The Optimal Duration of Executive Compensation

In the paper, The Optimal Duration of Executive Compensation: Theory and Evidence, which was recently made publically available on SSRN, we ask several questions: How long does it take for a typical executive pay contract to vest, and how does this vary in the cross-section? Does the mix of short-term and long-term pay affect executive behavior? We first develop a simple model to understand the determinants of executive pay duration, and then take its predictions to a unique dataset. Our model has two features. First, the stock market can misprice a firm’s equity in the short-run. Second, the executive can engage in inefficient extraction of private benefits which can be partly moderated through a long-term incentive contract. This setting allows us to focus on the shareholders’ tradeoff between short-term and long-term pay for the CEO. Given the potential for short-term mispricing of the firm’s stock, awarding the CEO short-term stock compensation allows her to benefit from the option of selling overvalued stock, which effectively lowers the initial shareholders’ cost of compensating the CEO. However, exclusive reliance on short-term compensation also encourages the CEO to behave myopically, diverting effort to the extraction of inefficient private benefits at the expense of long-term value. Thus, providing the CEO with long-term compensation is essential to attenuate this moral hazard. This model generates three main predictions. First, optimal pay duration is decreasing in the magnitude of stock mispricing. Second, optimal pay duration is longer in firms with poorer corporate governance. Third, CEOs with shorter pay durations are more likely to engage in myopic investment behaviors and this relation between pay duration and investment myopia is stronger when the extent of stock mispricing is larger.

To test the model’s predictions, we develop a new measure of executive pay duration to characterize the mix of short-term and long-term pay. This measure is a close cousin of the duration measure developed for bonds. We compute it as the weighted average of the vesting periods of the different pay components, with the weight for each component being equal to the fraction of that component in the executive’s total compensation. We use this measure with systematic data on the vesting schedules of restricted stock and stock options for our empirical analysis; we believe this is the first time in the literature that such comprehensive data have been brought to bear on the aforementioned questions.

We find that the vesting periods for both restricted stock and stock options cluster around the three to five-year period, with a large proportion of the grants vesting in a fractional (graded) manner during the vesting period. There is, however, significant cross-sectional variation in the vesting schedules. Industries with longer-duration projects, such as Defense, Utilities, and Coal, offer longer vesting schedules to their executives, suggesting an attempt at matching executive pay duration to project and asset duration. We also find that firms in the financial services industry have some of the longest vesting schedules in their executive pay contracts. This is somewhat surprising in light of the recent and heavy criticism that short-termism in executive compensation at banks may have contributed to the 2007-09 financial crisis.

To test the first prediction, we use stock liquidity and the extent of dispersion among analysts’ earnings forecast to identify stock mispricing, with lower liquidity and greater dispersion indicating a greater magnitude of mispricing. Consistent with our model’s prediction, we find that pay duration is decreasing in the extent of stock mispricing: it is longer for executives in firms with more liquid stocks (lower bid-ask spread and higher turnover) and in firms with less analyst earnings forecast dispersion. We also find that pay duration is longer for CEOs in firms with a higher Bebchuk, Cohen and Ferrell (2009) entrenchment index, and is longer for all executives in firms with smaller boards, with less non-executive director shareholding and for executives with lower shareholdings. These results provide support for our second prediction that pay duration is longer in firms with poorer governance as a means of overcoming the shortfall. Finally, turning to our third prediction, we find evidence that executives with short-duration pay contracts act myopically. We use the level of discretionary accruals and the likelihood of R&D expenditure cuts as proxies for actions spurred by managerial myopia. We find that firms that offer their CEOs shorter-duration pay contracts have higher levels of discretionary accruals. The positive association between CEO pay duration and discretionary accruals is only present for earnings-enhancing, positive accruals. We further find that firms that offer their CEOs shorter-duration pay contracts are more likely to cut R&D expenditure. This effect is stronger in the subsample of firms with less liquid stock where we anticipate the magnitude of mispricing to be greater. Thus, our third prediction is empirically supported as well.

There has been a long-standing intuition in the executive compensation literature that the extent to which a CEO’s compensation is long-term or short-term will affect the investment and effort allocation decision of the CEO. However, lacking an empirical measure that quantified the extent to which compensation is short-term or long-term, it has not been possible to give legs to this intuition. We believe our paper is a first step to fill such a gap in the literature.

The full paper is available for download here.