Economics used to be known as the dismal science. But that description could hardly be applied to the authors of scintillating books such as Freakonomics (Steven D Levitt) and The Logic of Life (Tim Harford). This new breed of economist focuses its attention on practical questions viewed through the prism that, as Levitt puts it, ‘incentives are the cornerstone of modern life’. And they both make a compelling case, explaining fascinating conundrums by examining the underlying incentives.

Charlie Munger, Warren Buffett’s business partner, puts it this way: ‘I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it.’

At The Intelligent Investor, we’re convinced: incentives matter. A lot. That’s why I’m always interested in the compensation schemes managing directors are able to negotiate for themselves. And I took a particular interest in the incentive scheme recently announced by Wesfarmers for its MD, Richard Goyder.

All too often, executives get large ‘golden handshakes' for arriving, and even larger 'golden parachutes' for leaving, well it appears that Goyder is being offered a generous 'golden armchair’ just to stick around. The new remuneration arrangements apparently reflect ‘the increased responsibilities the Coles Group acquisition has brought to the role’ (hmmm … did somebody force him to make that deal?) and follows ‘an independent review of his remuneration’ (which I’d have thought was one of the key things shareholders pay the board to do). But it’s the details shareholders need to worry about.

The sheer quantum of the numbers is striking: a base salary of $3.15m; the same amount again if he meets his short-term (less than a year) performance targets; 100,000 shares if ‘long-term’ return on equity (ROE) targets are met; and another 100,000 shares for each percentage point that the ROE exceeds the undisclosed target. The performance shares won’t be allocated for at least three years, and only then if ROE is ‘sustained’ above the relevant level (‘sustained’ meaning for a period of two years, at least for the additional percentage point bonuses; it’s not clearly spelt out for the first 100,000 shares).

At the current share price of $29, each percentage point he adds to the ROE would mean an extra $2.9m to Goyder’s hip pocket. By way of comparison, former managing director and careful steward or shareholders’ capital Michael Chaney’s salary was $2m a year. Chaney’s short-term performance bonus was a maximum of $500,000 and, when the business’s outstanding performance meant the payments due to him under the long-term incentive plan had ‘risen to levels beyond those originally envisaged for excellent performance’, he voluntarily capped his bonus at $2m a year.

Chaney’s behaviour is to be commended. But, in the scheme of things, a few tens of millions of dollars paid to the managing director won’t make a huge difference to Wesfarmers’ $19bn market capitalisation. My concern lies with the more insidious incentives this scheme puts in place for Goyder.

Boosting return on equity, in the short to medium term, is not difficult. Especially if you have a bunch of high quality assets like those on Wesfarmers’ books. Ask any investment banker and they’ll tell you the secret: borrow. Borrow all you can. If the returns provided by the assets are above the cost of debt, your return on equity will skyrocket. The highly leveraged acquisition of Coles shows Goyder knows this trick all too well.

Of course there’s a degree of risk involved. But, from Goyder’s point of view, it’s a good bet that it will take a few years before any risks rear their ugly head. Even if he struck out with an early disaster, his base salary is hardly chicken feed (and he’d have a lovely golden parachute to escape with).

Why boards don’t lock the remuneration up for longer is beyond me. If they do need to offer such potentially lucrative rewards (I’m sure Goyder would do it for half as much), at least tie him in. Make him hang on to his shares for 10 years – the company confirmed today that he can sell them the day he gets them – and he might think differently about the risks he’s taking on.

I have no reason to believe Richard Goyder is a bad person or that he’d intentionally destroy shareholder value. But most of the world’s current financial problems can be traced back to intelligent, confident, driven people, incentivised to maximise their own wealth without regard to risk. This Wesfarmers plan sounds far too similar.