Hermann Stern Speech On Executive Compensation Fairytales for CFA Institute
Channel: Obermatt Executive Compensation
Date: 2016-01-05

Hermann J. Stern talks about what makes a good executive compensation system. Many years ago, Stern has been told that a good incentive system is when your CEO must buy shares and options so that she goes bankrupt when the firm goes bankrupt. This would insure that the CEO has a strong incentive to perform well.

Stern focuses on three misconcepts in this approach to compensation:

- Executives are greedy.
- Executives’ pay should be linked to profits
- Pay should be linked to targets

The first misconept addresses the main problem of high executive salaries. The biggest problem with paying a low salary is the possibility of losing the CEO. Hence, board members must assure that they don’t underpay the CEO. This is a much better explanation for high CEOs’ salaries. This fact is emphasized by a quote of Van der Veer, former CEO of the Royal Dutch Shell: „You have to realize: if I had been paid 50% more, I would not have done it better. If I had been paid 50% less, then I would not have done it worse.“ 
In addition, there is a wide range of incentives that are not financial. Stern concludes that transparency and pay leverage are the reason for high executives’ pay, not greed.

The second misconcept addresses the strong link between compensation and company profit performance because profit based metrics motivate people to postpone investments and downsize. The main reason is that profits are much easier increased by cutting costs than investing into new markets and customers.

The third misconcept addresses the fact that paying based on targets is extremely dangerous. It mainly motivates the CEO to set low targets. In addition, the risk of an irrelevant outdated target is much higher than expected. Stern illustrates this risk with a sales target in a real example.