Saturday, January 25, 2014

Severance Pay Incentives and Disincentives

There is a lot of speculation today about the severance pay of a fired Yahoo executive. The payment is somewhere between $40 million and $80 million, depending on which assumptions you believe. This kind of money is worth a headline not just because it could be a new record for a corporate executive fired for poor performance, but also because the payment comes from an employer that is financially struggling and could shut down within a matter of a few years.

There is an obvious problem when severance terms are this generous — or indeed, whenever they exceed about $2 million. As a worker, if you know you will be paid a fortune if you are fired, it creates a powerful incentive to get fired. No matter how proud you are as a worker, there is an unavoidable subconscious impact of knowing that if you got fired, you would be set for life. And since incentive payments may not be payable in a case of misconduct, but are fully due if the cause is poor results or organization change, the large severance plan creates an unnatural and unavoidable incentive to perform poorly and to contribute to unproductive organizational change.

At Yahoo, poor performance was not the real cause of the firing, and the termination payments, though undeniably large, are not quite so large when you look at them in economic terms. The largest component of the severance pay is $20 million to replace the signing bonus that had not yet been paid to the executive, and the signing bonus in turn was meant to replace the retention bonuses he would have received had he stayed with his former employer. By all outward appearances, he did a good job at Yahoo, but it didn’t make much difference because of Yahoo’s weak business plan. When it became clear that the company had made a mistake in hiring him, he couldn’t resign, and not just because he liked his job and wanted to keep it as long as he could — if he had resigned, he would have forfeited at least $60 million in pay. That is enough of a disincentive to deter almost anyone from resigning, no matter how a job is going.

Of course, that is part of the intention of severance pay — that a worker will stay on as long as the employer needs him. It worked that way in this case. What is not so clear is whether either the worker or the employer benefited. Just the sheer magnitude of executive pay creates a bizarre web of incentives and disincentives that in the end, probably deter productive work just as much as they motivate it. Executives would be more directly motivated if they were not paid so much.

The tax code effectively subsidizes these oversized executive pay plans, and that is one avenue that could be explored for changing things. Currently, virtually all executive pay is a tax deduction for the employer, no matter how outlandish. I would suggest a cap on corporate tax deductions for salaries, perhaps somewhere around 1.5 million per year for any one employee, and a very strict cap on deductibility of compensation of any kind for any employee at the level I have suggested before, around $19 million. Congress could, in principle, enact this change with a two-page statute. Obviously a reform like this would never come to a vote in the current do-nothing House, but perhaps after this year’s elections this kind of reform could be considered.