Is Pay Too High and Are Incentives Too Low?

In this paper, Is Pay Too High and Are Incentives Too Low? A Wealth-Based Contracting Framework, which was recently published on SSRN, my co-author, Wayne Guay, and I describe a wealth-based contracting framework useful in structuring executive compensation and incentives.  In the wake of the recent financial crisis, US executive compensation has, once again, come under fire from regulators, politicians, the financial press, the general public, and some academics. Although the critiques are varied, many identify the level of pay and performance-based incentives as two key areas of concern. And, as is often the case in the wake of a crisis, proposals have been put forward to resolve the “problems” with executive pay and incentives. A deficiency with all of these proposals, however, is the failure to articulate a framework for determining the appropriate level of executive incentives. Rather, the proposals simply discuss ways firms or regulators might get executives to hold greater incentives without identifying how one should determine whether or when an executive has enough (or too much) incentives.

We lay out an economic framework for thinking about how much performance-based incentives an executive should have. This framework makes clear both the benefits and costs of incentives. And, given that there are both costs and benefits of performance-based incentives, problems arise when executives have either too little, or too much in the way of incentives. US executives typically have much stronger performance-based incentives than executives in any other country (e.g., Conyon, Core, and Guay, 2009). Thus, it is not at all obvious that there is too little pay-for-performance, and problems associated with too much in the way of incentives seem just as plausible as problems associated with incentives that are too little.

A key takeaway from our discussion is that performance-based incentives must be considered in the context of each executive’s wealth. For example, a requirement that all executives hold $10 million in firm stock will result in very different incentives for an executive with $100 million in outside wealth as compared to an executive with only $10 million in outside wealth. There is a popular saying that an executive should have “skin in the game.” But, what constitutes significant “skin” for one executive might be relatively trivial for another executive. Finally, while the merits of wealth-based contracting seem worthwhile, there are undoubtedly issues to resolve with respect to obtaining information about executives’ wealth. Public disclosure of such data (e.g., through proxy statements) is tricky due to issues of privacy. However, private disclosure of this information to boards, with more generic disclosures assuring investors that boards have considered this information, seems workable.

The full paper is available for download here.