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5 major problems with the SEC’s new executive compensation rule, according to a behavioral economist

September 2, 2022, 1:33 PM UTC
Dan Ariely, a professor of behavioral economics at Duke University, speaks at an event
Dan Ariely, cofounder of Irrational Capital, is not a fan of the pay versus performance disclosure rule.
Chris Goodney—Bloomberg/Getty Images

Runaway CEO pay at U.S. companies has proven to be unstoppable despite regulator efforts. Now, the Securities and Exchange Commission has adopted a rule that it hopes will curb one practice that’s part of the problem: rewarding CEOs with lavish compensation for lackluster performance.

Under the pay versus performance disclosure rule, which goes into effect ahead of the 2023 proxy season, companies will need to disclose how a CEO’s compensation aligns with the company’s success over time. More specifically, companies will be required to provide data from the last five fiscal years and explain how executive pay tracks with several financial performance metrics, including shareholder returns—at the company and those of companies in its selected peer group—net income, and a measurement of the company’s choosing. Predictably, the new rule has already attracted opposition and skepticism.

Republican critics say that the data and analyses that the rule relies on are outdated. (The concept was first proposed in 2015.) Some experts fear that companies will still find ways to tinker with their numbers so that a CEO’s performance and pay appear aligned.

Dan Ariely, a Duke University behavioral economist, sees different flaws; he believes the new SEC regulation could harm a company’s culture. At Irrational Capital, an investment research firm he co-founded with David Van Adelsberg, he uses data analysis to find connections between “the human capital factor”—which includes employees’ views of a firm and other variables—and a company’s future value. Their model for identifying winners has found that a strong company culture is predictive of positive performance.

I asked Ariely to explain the potential unintended consequences of the disclosure requirements. Here are the key takeaways from our conversation.

The below has been lightly edited for clarity and brevity.

The SEC’s perspective is skewed

Sadly, the SEC is taking the half-empty glass approach. A lot of the things people do are focused on reducing the downside, but they’re not thinking about the upside. Yes, bad things happen. A CEO’s pay is too high, or a company does something bad, and we are offended, and we say, “We never want to see this again.” But sometimes the things that we do to make sure we don’t see bad things happening also eliminate the potential for the upside.

In this case, it’s as if they’re assuming that all CEOs are bad, and that they all want to take the most out of the company. The big question is: Do CEOs come to a system already greedy or does the system make them greedy?

CEOs will be incentivized to maximize the formula

From our research, we find that making people feel appreciated is the number one driver of a company’s success in the stock market. I don’t know how these new rules fit with feeling appreciated. I think it’s the opposite. It will train CEOs to maximize the formula (not their performance).  

The one-size-fits-all approach doesn’t work

The one-size-fits-all approach is very comfortable for lawyers, but I don’t think it’s right for companies.

Instead, I can imagine a rule that says we want the CEO to write a letter to the shareholder explaining what their plans are for the company for the next five years, what the financial outlook is, and why they think their salary is reasonable. Explain the logic behind it, not the formula.

The rule creates misalignment

Our model for evaluating investment-worthy companies has a lot of variables, but it basically says that the more a person is connected to the goal of the organization, the more motivated they are, and the better off the organization is. Getting people to think about their salary does the opposite. Imagine that somebody comes to work and they spend an hour a day thinking about how wonderful their organization is and how connected they are, or they think about how to maximize their individual salary.

I can imagine creating some rules that lead to the CEO making less, but then they’ll be busy focusing on that formula. And it still feeds into the notion that “the CEO doesn’t really care about our company; they’re here for themselves.”

From the CEO’s perspective—if we think that they’re just like everybody else and motivated the same way—thinking of themselves as separate from the organization is not a healthy thing. Let’s ask, “How do we not treat them as thieves?” 

Focusing on pay puts performance at risk 

There’s this primitive economic notion that says if people think about their salary, they put more effort in. That’s a crazy notion. What we really want is for people in organizations not to be overly concerned with their salaries. Employees have things to do, and we want their mental activity to be directed to the work. I ran an experiment many years ago in which I paid people in India a bonus equal to either one day, two weeks, or five months of their salary. Their performance didn’t change much between the one-day and two-week groups, but it went down dramatically for the five-month bonus group. Why? Because they were busy thinking about the bonus.

For executive salaries, I want something that would be similar to the way we think about judges: I want them not to worry about money and I want them to take the long-term view.

Lila MacLellan
lila.maclellan@fortune.com
@lilamaclellan

Word of Advice

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Doug Hirsch, cofounder and co-CEO of GoodRx, in a conversation with Fortune about entrepreneurship and his experience sharing the top job with Trevor Bezdek.

On the Agenda

👓 Read: This week, the Fifth Circuit Court of Appeals heard arguments in an ongoing lawsuit challenging the SEC's approval of a Nasdaq rule that requires companies to disclose board diversity. The judges did not sound convinced by the right-leaning plaintiffs' argument that the mandate is discriminatory or that it shames companies into appointing directors from underrepresented groups, the Wall Street Journal reports. “Nasdaq’s rule is disclose or explain,” said Judge Stephen Higginson. “To me, it sounds like investors get whatever crazy information they want, because that’s going to decide where they put their money."

🎧 Listen: Peggy Foran, chief governance officer, vice president, and corporate secretary of Prudential Financial, joins the Deloitte Insights podcast to talk about her rise through the proverbial corporate ranks after growing up in a family where most women became nurses or teachers; what drew her to boards and governance; and her theories about why there may be more diversity on boards than in the C-suite.

📖 Bookmark: Standard tools meant to assist companies with long-term strategy planning can’t always keep up with whiplash-inducing changes in the business environment, say Bain consultants Michael Mankins and Mark Gottfredson in Harvard Business Review. They lay out an alternative framework that allows companies to plan ahead while staying flexible.

Onboard/Offboard

Nicandro Durante, former CEO of British American Tobacco, will step down as an independent director at Reckitt Benckiser, maker of Durex condoms and other consumer goods, to become that company's interim CEO. Laxman Narasimhan, Reckitt's former CEO, was tapped to become the CEO of Starbucks, where he will also join the boardroom next year. Jim Bridenstine, former President Donald Trump’s polarizing choice for NASA Administrator and former congressman from Oklahoma, was named a director at Phase Four, a spacecraft propulsion startup. Nike’s chief legal officer Ann Miller is joining the board at Dutch Bros, a fast-growing California-based coffee chain that’s popular with young consumers. Veteran oil and energy executive Robin Watson was appointed to Honeywell’s board as an independent director. Emily Melton, chair of the National Venture Capital Association, is stepping down from the board of Shift, an ecommerce site for used cars. 

In Brief

- Starbucks named Laxman Narasimhan, a former PepsiCo executive, as its next CEO. He'll join the company on Oct. 1 and take over as CEO in April.

- Covid has ruined venture capital investors' taste for board meetings, and ghosted founders are feeling frustrated, writes TechCrunch.

- Did Elon Musk violate his own company's code of conduct when he had twins with a Neurolink employee, who is not a romantic partner, through IVF? Reuters asked nine corporate governance experts and found divided opinions.

- A new poll finds that more Americans approve of unions than at any time in the past 60 years. 

- Responding to recent consumer demand, the investing app Alinea created a pro-abortion rights "playlist" of stocks at companies that have spoken out in defense of equal access to abortion.

Editor’s Pick

The anti-ESG investing movement seems to have chosen its hero: Vivek Ramaswamy, the 37-year-old co-founder of Strive Asset Management, which so far has $300 million in assets but has plans to take on BlackRock, according to Bloomberg. Ramaswamy apparently became interested in advocating for what he sees as politics-free investment decisions (an illusion, to be sure) as demonstrations against the murder of George Floyd swept the country. Employees at Roivant, a biotech he founded, nudged him to publicly support Black Lives Matter at the time and were angry when he refused. Months later, Ramaswamy chose to publicly criticize the social media companies that kicked Donald Trump off their platforms in the wake of the Jan. 6 Capitol riots.

Here’s a snippet from Bloomberg:

"Ramaswamy, too, says his message is nonpartisan and expresses disappointment that it 'has been too limited to the American right. It’s not for lack of effort.' Yet his pitch sounds a lot like a political manifesto. In language reminiscent of a Donald Trump rally or Fox pundit Tucker Carlson (Ramaswamy has appeared on Carlson’s show), he says Strive will speak for the 'forgotten,' the 'disempowered,' the 'abused'—for the 100 million-plus ordinary investors whose voices are being drowned out by elitist big money.

"A Zelig of the conference circuit, he’s cultivating the red-state governors, treasurers, and pension officials who decide where the public’s money flows. 'Money doesn’t talk, it screams,' Ramaswamy says. 'We allow people to speak in a way that they haven’t been able to speak before.' Lean and fast-talking, he throws off the frenetic energy of a campaigner on the trail—which, in a way, he is. Shirt sleeves rolled up, digging into Mexican takeout, he goes on about Vladimir Putin and the politics of victimhood and then name-checks Alexis de Tocqueville on American democracy during an interview at the NYSE."

Keep reading here, and have a great Labor Day weekend.

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