Wednesday, 24 June 2009

How to pay executives?

In their book "Pay Without Performance: The Unfulfilled Promise of Executive Compensation", Lucian Bebchuk and Jesse Fried argue that executive compensation is set by managers themselves to maximise their own pay, rather than by boards looking after the interests of shareholders. Some commentators have gone so far as to argue that executives’ pay schemes were major contributors to the financial crisis, encouraging them to take on too much risk and manage their company for short-term profit.

In a column at Alex Edmans and Xavier Gabaix propose a solution to address the economic issues that are at heart of the current crisis to prevent future value destruction. Edmans and Gabaix argue that existing payment schemes have two major problems,
First, stock and options typically have short vesting periods, allowing executives to “cash out” early. For example, Angelo Mozilo, the former CEO of Countrywide Financial, made $129 million from stock sales in the twelve months prior to the start of the subprime crisis. This encourages managers to pump up the short-term stock price at the expense of long-run value – for instance by originating risky loans, scrapping investment projects, or manipulating earnings – because they can liquidate their holdings before the long-run damage appears. Long-term incentives must be provided for the manager to maximise long-term value, which we call the “long-horizon principle.”

Second, current schemes fail to keep pace with a firm’s changing conditions. If a company’s stock price plummets, stock options are close to worthless and have little incentive effect – precisely at the time when managerial effort is particularly critical. This problem may still exist even if the executive has only shares and no options. Consider a CEO who is paid $4 million in cash and $6 million in stock. If the share price halves, his stock is now worth $3 million. Exerting effort to improve firm value by 1% now increases his pay by only $30,000 rather than $60,000 and may provide insufficient motivation. To maintain incentives, the CEO must be forced to hold more shares after firm value declines. Our research has shown that, to motivate a manager, a given percentage increase in firm value (say 10%) must generate a sufficiently high percentage increase in pay (say 6%). In the above example, this is achieved by ensuring that, at all times, 60% of the manager’s pay is stock. We call this the “constant percentage principle.” The appropriate proportion will vary across firms depending on their industry and life cycle, but we estimate 60% as a ballpark number for the average firm.
The "long-horizon principle" and the "constant percentage principle" can be achieved by giving the executive a scheme Edmans and Gabaix call an "Incentive Account". Their scheme
[...] contains two critical features – rebalancing to address the constant percentage principle and gradual vesting to satisfy the long-horizon principle. Each year, the manager’s annual pay is escrowed in a portfolio to which he has no immediate access. In the above example, 60% of the portfolio is invested in the firm’s stock and the remainder in cash. As time passes and the firm’s value changes, this portfolio is rebalanced monthly so that 60% of the account remains invested in stock at all times. In our example, after the stock price halves, the Incentive Account is now worth $7 million ($4 million cash and $3 million of stock). This requires the CEO to hold $4.2 million of equity, which is achieved by using $1.2 million of cash to buy stock. This satisfies the “constant percentage principle” and maintains the manager’s incentives after firm value has declined. Importantly, the additional stock is accompanied by a reduction in cash – it is not given for free. This addresses a major concern with repricing stock options after the share price falls – the CEO is rewarded for failure.

Each month, a fixed fraction of the Incentive Account vests and is paid to the executive. Even when the manager leaves, he does not receive the entire value of the Incentive Account immediately. Instead, it continues to vest gradually; full vesting will occur only after several years. By then, most manipulation or hidden risk will have become public information and affected the stock price and thus the account’s value. Since the manager has significant wealth tied in the firm even after his departure, he has fewer incentives to manipulate earnings in the short term.

While the Incentive Account may seem a marked departure from current practices, it can be approximately implemented using standard compensation instruments without setting up a special account. In each period, the board pays the CEO a mix of deferred (cash) compensation and restricted stock. If performance is poor, the next period the CEO’s salary is paid exclusively in restricted stock; upon strong performance, it is paid exclusively in deferred cash.
Edmans and Gabaix note that ideas of gradual vesting is not without its costs. When compared to short-term vesting, it imposes more risk on the executive and they may argue for a higher salary as compensation for this risk. But the benefits of a high-powered incentive scheme are much greater than its costs. Edmans and Gabaix point out that even if an optimal contract induces the CEO to increase firm value by only an additional 1%, this is $100 million when applied to a $10 billion firm. Such an increase in value vastly exceeds any required compensation for any additional risk being borne by the executive. For a given vesting period and target incentive level, Edmans and Gabaix can demonstrate mathematically that Incentive Accounts are always less costly than other common schemes such as stock options, restricted stock, clawbacks, and bonus-malus banks.

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