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Executive compensation: The fragile foundations of stock options

As
boards of directors have sought to align the interests of managers and
stockholders, executive stock options have become an ever-larger
fraction of the typical CEO’s total compensation (Murphy 1999).
Occasionally this practice has led to aggregate compensation payments
that are so large as to mock the very connection they are supposed to
encourage.

What does economic theory have to say about executive compensation
in a dynamic context? From a conceptual perspective, how effective is
the granting of stock options in promoting the correct managerial
decisions? How confident can we be that when a large fraction of a
manager’s compensation assumes this form he or she will be led to
undertake the same labour hiring and capital investment decisions that
the shareholders would themselves want to undertake if they were
similarly informed?

Managerial incentives and the design of compensation contracts

When the systemic implications of executive remuneration are taken
into account, that is, in a general equilibrium context, one finds that
for a contract to induce managers to take the correct business
decisions in the above sense, it must naturally have the following
three features.¹

A significant portion of a manager’s remuneration must be based, in
one way or another depending on the context, on her own firm’s
performance.

This concurs with the general message of a wealth of microeconomics studies. But this is not sufficient.

• The general contract characteristics must also be such that the
  manager is not, as a consequence of this first requirement, enjoying an
  income stream with time series properties that are too different from
  the time series properties of the income stream enjoyed by shareholders.

This later restriction arises because, as is well known, the income
and consumption position of a manager will determine his or her
willingness to undertake risky projects. Optimal delegation requires
that this risk attitude is not too different from shareholders’ own.

• The second feature may have to be modified if the manager’s risk
  tolerance is inherently different from that of the shareholders.

The typical motivation for stock options (as opposed to pure equity
positions) is precisely that the (recurrent) lack of income
diversification of a manager may make her excessively prudent (in
pursuit of a “quiet life”). This is the idea behind setting executive
compensation according to a “highly convex” contract, i.e. one where
the upside is really good, but the downside is not so bad. This
asymmetry is necessary induce risk averse managers to make the right
investment decisions from the perspective of well-diversified
stockholders.

Are options-dominated contracts warranted?

Shareholders receive both wage and dividend income, with the wage or
salary component being, on average, the larger of the two. This is an
implication of National Income Accounting. In the typical modern
economy, about 2/3rds of GDP is composed of wages, with capital’s
income account for only 1/3. Points 1 and 2 above therefore imply that
an optimal contract will have both a salary (with properties close to
those of the wage bill) and an incentive component (with properties
naturally linked to the income accruing to capital owners) with the
former being about twice as large as the latter.

The incentive component may take the form of a non-tradable equity
position (giving the right to regular dividend payments) or it may be
more closely tied to the firm’s stock price itself. Furthermore, both
of these components enter linearly into the manager’s compensation
function.

In today’s business world, the salary component appears to be too
small relative to the incentive component. Hall and Murphy (2002)
report that the grant date value of stock options represented 47% of
average CEO pay in 1999. Equilar, Inc., an executive compensation
advisory firm, reports that stock options awards represented 81% of CEO
compensation for the largest 150 Silicon Valley firms in 2006.

What happens to incentives if the salary component is too small relative to the incentive component?

Such an imbalance between the components of a manager’s compensation
will lead to excessive smoothing of the firm’s output from the
shareholders’ perspective. They typically prefer a highly pro-cyclical
investment policy whereas, without further inducement, the manager will
be much more reluctant to exploit the good opportunities and instead
select a mildly pro-cyclical or, even, possibly an anti-cyclical
investment strategy.

This problem is well recognised, and it is the main justification
for using highly convex managerial compensation contracts (i.e.
options). Convex contracts overcome this possibility by reducing the
personal (expected) cost to the manager of increasing the firm’s
investment when times are good. If the manager’s preferences are well
represented by a logarithmic utility function of consumption, however,
then this latter argument does not apply; the manager’s actions will be
insensitive to contract convexity. That is, even a compensation
contract that is heavily laden with options will not induce managers to
alter their behaviour one whit.

A straightforward application of this logic produces an even more
striking result. If the manager happens to be more risk averse than
would be dictated by log utility – an entirely plausible configuration
– the only way to induce optimal managerial behaviour is by using a
highly unconventional remuneration package in which the manager’s
compensation is inversely related to the firm’s operating results. This
would mean a contract that pays high compensation when profits are low
and vice versa.

In this situation an options laden compensation package will induce
the manager to behave in a manner directly opposite to what the
shareholders would like. More generally, the degree of contract
convexity must be related to the relative risk aversion of the manager
as compared to the shareholders and if these quantities are not
precisely estimated large welfare losses will ensue.

Conclusion

From a theoretical macroeconomic perspective, the circumstances
under which a highly convex compensation contract, for example, one
that has a large component of options, will properly guide the manager
in making the correct hiring and investment decisions are very narrowly
defined.

It would be surprising if these circumstances were fulfilled in the typical contract case.

References

Danthine, Jean-Pierre and John B. Donaldson, ‘Executive Compensation and Stock Options: An Inconvenient Truth,’ CEPR Discussion Paper 6890.

Hall, Brian J. and K. Murphy, “Stock Options for Undiversified Executives,” Journal of Accounting and Economics, 33 (2002), 3-42.

Murphy, K., “Executive Compensation”, in O. Ashenfelter and D. Card (eds) Handbook of Labor Economics, vol. 3B, North Holland, 1999, 2485-2567.