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Please begin with an informative title:

The more I read about the financial collapse happening around us, the more I’m convinced this is a result of something that’s bothered me for years...

A driving principle of conservative economics is the belief that if everyone acts in their own self interest, they will collectively make decisions beneficial to the larger group... that the market will pick the winners and losers, and we'll all be better off in the end.

On many levels this works pretty well. Much of our economic history and strength is built on this principle. However, there is a fundamental flaw with this model that I rarely see discussed.

More below the break...

Intro

You must enter an Intro for your Diary Entry between 300 and 1150 characters long (that's approximately 50-175 words without any html or formatting markup).

The Problem:

If I'm running a company, and make $10 million this year in salary and bonuses, I've lost my incentive to act in the company's long-term financial interest. I've already got $10 million. I could never work another day in my life, and do pretty well for myself - indeed I'd have made more than most make in a lifetime.

If the company I work for collapses, it's no skin off my nose. Indeed, I'm encouraged to take extraordinary risks that might pay off the short term - maybe I could make $100 million the next year. If I fail? At worst I get fired, so what? I'm already loaded. There is no personal risk of failure. In fact, I would be foolish not to take extreme risks in my corporate decision-making. It's in my self-interest to do so.  If those risks pay-off, the rewards are huge. If those risks prove disastrous, there is no downside. I simply make $0 and walk away.

And that's exactly what's led to our current disaster.

The more I read the inside stories about what happened the more I realize the problem I outlined above was at the heart of it.

People got what they could while the getting was good, without any regard for long-term health of the overall system. By the time the market reacted to their poor decisions, they already had accumulated massive personal wealth, and didn't care what happened to their investors or companies. So, the whole thing collapsed, and the people running it just shrugged their shoulders and walked away. They didn't even break any laws.

The Solution:

To fix this dynamic, the bulk of executive pay (salary and bonuses) should be in company stock - bought at the current market rate. But the key is that such stock can't be sold for 5 years from the point of purchase. The higher-up in the company you get, the more this system should govern your pay.

By doing this, officers of these companies will be in it for the long haul, and work hard to make sure their company is healthy in the long term. If they decide to leave in the interim, they'll take a huge risk that the next exec will screw it up. They'll have a personal incentive to hire only the best, to police the decisions of their coworkers. If they're successful, they make a ton of money - good for them.

For example, let's say a company's salary range looks like this:
80% of employees are making $25K/yr
10% of employees are making $50K/yr
5% of employees are making $100K/yr
3% of employees are making $500K/yr
2% of employees are making $1000K/yr

Under the new approach, the pay might look like this:
80% of employees are making $25K/yr + $0/yr in 5-year stock
10% of employees are making $50K/yr + $0/yr in 5-year stock
5% of employees are making $75K/yr + $25K/yr in 5-year stock
3% of employees are making $100K/yr + $400K/yr in 5-year stock
2% of employees are making $200K/yr + $800K/yr in 5-year stock

I don't think too many companies would volunteer to set themselves up this way however. As it is, the people making the rules at companies (boards of directors) are in the same social network as the executives. Despite the fact they're supposed to be acting in the interest of shareholders, why would they want to change the status quo?

I think the only way to make this happen is to legislate it. Perhaps it could start with an incentive-based approach; companies who agree to structure themselves like this get benefits in the form of tax breaks. They would have to agree to cap all existing executive compensation (everything: salary, bonuses, stock options, regular stock, etc) at a percentage of the lowest-paid employee. This would be good for the shareholders, good for the companies, and if they're successful, could be very good for the executives in the longer term.

Furthermore, for tax purposes, this income could be treated more like a long-term capital gain – only taxed at the point of sale (it would be a 100% gain, based on the sale price, and NOT the difference between the stock purchase price and the sale price – so, you couldn’t claim a loss on such income). This would mean a significant tax savings for the person receiving this type of compensation – again, an incentive to make this attractive. Personally, I think the long-term capital gain rate should be raised – a lot. But given the way things are, even if it is raised, it’s likely to be lower than the standard income rate would be for an equivalent amount.

I should note that this is very different than stock compensation which “vests” over a period. Instead, this is a “delayed-sale stock compensation”. As soon as you get it – it’s yours. You just can’t sell it. And when the 5 year period is up, you can sell it all. If you leave the company, you still keep the stock – it’s yours... Again, you just can’t sell it until the 5 years is up. If you do leave the company, then you’re running the risk that some idiot will replace you & ruin the stock price. Of course, if you’re a long-term employee of a company, after 5 years, you’ll have some stock coming due regularly.

The law would have to be written such that recipients could not agree to contracts that transfer ownership of this stock prior to the 5 year period (i.e. a possible loophole). It might be possible that someone could use this stock as collateral in a loan, effectively bypassing the delayed compensation, but this would open them up to a large risk – I’m not sure how many lenders would be willing to agree to it – unless they got very favorable terms on that loan. This could probably be addressed by legislation as well, since the whole purpose of this plan is to reward good long-term behavior. Loopholes like this should not be allowed.

In cases of death, the beneficiary couldn’t sell this stock until the 5 years had elapsed.

All bonuses, and all other short-term compensation - even stock that vests over time - are considered income in this case. Corporate perks however would not be considered income. The goal of this plan is to remove excessive short-term wealth accumulation, which can lead to persons taking bad risks. If the company owns your car, your house, gives you access to a jet, etc. you still have an incentive to run the company properly, since if you fail, you will lose all those things immediately.

Of course, the law would have to be updated to enable all of this. And it should be continually evaluated and updated to close loopholes and make sure that it’s working effectively.

If both executives and boards of directors truly have a company’s long-term financial prosperity as their primary concern, they should jump at the chance to have a plan like this. Signing up would send a strong signal to shareholders that the company is serious about long-term growth. Plus, if there were tax incentives included, it would make financial sense to engage.

Is anyone aware of such a strategy already in place? Or a similar proposal? If so, what is it called?

I’d really like to hear what others have to say on this subject, and “flesh-out” this idea. I really want to hear comments on this idea. I'd like to further refine the idea based on your feedback... and probably post new versions in future revs.

Thank you for taking the time to read & comment!

Extended (Optional)

Originally posted to walk2live on Fri Nov 21, 2008 at 08:01 AM PST.

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