There is absolutely nothing wrong with incentive pay for managers. When done properly, it can align shareholder and management interests such that it helps both parties become rich. Unfortunately, shareholders are not making sure that incentive pay is done properly, and recent news out of SuperValu, a stock with some terrific upside potential, serves as a perfect example.
Last week, SuperValu announced an incentive program from 2012-2014 that will see employees participate in increases in the company's market cap. Specifically, employees will receive up to 4.8% of the company's market cap increase!
There are a few major problems with this compensation structure. The first is the sheer size of the amount. If the stock price just returns to its 2007 level (so shareholders who have owned the stock over this period would end up with no gain), the bonus payout could be around $250 million. This is more than the company has generated in operating income over the last four years combined!
The second problem with this bonus program is that it is largely based on events that are outside the control of employees. Yes, a company's stock price is correlated with business performance to some extent, but over short periods other factors can play a much larger role in determining whether a stock rises or falls. Should managers really be paid (or not paid) as a result of Federal Reserve interest rate decisions, OPEC quotas and/or Chinese economic growth? All of these factors and then some help determine the multiples at which stock prices trade, so it seems silly that employees should be compensated based on things they cannot control.
The third problem with this arrangement is the asymmetry of it all. SuperValu shares have fallen some 75% since 2007. That loss was borne entirely by shareholders. But now shareholders are expected to share the "gains" as the company and share price recover. This type of compensation structure results in a misalignment of incentives between shareholders and management and can be destructive to the company. This particular topic has been discussed in more detail on this site before, but the short story is that it encourages managers to take more risks than they otherwise would, because they don't share in downside pain but they make out like bandits when it comes to upside rewards.
Most citizens appear to blame the managers themselves for asymmetric, over-the-top and unanchored-to-what-they-control compensation. But can you really blame an employee for accepting a bonus his employer offers him? All workers, from office workers to pro-sports athletes to hard labourers should receive the compensation for their services that market participants are willing to pay. Therefore, the problem lies with the "market participants" that are offering managers large amounts of cash that are only somewhat correlated to company performance.
In large US companies (of which SuperValu is a member), ownership of individual companies is rather fragmented across thousands of shareholders. As a result, shareholders elect directors to represent them as the "market participants" charged with negotiating with management. This arrangement sounds great in theory; the problem arises when directors act less like shareholders and more like management.
SuperValu's directors appear to fit this bill perfectly. At least a couple of directors own no shares of SuperValu, while the remainder appear to own shares valued at substantially less than their net worths. As a result, its not really their money that the directors are doling out. On the other hand, the average director earns more than $200K annually from SuperValu!
Directors also have other reasons to cozy up to management; for example, "directors are eligible to use the Company aircraft for personal purposes...at the direction of the CEO." Perks like these make directors want to curry management favour, rather than perform their duties as shareholder representatives.
Because of the fractured nature of ownership of America's largest corporations, this is a problem that is unlikely to alleviate any time soon. Recognizing the structural causes of this issue, however, shareholders need to do more to help themselves. This requires taking director elections seriously and favouring directors with large ownership stakes, as they are the most likely to act in the best interests of shareholders.
Disclosure: Author has a long position in shares of SVU