James Surowiecki lays it out:
a recent study of almost a thousand companies by the management professors W. Gerard Sanders and Donald Hambrick found that C.E.O.s whose compensation was made up mostly of stock options tended to “swing for the fences,” making investments and acquisitions that were riskier than those made by other executives. As a result, the performance of the companies run by the risk-takers was far more volatile, and not for the good of the companies: the risky strategies were more likely to end in a big failure than a big gain. Generous options grants may also encourage fraud; the business professors Jared Harris and Philip Bromiley, who have made a study of hundreds of firms forced to restate earnings after accounting irregularities, found that companies that paid out most of their compensation in stock options were far more likely to end up restating earnings. And, as with hedge funds, the perverse effects of performance pay are exacerbated by the fact that big bonuses are often based on short-term performance. Stanley O'Neal, who was recently forced to resign as the C.E.O. of Merrill Lynch, made eighty-four million dollars in 2005 and 2006, a figure based in part on the huge profits that Merrill booked as a result of its forays into the subprime market.This gets to larger issues with so-called "performance pay."
Depending on what metrics you're using to evaluate performance (and thus dictate pay), you risk distorting a worker's incentives to approach their job in a balanced, prudent, way. If a teacher's whole compensation is based on test scores, for instance, you'll not only have a lot of teaching to the test, you may simply see the test -- or at least past versions of it -- being taught. That may make for comfortingly high test scores, but it may also lead to less actual learning, less critical thinking, less adaptive educations, etc. If a CEO's pay is based on stock options, amping up the price of the stock -- even in the short-term -- becomes more attractive. If a journalist were to be paid on a per word rate, you'd get a lot of block quoting and very few contractions. And so on, and so forth. This stuff isn't as easy as people would like it to be.
