks or the ownership method. Equity based compensation plans have been widely embraced, specifically in the last decade due to the bull market. Bronstein (1980) believes that “[a]n ownership position which established an economic basis for equating executive interests with corporate goals is fundamental to compensating the executive, whose responsibilities exert a basic economic effect on business outcomes” (p. 64). However, criticism about the efficiency of the ownership design still remains. SHORTCOMINGS OF COMPENSATION PHILOSEPHIES 6 Compensation consultants and governance critics alike have effectively given up on compensation as a tool to achieve any alignment in interests whatsoever, resigned to the status quo where entrenched thinking and over-riding concerns with competitiveness have subordinated the alignment and motivational aspects of compensation (Pettit & Ahmad, 2000, p. 4) However, the equity schemes are not free of flaws, and there must be a strong owneremployee compensation contract. Based on the current literature, the wide use of stocks and stock options has also failed to cover the shortcomings in aligning the interests of owners with employees. There are some limitations to equity based compensation packages. Volatility and the price fluctuations is the first of the limitations. Many may not be able to psychologically handle the volatility, and to many others bearing the downside risk may be frustrating. Also, since the shares are always granted from the same company, the employee cannot enjoy diversification. The second factor imposing limitations on the scheme is the vague understanding that the majority of employees have on valuation, and in general from the global equity market. Besides, many employees may care about capital growth and the increase in stock prices, while the company may forgo the growth in stock prices for a market expansion. The third factor imposing limitation is the lack of direct link between the actions and the incentives. In case of cash incentives, the employee would receive the incentive for her decisions in a shorter period in comparison to equity based packages where the change in share prices has no correlation with the actions of the employee. There is yet another open question regarding the design which could ultimately be recognized as a flaw in the incentive design. The following question can best illuminate the issue. Should the managers’ pay be a function of performance and managerial ability as it is SHORTCOMINGS OF COMPENSATION PHILOSEPHIES 7 intended to be, or is it a function of the size of the company? A study has been done, as mentioned by Wyld (2008) which contributes to the understanding of managerial pay, and whether the pay will change if the manager is replaced by a manager with less or more managerial capability. “[P]erhaps the money invested by top firms to attract and retain “superstar” management talent doesn’t improve market returns relative to “less talented” (and cheaper) executives” (p. 83). This study is yet another proof of ineffectiveness in aligning the pay with performance.