Executive-Level Bonuses are Returns on High-Risk Investments

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Since September 2008 executive bonuses have been criticized as excessive, unfair, and unnecessary. Case in point: Last week in a public speech President Obama referred to executive bonuses as being “obscene.”

Are executive bonuses really a problem? Or just a way for politicians to gain public approval?

Consider the traditional return on investment model: the higher the risk, the higher the return. This also applies to job compensation: the higher the risk (i.e. responsibility), the higher the return (i.e. income and bonuses). It follows that an executive’s income and bonus reflects the high level of responsibility and commitment to the company required at the senior management level.

Xavier Gabaix and Augustin Landier, economics professors at New York University’s Stern School of Business, investigated the increase in the American CEO pay since 1980 and found that executives are not overpaid as most people on Capitol Hill think:

[…] the sixfold increase in American CEO pay from 1980 to 2003 is almost wholly explained by the roughly sixfold increase in market capitalization of big U.S. companies over the same period. (Asset values have increased sixfold because both corporate earnings and the price-to-earnings ratio investors are willing to tolerate have increased by factors of 2.5.) The trend lines of market capitalization and executive payouts rose and dipped in near-perfect tandem.

In a free market society, executives that bring value are rewarded handsomely, while those who do not bring value are replaced. But when government tampers with market forces, efficient levels of incomes and bonuses are skewed. The result is an economy that is misguided by fabricated, artificial signals.

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  • Paul Mulcahy

    Bonuses are rewards for taking risks with other people’s money. If bonuses are justified when they are successful, then what about when the risks taken fail? Negative bonus? Not just losing their job, but losing their own money. The current system is “heads I win, tails you lose” and as the free market conservatives showed during the Bush administration, there is no such thing as a free market.

  • Frank

    The main problem with this argument is that their is no high level of risk. When their firms lost money their bonuses were not whittled away significantly. The risk is marginal for any individual employee outside of losing their job.

  • will

    I think the point the politicians are making is that bonuses have been paid for failure, not the typical risk/reward ratio you speak of. further, are the risks being taken at all beneficial to the economy or productivity?

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