How incentive schemes can go horribly wrong

There isn’t much everyone can agree on in finance, but there is one statement you won’t find much argument on: the CEOs of big companies are paid much too much.

Look at the research here and you will see that the average US CEO is paid 350 times that of an ordinary worker. That’s the highest ratio in the West, but the differences are pretty extreme in Europe too: the ratio varies from a low of 28 times in Poland to a high of 147 times in Germany.

This is a problem. But it isn’t necessarily a problem just because the absolute levels are too high (although my own view is that they are). The thing we all really need to worry about is how remuneration incentives are agreed, how they work, and how they affect the behaviour of the CEOs we all depend on to run our big companies.

We’ve noted here before that everyone reacts to financial incentives and so putting the wrong incentives in place (or indeed any incentive or group of incentives beyond “do your best and you probably won’t be fired”) can only end in tears.

Anyone in any doubt needs only look at the Tesco incentive scheme, says Jonathan Ford in the FT. Tesco’s accounting troubles stem from efforts to squeeze suppliers to keep trading profits up.

Why didn’t the top excutives notice? “50% of top executive bonuses were dependent on the level of trading profit. They were not incentivised to ask level-headed questions about the precise nature of those trading profits.” Bad incentives. Bad result.