Replacing Executive Equity Compensation: The Case for Cash for Long-Term Performance

Nitzan Shilon is Associate Professor at Peking University School of Transnational Law and a Commissioner of the Israel Securities Authority. This post is based on his recent paper. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).

In a new paper, Replacing Executive Equity Compensation: The Case for Cash for Long-Term Performance, I reconsider the way in which corporate executives in U.S. public firms are paid for long-term performance. Paying top executives in equity (stock and stock options) is the most significant reform of executive compensation in our generation, universally welcomed not only by firms but also by academics, investors, and policy makers. Yet I argue that equity compensation is undesirable. It provides perverse incentives for managers to destroy shareholder value and behave manipulatively and recklessly. It is also economically wasteful, and its wastefulness, which is exacerbated by agency costs and cognitive biases, significantly contributes to the immense explosion of executive compensation.

Instead, I suggest a radical proposal: to replace such equity pay arrangements with carefully designed cash-for-performance schemes in which executives are rewarded in cash for attaining certain long-term performance criteria. I further recommend that this reform be implemented systemically and that the tax and disclosure rules that are applied to cash incentive remuneration be placed on a level playing field with those that are applied to equity incentive pay. This reform is expected to eliminate the significant costs of equity compensation and make incentive pay more effective, transparent, cheap, and better tied to performance, while retaining the limited incentive benefits generated by current equity compensation arrangements.

Below is a more detailed account of my analysis:

The corporate governance scandals of the early 2000s and the financial crisis of 2008-2009 led to a widespread recognition that equity compensation arrangements provide corporate executives with incentives to destroy shareholder value and that the aggregate compensation payments that equity pay creates are so large as to mock the shareholder interests that such pay is intended to promote. The media as well as academic studies have pointed out how executives and directors of many failing companies during that decade managed to enrich themselves by selling their stock-based compensation shortly before their companies’ stock prices crumpled. Their reports have cast doubt on executive compensation’s intended incentive efficiency and, as President Barack Obama emphasized, highlight its focus on narrow self-interest and short-term gain at the expense of everything else. Leading government officials such as Federal Reserve Chairman Ben Bernanke and Treasury Secretary Timothy Geithner, as well as high-ranking business moguls such as Goldman Sachs’s CEO Lloyd Blankfein, have all stressed their concern about the flawed incentives that equity compensation provides. Such concern resulted in strong language used against executive compensation when, in 2002, Bill McDonough, president of the Federal Reserve, referred to its skyrocketing levels as “morally dubious” and, in 2009, President Obama called the situation “shameful.”

I explain that the extensive use of equity pay for corporate executives reflects the classical view of executive compensation: that paying managers in stock and stock options can make them think more like stockowners, thus greatly aligning their incentives with the interests of shareholders; that equity pay efficiently trades off risk sharing and incentive considerations, and incorporates performance information that cannot be extracted from the firm’s accounting data; and that equity pay aims not only to help attract and retain talent but also to optimize executives’ risk appetite. In support of this view, a series of empirical studies shows that executives who hold more stock are significantly better stewards for their shareholders.

Yet, contrary to this view, my analysis indicates that paying managers in equity is undesirable. For starters, stock price is a biased estimator of management performance. First, for most firms, stock price movement is generally not due to executives’ actions but instead reflects market- and industry-wide trends. In this sense, equity pay does not so much reflect “pay for performance” as it does “pay for pulse.” Second, because of market inefficiencies, stock prices can deviate from fundamental values for prolonged periods of time and thus are especially poor reflections of managerial actions with long-term horizons. Third, managers may be able to manipulate stock price by managing direct earnings, misreporting results, suppressing bad news, making misleading public statements, conducting stock buybacks, or performing other acts of “window dressing.”

Moreover, instead of making corporate executives better stewards for shareholders, equity compensation—owing to executives’ freedom to hedge or sell it—not only reduces their incentives to enhance firm value but also provides them with perverse incentives to destroy it. Executives who expect to unload their shares are motivated to sacrifice long-term value for short-term gain, take excessive risks, reject value-increasing risky projects, manipulate stock price, and trade on inside information.

My article further shows that equity pay’s inherent wastefulness—caused by both the transfer of firm-specific risk from well-diversified, risk-neutral public shareholders to risk-averse, underdiversified managers and the imposition of liquidity costs on managers, and exacerbated by the psychological biases that it triggers, which make firms underestimate the cost of equity and for managers to underestimate it—propels an explosion in executive compensation amounts. Moreover, equity pay creates an opportunity for managers to increase their agency costs and push boards to pay them in equity in addition to, rather than in return for, other pay components. Equity pay costs are so high that, since its introduction in the early 1980s, CEO compensation rose almost tenfold, doubling the growth in the stock market and making the gap between CEO pay and that of the average worker nearly ten times larger.

To solve the problems involved with using change in stock price as a performance measure, firms aggressively shift from time-based to performance-based equity plans; to alleviate the perverse incentives arising from managers’ ability to unload their equity pay, academics propose optimal unloading restriction schemes. However, I suggest that both issues—as well as the inflated amounts that executives currently receive as compensation—could be addressed by replacing equity compensation with cash awards paid to executives for attaining long-term performance criteria. To this end I outline two variants: (1) a “Predetermined Cash Amount,” which uses fixed cash amounts that executives would pocket for attaining certain performance criteria, or (2) a “Performance Phantom Shares” approach, which entitles managers who hit their performance targets to the grant-date cash value of fixed stock amounts. By saving the risk-bearing, liquidity, and diversification costs inherent in equity pay and instead paying managers in cash, which they value significantly more, the proposed cash-for-performance plans would assist boards in negotiating reduced executive compensation amounts. By avoiding the grant of gigantic amounts of unloadable equity, these plans would obviate the perverse incentives inherent in equity pay. And by measuring performance using deliberate long-term performance measures, they would not only improve measurement accuracy and pay effectiveness but also enhance pay transparency and pay-performance sensitivity.

My statistical analysis of the quantitative and qualitative data disclosed in public filings of firms included in the S&P 100 showed that eighteen of the one hundred most prominent U.S. firms already reward their executives for long-term performance in cash. Unfortunately, their plans are generally designed in ways that benefit managers at the expense of shareholders. My proposed reform instead offers a trade: reduced executive pay for an improved form of pay and improved executive incentives. To avoid the flaws present in current long-term cash incentive schemes, plans that would facilitate my reform must be designed and promoted systemically by institutional investors and their influential proxy advisory firms. In addition, to enable firms to evaluate the proposed arrangement fairly, cash remuneration should be placed on a level playing field with equity, and distortions created by tax and disclosure rules should be eliminated.

My paper, I hope, will contribute to the ongoing discussions on improving executive compensation. Paying executives in cash for long-term performance in line with my proposed arrangement would benefit shareholders and do much to revamp executive pay arrangements.

The complete paper is available for download here.

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