In a popular novel of a few years ago, all the students at Lake Woebegone were above average.  If you can understand the fallacy in that comment, you can begin to understand what is happening to the compensation of corporate managers. 

The lack of alignment between corporate pay and shareholder performance has been outlined by several magazine studies.  Some problems exist in those studies, as the exercise of stock options may not be related to a company's performance in the same year. 

Nevertheless, the general thrust of those studies has merit.  Increasingly, corporate managers are receiving compensation without regard to the value they create.  Who can forget the $75 million severance package that was given to one manager when he was fired for failing to provide value to the company?  Anyone using shareholder funds so recklessly raises concerns about how compensation is determined.

Most stock market studies indicate that more than half the fluctuation in the value of enterprises is related to the economic environment, not to the management of individual companies.  Too many managers receive benefits for a rising stock market instead of for any additional value that their efforts may have provided to the value of their company. 

Not only are managers receiving too much credit for creating value, but they are receiving too much of the value that is created.  Good management clearly makes a difference, but the shareholders are shouldering most of the market risk and should receive commensurate returns.  Employees other than management also add value and should receive appropriate recognition, either through bonuses, promotion opportunities, or their own stock ownership. 

Unfortunately, determining how the value of the enterprise should be allocated is not an easy task.  If workers demand security, they give up the opportunity to be rewarded for successfully handling market risk.  Some employment contracts, which  guarantee returns even if the company no longer performs, go against such a principle. 

In the end, one should ask what is the cost of replacing the person currently holding a job.  That question, of course, should be adjusted for the quality of work expected from that person. 

Now let's return to Lake Woebegone and the methods used by many to compensate CEOs. 

Usually, compensation is divided into three compartments.  The first is the salary that will be paid independent of company performance.  Of course, continued bad performance should lead to dismissal. 

Second, is a bonus to be paid for achieving company goals.  Sometimes, these goals are earnings based, but they also may be based upon safety, customer satisfaction, or other management goals that may lead to better earnings performance over time. 

Third, long term compensation is provided to encourage managers to build the value of the enterprise.  Under no circumstance should the compensation exceed the value created.

Normally, the first and second compensation pieces are money based, although restricted stock and stock options sometimes are attached to bonuses.  In other words, crossing a bonus hurdle may entitle the manager to a number of stock options along with an end of the year check. 

The vast majority of the long term compensation is in stock options, although new managers might receive a stock grant (looking something like a signing bonus) to begin their interest in raising the value of the company.  These stock options will be earned (vested) over time. 

There usually is a ratio between the salary and bonus and between the salary and the long term compensation.  Thus, determination of the basic salary sets all the compensation in motion. 

That salary is determined based upon a survey of comparable positions at peer companies (e.g. those companies of similar size, risk, and activity if such exist).

Yet, what board of directors will declare that their managers are below average.  Everyone starts at the 50 percent level of wages or beyond.  Not surprisingly, the next time surveys are made of what CEOs are getting paid, their average salaries have grown much more rapidly than in the overall economy. 

Some long term compensation has been based upon as little as two years of performance.  This is absurd, regardless of the short tenure of company managers.  I would not allow stock option programs that had less than a five year total vesting. 

Indeed, the problem of this compensation approach is not in the options per se.  The amount of options certainly matters and the short vesting also distorts corporate behavior.  Nevertheless, options are a useful device for aligning the manager's interests with the interests of the shareholders.

What is amiss is this compounding of salaries through the above average assessment of boards.  I wonder how many boards even care to ask how much compensation has increased in each of the major management positions in the past ten years.  If they did, they might be shocked at how much of the enterprise's value has been transferred to the managers over time.