The issue of executive pay has resurfaced again in the wake of questionable AIG bonuses, and exorbitant compensation packages for banking executives. Pundits see the problem largely as a consequence of a lack of independence among boards of directors. They criticize compensation committees for being too cozy with top management – showering them with lavish pay, outsize option packages, and a host of other perquisites. The solution, they argue, is to increase the percentage of independent directors serving on the board, and to provide shareholders the right to vote on executive compensation. Increasing the number of independent directors, and allowing a corporation’s owners to vote on pay, should provide a healthy check to balance the system.

I agree that boards ought to share some of the blame for a system that has seen executive compensation rise from about 30 times the average employee’s salary in the 1970’s to over 100 times the average employee’s salary today. If of nothing else, board members were guilty of being complicit. In this sense then, strong independent directors might help reign in pay at the margin.

But boards are not wholly to blame.

Realistically, boards can only do so much. Outside directors must rely on management to provide them the information necessary to fulfill their obligations as stewards of the shareholders. And when it comes to executive compensation, boards rely on information provided not just by senior managers, but also by compensation consultants, who play an important role in influencing executive pay.

Allowing shareholders to vote on compensation packages might also help improve the process. But again, it is no panacea. There is no guarantee that shareholders have the level of interest and sophistication necessary to evaluate disclosures on executive pay. Those disclosures are quite complex, as putting a precise value on pay packages, especially when it comes to options, is not an exact science. What’s more, the interests of disparate shareholders do not always converge. It is not as simple as using compensation to align the incentives of shareholders and management as if shareholders were a single entity with one overarching, agreed-upon goal.

The issue is much larger than these proposed solutions can address. The reasons for the spectacular rise in executive compensation are complex. The problems are endemic to a market and institutional system which has radically changed over the last half century. Therefore, to arrive at an appropriate solution, we must start by asking ourselves some fundamental questions.

For example, we need to ask ourselves, “Who are shareholders?” Although seemingly a silly question, the answer has important implications for corporate governance and executive pay.

Historically, shareholders were individual company owners (often dispersed) who held stock for long periods of time. Today, the picture is quite different. Shareholders are represented less and less by individuals and institutions holding stocks for the long-term, and more and more by individuals and institutions looking to make a quick profit - buying and selling shares with frequency. The rise of such traders who seek to profit from near-term volatility in stock prices has changed the nature of the system. These traders are inconsistent with the spirit of the view of the shareholder as a long-term owner. They are not really owners, and sometimes have little interest in the long-term survival of the firm. They often only care about micro-movements in share price in a very narrow window of time.

This short-termism among shareholders has spilled over to CEO’s as well. Recall that the standard assumption in finance and accounting is that firms have an infinite lifespan, and that firms should therefore maximize the net present value of all future cash flows. Unfortunately, there is a fundamental disconnect between some of these assumptions and the state of the world. Humans do not have an infinite lifespan; firms fail; and the average tenure of a typical CEO is now fewer than 5 years.

This creates a severe incentive problem. What incentive do CEO’s have to look out for the best long-term interests of the firm if they will only be around for a few years? In this sense then, CEO’s have an incentive to increase near-term performance sometimes at the expense of long-term performance.

It has been argued that the market keeps such CEO’s in check because it penalizes CEO’s (and a firm’s share price) for making short-sighted, near-term decisions. Unfortunately, the field of behavioral economics has been showing us that market participants are not very good at valuing the long-term consequences (with more than a 5 year horizon) of managerial decisions. What’s more, with institutions interested in trading than in ownership, the incentives of the institutions align with those of the CEO’s. That is, with institutions looking to make a quick profit, short-termism on the part of the CEO is not only condoned, but sometimes encouraged.

This is an often overlooked factor leading to increased CEO pay - the advent of a short-termism, consume now pay the consequences later, system.

For boards, this presents a dilemma. How are boards to act as stewards of the shareholder when it is unclear who shareholders are, and which shareholder’s interests they should advocate? To resolve this dilemma, boards should abstract from any individual shareholder. They must also think beyond the lifespan of the CEO. In essence, they must act in the best interests of a theoretical, long-term owner.

Admittedly, executive pay is a complex problem. An important first step is to recognize the problem. Our aim should be to find a way to tie executive compensation to some metric that allows us to assess whether the CEO and management team leave the firm in a better position than they found it. That is easier said than done.

In the meantime, until we solve the dilemma endemic to our current system, an increase in the independence of director, and measures that improve shareholder rights, are a step in the right direction. But ultimately, the solution must be more broad-based than simply applying band-aid type measures.