Executive Compensation: The Cobra Effect
How Goodhart’s and Campbell’s Laws Explain Executive Pay Failures
Recently I published a post entitled ‘How Companies Lose Their Soul - And Take Your Money With Them’ which proved very popular. This post continues on the same theme.
The Cobra Effect
When incentives are wrong, unintended outcomes follow.
This is known as the ‘Cobra Effect’.
Why?
In Colonial India, the British government became concerned about the number of venomous cobras in Delhi. They offered a bounty for every dead cobra brought to them. You can imagine what happened next. Enterprising locals began breeding cobras to harvest the reward. When the government realized people were gaming the system, the reward was withdrawn. In response, the breeders set their now-worthless snakes free, resulting in an explosion in the cobra population which was now much higher than when the program started.
People respond to incentives, but poorly designed incentives lead to the wrong responses.
This pattern is evident throughout history.
In the 19th Century, lawyers in England were paid by the word for drafting legal contracts. The response? Unecessarily long, complex and verbose legal agreements.
Unfortunately, we seem never to learn from history.
Incentives designed to achieve one objective often lead to an outcome that is entirely counter to objective.
This brings us neatly to the topic being discussed today; executive compensation. Incentives are often all wrong, and that matters to the returns we will ultimately achieve.
Boards anchor pay to measurable outcomes such as earnings per share, return on equity, revenue growth, and share price. The stated goal is alignment. The realised outcome is often optimisation of the metric.
“When a measure becomes a target, it ceases to be a good measure.”
Goodhart’s law
EPS may be a useful measure of progress for investors, but as a target, it becomes a lever for manipulation.
Committees mistake the metric’s ease of use for its truthfulness, forgetting that executives will optimize precisely what is measured, not what is intended.
“The more a quantitative indicator is used for high-stakes decision-making, the more subject it is to corruption pressures, and the more it distorts the process it’s meant to monitor.”
Campbell’s law
In the C-suite context, “corruption” need not mean fraud, it means behavioural distortion.
A CEO can reach an EPS target through buybacks, cost deferrals, accounting choices, or reduced investment. Each action improves the number. None guarantee durable value creation. When equity awards are tied to short term markers, decision making follows the scorecard.
The same applies to EBITDA targets. EBITDA can be increased through acquisitions that add scale but destroy value, particularly where management overpays or pursues deals for optics rather than returns.
Market capitalisation or share price targets present a different flaw. To a large extent, both are influenced by market sentiment, interest rates and sector multiples. Why reward a CEO for variables outside of his control?
Market cap can also be inflated through issuing new equity to fund empire building. The headline valuation may rise, while dilution leaves existing shareholders no better off.
A confidence trick is to tie remuneration to share price. Investors love the idea that management are focused on driving up the share price. But what might it do to capital allocation priorities? Reinvestment in growth may be sacrificed in favour of buy-backs, irrespective value accretion. If the number of shares outstanding declines, the market cap may be unchanged, but the share price increases. Will anyone notice the destruction of equity capital? Worse still, cost cutting and reinvestment reductions flatters near-term earnings, supporting the share price temporarily, but often at the expense of the long-term prospects for the company.
Unfortunately, remuneration committees are mostly incompetent (or else corrupt).
Quantifiable systems feel objective and defensible. They are usually defended using one of the most misquoted sayings in business: “You can’t manage what you can’t measure.”
The correct quote actually states the complete opposite:
“It is wrong to suppose that if you can’t measure it, you can’t manage it – a costly myth.”
W. Edwards Deming (The New Economics)
Ultimately, Goodhart and Campbell remind us the Cobra Effect is a classic agency problem. When you tether a massive executive payout to a narrow metric, executives will naturally optimize for that metric, even if it means burning the house down to keep the thermometer at the right temperature.
The Incentive Trap
Financial incentives are overrated as a driver of performance. If anything, they are a contrarian indicator. If management need a financial carrot dangled before their nose simply to make them work, they’re not the right people.
What tends to matter more is a combination of passion, drive, and ability. Those qualities determine how someone approaches the work when no one is watching and no metric is being tracked.
Incentives can sharpen focus at the margin, but they rarely create the underlying energy required for sustained excellence.
Charlie Munger liked to quote the mathematician Carl Gustav Jacob Jacobi: “invert, always invert.”
Most people look at elite performance and ask what it costs to produce it. But inversion leads to a more revealing question: what would it cost to persuade someone to stop?
That changes the frame entirely.
For people operating at the highest level, the work isn’t transactional. It’s their identity, obsession, curiosity, and craft wrapped together. There simply is no amount of money that would persuade them to walk away because the work itself is their reward.
You see this most clearly in people whose identity is inseparable from what they build. Steve Jobs, Thomas Edison, Walt Disney, Henry Ford and Jeff Bezos did not treat work as something to be exchanged for a better compensation package elsewhere. They were driven by a view of how the world could change and a determination to shape that outcome themselves.
None of them began wealthy. Their fortunes were not produced by carefully calibrated incentive plans or bonus structures. Wealth arrived later as a byproduct of success in the work itself.
The common thread was obsession. An unusual tolerance for failure. A willingness to persist long after rational incentives would have stopped most people.
A sports analogy makes the same point in a simpler way. Since we are in the midst of the Football (‘Soccer’ if you’re American) World Cup, let’s consider the elite Portuguese player Cristiano Ronaldo who has won almost everything in the game worth winning.
Long before contracts, endorsements, or global fame, he was obsessively playing football on the streets of Madeira as a kid. Even after becoming one of the best players in the world, the pattern never changed. He stayed after training; repetition, practice, chasing marginal improvements. Not because anyone required it, but because he wanted to.
You could see it in the emotional intensity he brought to the game. When he failed, or when his team fell short, he took it personally. Crying became his trade mark. It wasn’t a sign of weakness, it was evidence of passion which was his strength.
That combination of ability, internal drive, and relentless self-imposed expectations produced the outcome. Those are the real ingredients of elite performance. Money is entirely downstream; a consequence of success, not its driver.
Most professional footballers are retired by their mid-30s. Ronaldo is still competing at 41. He became the first active footballer to surpass $1 billion in career earnings, but the financial outcome misses the point entirely. There is no amount of money that would persuade him to stop playing while he still believes he can compete. He continues because he loves the work itself.
He is, in many ways, the Warren Buffett equivalent in the football world.
You could reduce Ronaldo’s pay materially (or Buffett’s for that matter) and his performance would still be elite. In stark contrast, try to reproduce that level of performance by offering more money to someone without the requisite passion. Great performance doesn’t need to be bought. More particularly, it can’t be bought.
This is where incentive design runs into its limits. Money follows success, it doesn’t creates it. When organizations focus too heavily on compensation as the lever, they tend to get surface-level compliance rather than performance.
The real constraint is usually not the incentive system. It is the people inside the system. People don’t need to be superstars like Steve Jobs, Warren Buffett or Cristiano Ronalso. Organizations like Toyota and DuPont have shown that by encouraging people take genuine ownership over the work itself, performance becomes durable and repeatable. Incentives can support that culture, but they can’t substitute for it.
Avoiding Flaws in Incentive Programmes
If incentive plans are deemed necessary, the most common pitfall is rewarding short-term spikes in performance.
The drivers of long term value sit outside clean measurement. Culture, product quality, innovation, employee retention and customer satisfaction do not fit into a compensation formula, yet they determine outcomes.
The job is to build durable value. Targets are, at best, rough signals. At worst, diverting energy and resourse away from where they ought to be focused.
Remuneration committees must embrace humility: no set of numbers can capture true executive performance.
A well defined remuneration policy includes, without limitation:
Longer Vesting Periods and Post-Exit Holding Requirements ~ Extend vesting beyond the tenure of the executive. This forces executives to care about the "long tail" of their decisions. Requiring executives to maintain a significant equity stake for a year or two after they leave the company discourages "pump and dump" strategies before retirement.
Malus and Clawback Provisions ~ Strengthen the ability of the company to recoup bonuses if later found that results were achieved through unsustainable risk or accounting manipulation.
Peer-Group Calibration ~ If the whole sector moves with the cycle, should an executive be rewarded for something that would have happened with or without him? Similarly, rewarding growth in absolute terms is a flawed approach; If the entire industry grows by 20% and your company grows by 5%, a bonus based on absolute growth is rewarding underperformance (yet many companies do just this).
Multiple Metrics to Balance the Equation ~ The Rule of 40, as popularized by the SaaS sector, requires that the revenue growth rate added to its profit margin exceeds 40%. This avoids the temptation to boost top line growth by sacrificing profitability.
Selection of Metrics with Purpose ~ Return on Invested Capital (ROIC) ensures growth isn't just fueled by cheap debt.
Is there a Better Way?
Ultimately, the goal is to transition the executive from a "hired gun" focused on hitting a target, to a "steward" focused on compounding value.
Steve Jobs captured this well. He separated mercenaries from missionaries. One optimises for pay and status. The other is driven by the outcome itself. Over time, only one of these mindsets builds enduring value.
A sporting lens makes this clearer. If a player only performs when incentivised in the moment, you question their place in the team. Elite athletes train, recover, and compete at extreme levels because they are wired that way. The discipline is internal. The incentive is secondary. That is the standard you want in leadership.
Corporate executives should not be any different. They accept their salaried position in the belief that they have the skill and expertise to make a difference to the team they are joining. If the company has to constantly “pull” performance out of them through fancy remuneration structures, the wrong person is in the job.
At Berkshire Hathaway, Warren Buffett took a fixed $100,000 salary for decades and declined bonuses despite extraordinary results. The message was unambiguous. Alignment comes through ownership, not engineered pay schemes.
…most of our directors have a major portion of their net worth invested in the company. We eat our own cooking… we can guarantee that your financial fortunes will move in lock-step with ours for whatever period of time you elect to be [invested]. We have no interest in large salaries or options or other means of gaining an ‘edge’ over you. We want to make money only when our partners do and in exactly the same proportion. Moreover, when I do something dumb, I want you to be able to derive some solace from the fact that my financial suffering is proportional to yours.
BERKSHIRE HATHAWAY OWNERS MANUAL
The result was sustained compounding, not periodic target hitting. Berkshire Hathaway never fell victim to the Cobra Effect.
Is there a better way? You bet there is!
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