Ex-Ante Severance Pay Contracts and Optimal Executive Incentive Schemes

The following post comes to us from P. Raghavendra Rau, Professor of Finance at the University of Cambridge, and Jin Xu of the Finance Area at Purdue University.

In recent years, large severance payouts to executives who have been fired from poorly performing firms have attracted a great deal of attention in the popular press. There is a considerable degree of popular outrage on what seem to be egregious ex post payments that are unrelated to the executive’s performance during his tenure at the firm. However, though severance agreements are potentially important elements of executives’ compensation contracts, there is little empirical evidence on the incidence and terms of ex ante severance agreements negotiated by executives, let alone on how these contracts fit into executives’ overall incentive compensation schemes.

In our paper, How Do Ex-Ante Severance Pay Contracts Fit into Optimal Executive Incentive Schemes?, forthcoming in the Journal of Accounting Research, we analyze a unique hand-collected sample of 3,688 severance contracts in place at 808 firms in 2004. Based on the full list of S&P1500 firms, this sample is the most comprehensive of any work in this area, including firms of all sizes, ages, and industries, and executives of a wide range of ranks including the Chief Executive Officer (CEO), Chief Financial Officer (CFO), Chief Operating Officer (COO), and other executives. Around 68% of the firms list explicit severance contract terms with their executives. Most contracts list up to three sets of benefits: explicit cash payments as multiples of salary and bonus (most common benefit); medical and life insurance benefits, and benefits covering the payment of legal fees, outplacement, and other perks.

We examine the determinants of severance pay as a component of the optimal executive contract which consists of a mixture of cash and bonus payouts, equity and option-based incentives, and severance pay. Greater total incentives (including severance pay) should be granted if existing incentives are insufficient. To incentivize managers to exert effort on behalf of shareholders, it is important to encourage them to take risk. Option pay alone is insufficient to encourage risk taking especially when firm performance is relatively poor. By modifying the payout to executives under poor performance, severance pay complements the role played by options in the optimal compensation contract.

We find that executives with explicit severance pay contracts are likely to be younger, have significantly lower lagged equity incentives and higher contemporaneous equity grants, than executives without contracts. In addition, firms with explicit severance contracts have significantly higher distress risk than firms with no explicit severance contract terms. These results hold for all executives and for the CEO in particular, and are robust to various regression specifications. We find similar results when we examine the determinants of the magnitude of severance contracts or when we analyze variations in contract types including golden parachutes (takeover related) and golden handshakes (not takeover related). Finally, we examine if firms and executives renegotiate actual severance payouts when the executive leaves the firm. In a hand collected sample of 198 firms, we find that the value of ex ante contracted severance pay is the only variable that consistently explains the ex post payouts to CEOs across all our regression specifications. We also find evidence that firms compensate CEOs for losses in ex ante contract amounts that are likely to be driven by factors that are largely out of the CEO’s control.

Overall, our evidence suggests that firms treat severance pay as they treat other equity incentives and structure their contracts to provide executives with optimal incentive levels. Thus, what appears to be an egregious discretionary payout to executives fired for poor performance is actually an execution of their ex ante employment contracts. While paying for failure seems inefficient ex post, severance pay does serve an incentive purpose ex ante.

The full paper is available for download here.

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