Warren Buffett and the Problem of Executive Compensation, Pt. 2
In my previous article, I used Warren Buffett (Trades, Portfolio)'s latest Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) shareholder letter as a starting point to talk about some of my reservations regarding the explosion in executive compensation that has taken place over the past several decades. I now want to look at some comments that Buffett himself made about this issue, and at some possible solutions to what he sees as a problem for corporate America.
Problem one: Consultants
Buffett says that compensation committees rely much more on consultants today than they did in the past in order to determine how much to pay their executives. In theory, this allows an independent outside force to objectively set salaries. In practice, compensation consultants are often incentivised to provide executives with rosy deals in the hope of being re-hired. Worse, there is an incentive to make proposals more complex to justify the fees being paid. In Buffett's own words:
"What committee member wants to explain paying large fees year after year for a simple plan? The reading of proxy material has become a mind-numbing experience."
Buffett has always been highly skeptical of financial middlemen - be they consultants advising on CEO pay rises or investment bankers looking to underwrite a bond or equity issue, so it's not really surprising to see him take this stance.
Problem two: Money
The second issue that Buffett identifies is money. According to him, the average board member of a large American corporation can expect to receive between $250,000 and $300,000 for what amounts to a few days of work a year. The financial incentive to remain on the board (and, indeed, to be appointed to other boards) means that directors are less likely to speak up against management. This isn't to say that boards never challenge executives - far from it - but in general, they clearly have very strong reasons to keep quiet.
So what is to be done? Buffett suggests a number of solutions. For one thing, he approves of the practice of having mandated "executive session" board meetings, which managers are not allowed to attend. He also suggests that for every proposed acquisition, the board invite two experts to argue - one for, one against - the deal. As it stands, deals like this are often pursued by CEOs looking to expand their businesses, but may not actually be good for shareholders.
Of course, that still doesn't change the fact these "experts" might be subjected to the same skewed incentives that compensation consultants face (though Buffett does suggest that the winner of the argument be paid 10 times a token sum paid to the loser).
Conclusion
Buffett also believes that stock options do not align the incentives of management with those of other shareholders because they represent a free transfer of wealth from the latter to the former. Incentives would only truly be aligned if managers purchased shares in the open market like any other shareholder - increasingly, this is no longer the case. Why buy something when your board will give it to you for free?
Disclosure: The author owns no stocks mentioned.
Read more here:
Warren Buffett and the Problem of Executive Compensation, Pt. 1
Joel Greenblatt: 3 Mistakes That Investors Make
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This article first appeared on GuruFocus.
