Contemporary executive compensation is largely a case of rewarding X while hoping for Y. Let me explain.

Imagine that you hold stock in a firm where the chief executive officer's pay is set to match the pay of the other CEOs that sit on the company's board, even though their companies are in entirely different industries. Or, imagine that a company you invested in has just publicized a major downsizing, causing the stock to spike in time to reap a windfall for the CEO whose pay is tied to the stock price.

Now stop imagining, because both of these scenarios are the rule rather than the exception in the United States. Executive compensation today is largely a case of paying for X while hoping for Y, a situation that doesn't ultimately benefit the company, its investors or its employees.

The first scenario -- a clubby pay-matching scheme -- bears no relation to the particular CEO's contribution, accomplishments or even market value. Indeed, there is compelling evidence that the CEO's social network and personal power play a far greater role than actual bottom-line performance in determining CEO pay. In many publicly traded companies, the CEO's friends on the board and personal clout are the essential determinants of how much money he or she takes home, according to Forbes data.

The second scenario illustrates the findings published in the 1997 Academy of Management Journal: Downsizing raises stock prices in the short term, but within three years, stock prices drop to well below prior levels. Short-term stock price is readily manipulated, but not so in the longer term. That's a key factor in high CEO turnover in firms with a short-term orientation.

As investors and employees, we depend on a company's management to make decisions that advance our interests. But the fact of the matter is that current compensation practices often undermine CEO effectiveness and harm both a firm's stockholders and workers. Typically, executive pay encourages (and rewards) short-term thinking and self-serving behavior, fails to serve both investors and employees, and probably isn't what most CEOs themselves set out to accomplish.

Why are CEOs paid in ways that don't benefit their companies and shareholders? Corrupt corporate governance is one reason. A board assembled by a CEO is not especially independent. Pay is tied to performance in companies where a powerful shareholder, like an institutional investor, can discipline top management, and that's less likely to happen at a corporation where the board is beholden to the CEO.

But better governance alone is not enough. CEO compensation packages should be designed to correlate to company performance. In 2005, the best predictor of executive compensation is not profitability, but firm size, giving CEOs a big incentive to look for merger and acquisition opportunities.

The lack of relationship between executive pay and bottom-line performance has led to calls for reform. But how? At issue are our beliefs regarding the right way to pay CEOs. To date, many companies have gotten it wrong.

We wouldn't expect a CEO in a volatile competitive business to be paid in the same way as someone in a regulated utility. A CEO leading a risky turnaround requires different compensation than one managing a firm targeting long-term growth.

The wrong compensation scheme can cause executives to forgo investments in research and development or in work force training, focusing instead on short-term profits where corporate strategy calls for growth. By abandoning long-term strategies that benefit both investors and workers in favor of cash-flow tricks and stock-price maneuvers, executive compensation becomes an end in itself, diverging from the health and prosperity of the company. Incentives -- which are certainly important in the "war for talent" -- must be the right ones to protect an organization's long-term interests.

Exorbitant bonuses, options and other incentives, written into total compensation packages, convey a sense of entitlement, perpetuating the notion that a single individual can make the critical difference to a company's success. This notion ignores the strategic value of a firm's asset mix: human and intellectual capital.

It also perpetuates a "star" system with seemingly unlimited upside to income, at one company or another. Why should CEOs stay on for the long hard work when they can jump to other ships for still more pay? Why worry about results if pay is not pegged to performance?

CEO pay is often out of line with the basic equities of contribution and accomplishment. In most companies, work force efforts have a direct and significant effect on strategic goals (e.g., quality, innovation). Pay equity and fairness matter tremendously in such companies.

The higher the ratio of CEO to worker pay, the greater the disconnect between the results stakeholders hope for and what's actually being rewarded. Out-of-whack ratios lead to lower quality and innovation. Office workers and point-of-service employees are sensitive to the signals that big pay packages send when company performance doesn't justify them. Even setting CEO pay based upon industry benchmarks may not be an effective standard given the distinctive contributions required of a given CEO and the inflated nature of many current compensation packages.

Genuine incentive compensation means paying CEOs based on strong business strategy and suitable measures for gauging its accomplishment. It means internal equity where the basis of compensation makes sense to both employees and investors. And it means transparency where the compensation package can be disclosed without embarrassment.

A board's responsibility is to see to it that the CEO compensation package does what good reward systems do: attract competent people and reward them for objectively above-standard contributions and long-term performance. Executives should certainly be paid well, as long as their companies do well, too.