What Executive Compensation and Tenure Have in Common
By: Ethan Milne
Tags: Philosophy, Luck, Academia, Management, Executive Compensation

What Executive Compensation and Tenure Have in Common

Or: What Nagel’s theory of “moral luck” can teach us about performance-based reward systems

We begin with Kant:

A good will is not good because of what it effects or accomplishes, because of its fitness to attain some proposed end, but only because of its volition, that is, it is good in itself… Even if, by a special disfavor of fortune or by the niggardly provision of a step motherly nature, this will should wholly lack the capacity to carry out its purpose — if with its greatest efforts it should yet achieve nothing and only the good will were left (not, of course, as a mere wish but as the summoning of all means insofar as they are in our control) — then, like a jewel, it would still shine by itself, as something that has its full worth in itself. Usefulness or fruitlessness can neither add anything to this worth nor take anything away from it — Immanuel Kant, 1784

I’ll first apologize on Kant’s behalf. He’s a terrible writer, but the concepts he proposes are interesting. To translate the above quote into plain english: Actions are good or bad regardless of outcome, what matters is the intent and reasonable expectation behind the action.

This quote is used by another philosopher, Thomas Nagel, in his essay on “moral luck”. In it, Nagel proposes two scenarios:

A man leaves the bar late at night, drunk. He gets in his car and drives home, swerving back and forth as he does so. At one point in his journey, he veers into the sidewalk for a brief moment before he steers himself back onto the road. He is later apprehended by a police officer. A man leaves the bar late at night, drunk. He gets in his car and drives home, swerving back and forth as he does so. At one point in his journey, he veers into the sidewalk for a brief moment and hits a child before he steers himself back onto the road. He is later apprehended by a police officer.

The only difference between these scenarios is that in option 2, the man hits a child with his car. Nagel rightly asks: why do we punish these two men differently? In both cases, the intention, action, and expectation of outcome is the same: Both men are assuming the same risk by driving drunk; Both men make the same swerve onto the sidewalk; All that’s changed is their external environment — the presence of a child.

To punish the second man harsher than the first is to punish him for things outside his control. Framed differently, letting the first man off easier is to reward him for there not being a child walking on the sidewalk — something outside of his control.

I suspect the reason is related to the structure of our legal system, which is focused more on providing adequate compensation for victims than for perpetrators of bad actions. Regardless, this example illustrates an important point: in our society, we reward and punish people for things they cannot control, by evaluating actions based on outcome instead of processes.

For a more in-depth explanation, here’s a Crash Course video focused entirely on this concept:

For now, I’d like to focus on where we see Moral Luck-type problems in management and academia. Let’s start with management.

Moral Luck in Management

The management strain of moral luck is less concerned with morality, and more focused on financial reward. This is particularly evident in executive compensation.

Per a report from the Canadian Centre for Policy Alternatives: “Canada’s 100 highest paid CEOs on the TSX index earn the average Canadian [annual] wage by 11:47 a.m. on January 3.” A huge chunk of this compensation is in the form of bonuses and stock compensation — both of which are subject to Moral Luck-type problems.

Bonuses

Suppose you are the CEO of a gold mining corporation. You get paid a large salary for your work, but also have a compensation plan intended to reward you for meeting company targets. Some of these targets will be related to revenues, others to costs, and still more to profit — along with a host of other governance-oriented goals.

One of the single biggest factors in the revenue — and by extension, profits — that the company earns is dependent on the price of gold. The following graph shows US gold prices for the past 5 years:

As you can see, there’s significant fluctuation in gold prices. As a commodity store of value, gold is often used to hedge against inflation, or to diversify portfolios in bad times. Notice how none of this is in any way impacted by the behaviour of a gold company’s CEO — yet they may still be compensated differently in years where gold prices are high versus when they are low.

Much like Nagel’s driver example, the CEO of a gold company may find their bonuses contingent on factors outside of their control. We need to ask ourselves if this is fair?

To be fair, there are complicating factors here:

Compensation may be more related to retention than performance, and high gold prices may mean other companies have cash to spend on poaching a CEO, so their compensation should rise to defend against this.

A CEO can still greatly improve on cost efficiency — which is relatively untethered from the external environment — and thereby improve profits

Note that I’ve presented a heavily-simplified example. Many gold-mining companies are aware of this problem and have programs in place to focus on measurable CEO-specific activity rather than strict outcomes subject to external fluctuations. Regardless, I hope this example has helped you build an intuition for how moral luck may work in executive compensation.

Stock Compensation

Similar to bonuses, the value of stock compensation and stock options can be highly susceptible to fluctuations outside the control of any specific employee. A Tesla employee, for example, can’t predict what Elon will tweet next, yet would have different outcomes in total compensation based on Elon’s tweets:

I’m sure this tweet was not well received by those with stock options looking to cash out.

Musk’s tweeting aside, a host of factors can influence the valuation of a company beyond the control of individuals holding the stock. Shifting external environments incentivizing certain portfolio items, an acquisition the stock-holder was not involved in, or random market corrections can all impact the value of a stock in uncontrollable ways.

I’ll note that the appeal stock options and stock compensation more generally is in part driven by the external variation in stock prices — so in a way people are buying into a system driven by moral luck-type problems. Regardless, this is something we should be thinking about when considering the “fairness” of various compensation schemes.

Moral Luck in Academia

Let’s split reality again like we did with Nagel’s driver:

A psychologist comes up with a clever experiment that would resolve an important — but untested — belief in her field. She conducts her experiment properly and goes to analyze the results. She cannot reject the null hypothesis and submits her findings to the top journals in her field. Her paper is rejected. A psychologist comes up with a clever experiment that would resolve an important — but untested — belief in her field. She conducts her experiment properly and goes to analyze the results. She has a significant result and submits her findings to the top journals in her field. Her paper is accepted to great acclaim — securing her path to tenure in the process.

In fact, suppose there wasn’t just 2 scientists. Maybe there’s 100, 99 of which follow the path of the first scenario, and one who finds a significant result.

If the true “effect” of what they were testing was 0 — or the proposed intervention had no effect — then we might see a bell curve of these various scientist’s results that looks something like this:

The shaded part at the right? That’s the second psychologist — the one who did find an effect. She found an effect where others didn’t by sheer virtue of small variations in study design, or participants, or a host of other factors. Publication bias is strong, and no journal wants to publish a null result, so only the psychologist who achieved a significant result gets published.

Why should we reward the second psychologist for getting “lucky”? Again, I’m simplifying a great deal, but this dynamic feels unfair. Many people could use the same methodology and get a different result. This is why we use meta-analyses and tools like funnel plots to see the overall “shape” of the literature on any given effect — yet we still reward researchers for success in individual studies that we implicitly acknowledge aren’t valid on their own.

We use publications as a metric for determining the worth of new academic hires, the tenure prospects of existing professors, and the level of eminence we grant them. No wonder publish or perish culture has created a plague of so-called “questionable research practices”.

Takeaway

Like Nagel, I don’t see a good way to resolve this seeming unfairness. All I can offer is that, when possible, we should try to reward people based on their process and validity of decisions rather than the outcome they achieve. The scientists who get null findings in well-designed experiments and the CEOs who see falling profits due to environmental fluctuation should perhaps be treated more similar to their more successful counterparts — provided their methods are just as good.