Corporate boards that aim to maximize shareholder value should use executive compensation not to reward managers for luck, but to pay for their abilities and the quality of their decisions. However, this poses two significant challenges: measuring management’s ability and ruling out other independent factors. First, it is very difficult to measure and assess the ability and quality of managerial decisions, which prevents boards from paying strictly for management’s ability or decision-making. Second, performance outcomes may be used to measure management ability, but relying solely on financial performance reflects a mixture of ability, managerial decisions, luck, and other factors independent of management’s ability. Even powerful and well-intentioned corporate boards with their shareholders’ interests in mind encounter these problems of measurability and evaluation, so they resort to imperfect options.
So, in the absence of a perfect incentive structure for managers, what is the best option? The answer lies in using different performance metrics—both financial and non-financial. Although all performance measures are imperfect, each one is at least partly attributable to managers’ abilities and the quality of their decisions. By including incentives for multiple performance measures, each capturing at least some component of managerial ability and the quality of managerial decision-making, firms can provide incentives that more closely match compensation.