LTI Pay Escrow, is this the future for executive comp?

Sam,

Thanks for posting this article.  I think the concept is very interesting.  When I return from the GEO conference in Paris I will spend some serious time considering the postive and negative impact of a program such as this. 

At a first glance I can see how thet argument for this type of program can be made for individuals who are rewarded for the immediate success of risky decisions, while providing a way to balance their income in the event that the risk does not, in the end, pay off as expected.  I think the argument is less clear with individuals whose line-of-sight to risk decisions is less direct.

I would love to hear what other ECE members think about this. 

1. Could you see such an "escrow plan" being used in your company or industry?

2. How would this impact the accounting, tax and other aspects of compensation?

Dan

We are definitely moving towards it in UK financial services, although clawback is where it's at - partly because of the complexity of introducing deferral in a declining compensation landscape and partly because of the tax issues. I imagine that "dynamic incentive accounts" would be feasible under US tax rules because of the concept of cash in escrow being taxed as property under section 83, but it would be much harder elsewhere (I do think that two of our existing plans could be modified to allow it to work in the UK).

5 JULY 2009 - UPDATE ON DYNAMIC INVESTMENT ACCOUNTS

Dynamic Incentive Accounts

by Jim Naughton,
co-editor, HLS Forum on Corporate Governance and Financial
Regulation,

Sunday, July 05, 2009 at 12:20 PM EDT

(Editor’s Note: This post comes from Alex
Edmans
at the University of Pennsylvania, Xavier Gabaix and Tomasz
Sadzik, both of New York University, and Yuliy Sannikov
of the University of California, Berkeley.)

In our paper, Dynamic Incentive Accounts, which was recently
updated after being presented at the Harvard Law School / Sloan Foundation
Conference on Corporate Governance in March, we study how executive
compensation might be reformed to address a number of issues that were
important contributors to the recent financial crisis. We consider a setting
in
which the CEO can manipulate short-term earnings at the expense of long-run
value (e.g. by writing sub-prime loans that become delinquent several years
later, or scrapping investment projects) and may undo the contract by
privately
saving. In addition, shocks to firm value may reduce the incentive effect of
securities that the CEO is given as part of his contract - for example, if the
stock price declines, options may fall out of the money and have little
incentive effect.

We solve for the optimal contract in such a setting. We find that it
involves a “deferred reward principle”: since the agent is
risk-averse, it is efficient to spread the reward for effort across all future
periods rather than concentrating it in the current period. The relevant
measure of incentives is the percentage change in CEO pay for a percentage
change in firm value; in real variables, this is the fraction of CEO pay that
comprises of stock. The required fraction of stock represents the
contract’s sensitivity and is both scale- and time-independent: it does
not depend on firm size or total pay, and is the same in each period. With a
finite horizon, the required fraction of stock is now increasing over time -
the “increasing incentives principle.” As the CEO approaches
retirement, there are fewer periods in which to spread the reward for effort,
and so the reward in the current period must increase.

The possibility of manipulation has two effects on the optimal contract,
which must change to prevent such behavior. The CEO’s income is now
sensitive to firm returns even after retirement, to deter him from inflating
the stock price just before he leaves. In addition, the contract sensitivity
now rises over time, even in an infinite-horizon model. The CEO benefits
immediately from short-termism as it boosts current consumption, but the cost
is only suffered in the future and thus has a discounted effect.

In practice, the optimal contract can be implemented in a simple manner.
When appointed, the CEO is given a “Dynamic Incentive Account”: a
portfolio of which a given fraction is invested in the firm’s stock and
the remainder in cash. The Dynamic Incentive Account contains two key
features.
The first is rebalancing, to ensure that the CEO always exerts effort. As time
evolves, and firm value changes, the portfolio of cash and stock is constantly
rebalanced, to ensure the fraction of stock remains sufficient to induce
effort
at minimum risk to the CEO. For example, if the stock price falls and the
fraction of stock drops, the CEO is “reloaded” by exchanging some
of his cash for stock. Importantly, this additional equity is not given for
free - it is fully paid for by a reduction in cash. This addresses a key
concern with the current practice of “reloading” CEOs by repricing
stock options that fall out of the money - the CEO is rewarded for failure.

The second feature is gradual vesting, to ensure that the CEO never wishes
to manipulate. The Dynamic Incentive Account vests gradually: the CEO is only
allowed to withdraw a fraction of his cash and shares in each period. The
account continues to vest slowly after retirement, to dissuade the CEO from
inflating the stock price and then cashing out upon departure. The paper thus
provides a theoretical framework to guide a potential reform of executive
compensation (by either shareholders or the government), to prevent the
problems that manifested in the recent crisis.

The full paper is available for download here.

This article originally appeared on The Harvard Law School Forum on Corporate Governance and Financial Regulation.