Bottom Shekel / A Step Toward Reining in Executive Pay

Executive salaries at publicly traded companies have tripled in six years, according to a study by the Israel Securities Authority. The ISA also found that pay increased with no correlation to value creation for shareholders. Ergo, executive pay rose even in years when corporate value declined. Although pay didn't rise in 2008, generally speaking, come the recovery in 2009 executive pay shot skyward again.

MK Shelly Yachimovich (Labor ) reacted to the study by calling on the watchdog to do something about executive pay. She's right, and even more than she realizes. The worrying thing about the ISA's findings isn't executive raises, which are generally appropriate, but the fact that the raises are divorced from the lessons of the global financial crisis, a crisis entirely linked to executive compensation. The financial collapse proved how much economic theories are correct, particularly when it comes to incentives. This means the right kind of incentive motivates people to carry out the right activity, whereas misguided incentives motivate people to carry out misguided activity.

The wrong kind of pay incentives to senior managers at sensitive institutions like banks and international insurance companies was the essence of the crisis. The executives led the banks under their management to the edge of the abyss simply because it was personally worth their while, and in the process brought the entire world to its knees.

What's the conclusion? The system of pay incentives, especially for senior executives, must be fixed, particularly in the financial sector's sensitive areas. Even more important than reining in executive compensation, which is what Yachimovich is demanding, is reassuming control of the connection between senior salary levels and the performance of the companies they manage. Otherwise, the next crisis is unavoidable.

It was actually the actions of two financial-sector oversight officials, the supervisor of banks and the supervisor of insurance, that revealed this week just how much executive salary incentives are bloated and misguided. In relating to the lessons of the financial crisis, both financial supervisors required financial firms to set policies on executive compensation incentives. The two largest financial companies in their fields, the biggest bank, Bank Leumi, and the biggest insurance company, Migdal, have released their new compensation policies. The two have also examined how the compensation they paid in recent years looked through the prism of their new wise policies.

Bank Leumi found that the bonuses they paid in 2007 were appropriate. In 2008 the bank not only did not pay any bonuses, it found that employees would have had to return NIS 16 million in bonuses from previous years.

Migdal made similar findings. If the company's new compensation policy had been applied in the past, its employees would have received total bonuses of NIS 34.2 million in 2009. In actuality, they got NIS 52.1 million last year, amounting to a NIS 18 million "overpayment." Migdal's own CEO got NIS 250,000 more than the new policy would have provided, and the company's chairman got a NIS 260,000 overpayment.

So the first and most important means of controlling executive compensation is guidelines that both set a ceiling on bonuses and provide appropriate incentives. Appropriate means management works for the company's long-term good.

There are many theories about how to define a company's long-term good and how to link it to individual performance, but it's clear that a good incentive plan must include the following.

It must be based on the company's long-term performance. At Migdal, it's linked to up to six years of performance (two three-year segments ). At Bank Leumi, it's based on three years of activity. It must not only be based on profits but on risks so managers don't drag companies into overly risky adventures. Migdal is failing from this perspective in that its plan doesn't feature any parameters dealing with risk. At Bank Leumi, a 20% component of the bonus relates to the bank's risk capital.

The incentive has to be symmetrical so a manager personally takes a hit over a loss and not just a windfall for high profits. Bank Leumi is a pioneer in this respect in that it imposes a "negative bonus" on its executives. In years in which the bank falls far short of its targets, prior years' bonuses are reduced and the manager may even face a "debt" that will come off future years' compensation. Migdal does nothing similar.

In addition, there is symmetry of sorts in that only shares and not options are allocated to employees. An employee who is offered an option will only exercise when it is to his financial advantage, so he is not hurt when there are losses. Shares, on the other hand, rise and fall with the company's performance, reflecting not only the company's successes, but its failures.

Profit and bonus incentives must be of defined scope so they are not so big that they go to the executive's head. For this purpose, both Leumi and Migdal set profit ceilings (based on targets on returns ) so managers don't have aspirations of overly large and unhealthy bonuses. The two companies also set specific limits on bonuses so they do not exceed what is reasonable.

The compensation plans at these two major Israeli financial firms are an important step in controlling out-of-control salaries. Bank Leumi's plan is more impressive than Migdal's, but both are a step in the right direction. Even if the plans don't bring about a sharp decline in executive compensation, they at least introduce business logic and responsibility in what corporate executives receive.