CEO risk-taking incentives and relative performance evaluation

This paper examines how changes in CEO risk-taking incentives are associated with changes in the use of relative performance evaluation (RPE) in CEO contracts. Using a shock to the accounting for executive stock options (FAS 123R), I confirm that risk-taking incentives and option grants declined following FAS 123R using a within-firm design, but not a within-CEO-firm design. Decreased risk-taking incentives lead executives to invest in projects with lower systematic risk and can result in reduced incentives to hedge exposure to systematic risk in CEO compensation contracts via RPE. However, CEO relative risk aversion increases with decreases in risk-taking incentives, potentially increasing incentives to protect CEO wealth from systematic performance via RPE. Testing these competing predictions, I find modest evidence consistent with reduced RPE surrounding FAS 123R, suggesting that when CEO risk-taking incentives are reduced, so are incentives to shield CEO pay from systematic performance.     

Executive compensation and corporate risk-taking: Evidence from private loan contracts

We examine how management stock options affect corporate risk taking. We exploit exogenous variation in stock option grants generated by FAS 123R and use loan spreads to infer risk taking. Using a difference-in-differences approach, we find that the spreads of loans taken by firms that did not expense options before FAS 123R (treated firms) significantly decrease after FAS 123R relative to firms that either did not issue stock options or voluntarily expensed stock options before 123R (control firms). We also find that the effect is stronger for firms with high agency conflicts associated with risk-shifting. Furthermore, loans taken by the treated firms are less likely to contain collateral requirements and are less likely to have covenants restricting capital investment post FAS 123R.     

Good for managers,bad for society? Causal evidence on the association between risk-taking incentives and corporate social responsibility

Using FAS 123R as an exogenous shock to stock options, I provide evidence that equity-based risk-taking incentives discourage corporate social responsibility (CSR). This finding suggests that compensation incentives can motivate managers not to pursue CSR strategies because CSR reduces firms’ risk and provides insurance-like benefits. Firms with a greater demand for CSR's risk reduction are more sensitive to changes in risk-taking incentives. I triangulate my results by confirming that CSR weaknesses are positively related to subsequent stock return volatility. Overall, using a robust empirical design, I find that risk-taking incentives are a determinant of firms’ CSR.     

Stock options and managerial incentives for risk taking: Evidence from FAS 123R

We provide new evidence on the relation between option-based compensation and risk-taking behavior by exploiting the change in the accounting treatment of stock options following the adoption of FAS 123R in 2005. The implementation of FAS 123R represents an exogenous change in the accounting benefits of stock options that has no effect on the economic costs and benefits of options for providing managerial incentives. Our results do not support the view that the convexity inherent in option-based compensation is used to reduce risk-related agency problems between managers and shareholders. We show that all firms dramatically reduce their usage of stock options (convexity) after the adoption of FAS 123R and that the decline in option use is strongly associated with a proxy for accounting costs. Little evidence exists that the decline in option usage following the accounting change results in less risky investment and financial policies.     

CEO Incentives and Corporate Innovation

Using scaled wealth‐performance sensitivity as my measure of Chief Executive Officer (CEO) incentives, and utilizing cross‐sectional variations in industry innovativeness, product market competition and firms’ degree of exposure to the market for corporate control for identification purposes, I find that higher long‐term incentives that stem from CEO holdings of unvested options are associated with greater subsequent corporate innovation in innovative industries, competitive product markets, and firms more exposed to the threat of hostile takeovers, that is, exactly where incentivizing innovation is a matter of necessity. I address the endogeneity concerns with systems of simultaneous equations estimated using three‐stage least squares. A possible channel for the observed relation between unvested options‐based incentives and subsequent corporate innovation is that these incentives encourage managers to undertake riskier projects to achieve long‐term economic benefits.     

Do U.S. Insurance Firms Offer the “Wrong” Incentives to Their Executives?

We examine the relation between executive compensation and market‐implied default risk for listed insurance firms from 1992 to 2007. Shareholders are expected to encourage managerial risk sharing through equity‐based incentive compensation. We find that long‐term incentives and other share‐based plans do not affect the default risk faced by firms. However, the extensive use of stock options leads to higher future default risk for insurance firms. We argue that this is because option‐based incentives induce managerial risk‐taking behavior, which seeks to maximize managerial payoff through equity volatility. This could be detrimental to the interests of shareholders, especially during a financial crisis.     

CEO Compensation and Firm Performance: an Empirical Investigation of UK Panel Data

This paper examines the link between CEO pay and performance employing a unique, hand‐collected panel data set of 390 UK non‐financial firms from the FTSE All Share Index for the period 1999–2005. We include both cash (salary and bonus) and equity‐based (stock options and long‐term incentive plans) components of CEO compensation, and CEO wealth based on share holdings, stock option and stock awards holdings in our analysis. In addition, we control for a comprehensive set of corporate governance variables. The empirical results show that in comparison to the previous findings for US CEOs, pay‐performance elasticity for UK CEOs seems to be lower; pay‐performance elasticity for UK CEOs is 0.075 (0.095) for cash compensation (total direct compensation), indicating that a ten percentage increase in shareholder return corresponds to an increase of 0.75% (0.95%) in cash (total direct) compensation. We also find that both the median share holdings and stock‐based pay‐performance sensitivity are lower for UK CEOs when we compare our findings with the previous findings for US CEOs. Thus, our results suggest that corporate governance reports in the UK, such as the Greenbury Report (1995) that proposed CEO compensation be more closely linked to performance, have not been totally effective. Our findings also indicate that institutional ownership has a positive and significant influence on CEO pay‐performance sensitivity of option grants. Finally, we find that longer CEO tenure is associated with lower pay‐performance sensitivity of option grants suggesting the entrenchment effect of CEO tenure.     

Option compensation,risky mortgage lending,and the financial crisis

We examine how option compensation affects banks' risky mortgage origination and sale decisions before the financial crisis in 2008. We find that, in the period immediately before the financial crisis, option compensation has little impact on the riskiness of mortgages originated and is negatively associated with mortgage lenders' propensity to sell risky mortgages. The results are consistent with banks' incentives to maximize revenues from origination and servicing fees while managing risk exposure by adjusting the sale of risky mortgages. For identification, we use bank-year fixed effects and matched loan applications to control for both supply- and demand-side factors of mortgage lending. We find similar results when using the variation in option compensation generated by the implementation of FAS 123R.     

Managerial Incentives and Stock Price Manipulation

We present a rational expectations model of optimal executive compensation in a setting where managers are in a position to manipulate short‐term stock prices and the manipulation propensity is uncertain. We analyze the tradeoffs involved in conditioning pay on long‐ versus short‐term performance and show how manipulation, and investors' uncertainty about it, affects the equilibrium pay contract and the informativeness of prices. Firm and manager characteristics determine the optimal compensation scheme: the strength of incentives, the pay horizon, and the use of options. We consider how corporate governance and disclosure regulations can help create an environment that enables better contracting.     

Executive compensation and corporate risk management

We provide the first evidence on the effects of executive compensation on corporate risk management for insurers. Our unique data set allows the construction of a new, more complete measure of corporate risk management behavior. Specifically, we include hedging-driven usage of not only derivatives but also insurance. To address potential endogeneity, we utilize a difference-in-differences approach, based on the implementation of FAS 123R that required firms to expense stock-based compensation at fair value. We find that the decline in the convexity of executive compensation following FAS 123R led firms to significantly increase corporate risk management, primarily through increased demand for insurance.     

Ironing out the kinks in executive compensation: Linking incentive pay to average stock prices

Traditional stock option grant is the most common form of incentive pay in executive compensation. Applying a principal-agent analysis, we find this common practice suboptimal and firms are better off linking incentive pay to average stock prices. Among other benefits, averaging reduces volatility by about 42%, making the incentive pay more attractive to risk-averse executives. Holding the cost of the option grant to the firm constant, Asian stock options are more cost effective than traditional stock options and provide stronger incentives to increase stock price. More importantly, the improvement is achieved with little impact on the option grant’s risk incentives (after adjusting for option cost). Finally, averaging also improves the value and incentive effects of indexed stock options.     

SIX CHALLENGES IN DESIGNING EQUITY-BASED PAY

The past two decades have seen a dramatic increase in the equitybased pay of U.S. corporate executives, an increase that has been driven almost entirely by the explosion of stock option grants. When properly designed, equity‐based pay can raise corporate productivity and shareholder value by helping companies attract, motivate, and retain talented managers. But there are good reasons to question whether the current forms of U.S. equity pay are optimal. In many cases, substantial stock and option payoffs to top executives–particularly those who cashed out much of their holdings near the top of the market–appear to have come at the expense of their shareholders, generating considerable skepticism about not just executive pay practices, but the overall quality of U.S. corporate governance. At the same time, many companies that have experienced sharp stock price declines are now struggling with the problem of retaining employees holding lots of deep‐underwater options. This article discusses the design of equity‐based pay plans that aim to motivate sustainable, or long‐run, value creation. As a first step, the author recommends the use of longer vesting periods and other requirements on executive stock and option holdings, both to limit managers' ability to “time” the market and to reduce their incentives to take shortsighted actions that increase near‐term earnings at the expense of longer‐term cash flow. Besides requiring “more permanent” holdings, the author also proposes a change in how stock options are issued. In place of popular “fixed value” plans that adjust the number of options awarded each year to reflect changes in the share price (and that effectively reward management for poor performance by granting more options when the price falls, and fewer when it rises), the author recommends the use of “fixed number” plans that avoid this unintended distortion of incentives. As the author also notes, there is considerable confusion about the real economic cost of options relative to stock. Part of the confusion stems, of course, from current GAAP accounting, which allows companies to report the issuance of at‐the‐money options as costless and so creates a bias against stock and other forms of compensation. But, coming on top of the “opportunity cost” of executive stock options to the company's shareholders, there is another, potentially significant cost of options (and, to a lesser extent, stock) that arises from the propensity of executives and employees to place a lower value on company stock and options than well‐diversified outside investors. The author's conclusion is that grants of (slow‐vesting) stock are likely to have at least three significant advantages over employee stock options:

• ? they are more highly valued by executives and employees (per dollar of cost to shareholders);
• ? they continue to provide reasonably strong ownership incentives and retention power, regardless of whether the stock price rises or falls, because they don't go underwater; and
• ? the value of such grants is much more transparent to stockholders, employees, and the press.

     

Motivating Innovation

Motivating innovation is important in many incentive problems. This paper shows that the optimal innovation‐motivating incentive scheme exhibits substantial tolerance (or even reward) for early failure and reward for long‐term success. Moreover, commitment to a long‐term compensation plan, job security, and timely feedback on performance are essential to motivate innovation. In the context of managerial compensation, the optimal innovation‐motivating incentive scheme can be implemented via a combination of stock options with long vesting periods, option repricing, golden parachutes, and managerial entrenchment.     

Executive compensation and the cost of debt

This study examines how different components of executive compensation affect the cost of debt. We find that debt-like and equity-like pay components have differing effects: an increase in defined benefit pensions is associated with lower bond yield spread, while higher share holdings lead to higher spreads. In addition, we find that stock options have a mixed impact on the cost of debt whereas cash bonus has no significant impact. Overall, our results indicate that corporate bondholders are fully aware of both risk-taking and risk-avoiding incentives created by various executive pay components.     

Does Accounting Treatment of Share‐based Payments Impact Performance Measures for Banks?

This paper identifies, evaluates and analyses the resulting impact of mandatory expensing of share‐based compensation (SBC) under IFRS2/FASB123R on a set of widely used performance measures in the EU and US banking industry. The paper shows that the accounting treatment of SBC schemes, following the mandatory adoption of IFRS2/FAS123R, has a statistically significant negative impact on the selected performance measures over the period 2004–11. The impact also seems to be material, yet modest, for US banks and only for large and high‐growth EU banks, indicating that earlier public concerns and criticisms of the implementation of IFRS2/FAS123R are largely unsubstantiated. The findings also show that banks continue to use SBC, but there is a reduction, albeit insignificant, in the recognised SBC expense over the period 2009–11. That is, earlier public concerns that firms would curtail employing SBC in their employees’ compensation schemes to avoid the effect of SBC expense recognition on their financial ratios came to light after the first option life‐cycle in the post‐adoption period was over. The findings also show a marked movement towards using cash‐settled‐based payments, possibly due to their manipulative accounting treatment, a potentially interesting issue for related accounting research and accounting standard setters.     

Incentivizing managers to build innovative firms

We investigate whether the equity-linked components of top executive pay have an effect on patenting activity within a firm. We find a positive relationship between firm patenting activity and managerial alignment incentives created by stock and stock option grants. Prior work has shown that the market value of a firm reflects the value of its patents. Thus, our finding suggests innovation is one such channel through which equity alignment incentives positively impact firm value. On the other hand, we find that the risk-taking incentive from stock options does not increase patenting.     

Say on Pay: Is It Needed? Does It Work?

A leading compensation practitioner reviews “Say on Pay” rules, those corporate practices giving shareholders the right to vote on executive compensation. The assumption behind “Say on Pay” is that managers may be overpaid because directors fail to provide adequate oversight. O'Byrne questions this underlying assumption. He provides substantial evidence that directors do a poor job overseeing executive pay and that directors have weak incentives to pursue shareholder interests in executive pay. He also finds that “Say on Pay voting is sensitive to differences in pay for performance, but so forgiving that extraordinary pay premiums are required to elicit a majority ‘no’ vote”; and “that three quarters of institutional investors have lower SOP voting quality… than the average investor and almost all have a short‐term focus, with much greater vote sensitivity to current year grant date pay premiums than to long‐term pay alignment and cost.” The common corporate practice of providing competitive target compensation regardless of past performance leads to low alignment of pay and performance. Unfortunately, directors have little incentive to protect shareholder interests “because they are paid labor providers, just like management, not stewards of substantial personal capital.”     

Chief Financial Officers’ Short‐ and Long‐term Incentive‐based Compensation and Earnings Management

This study examines the association between chief financial officers’ (CFOs) short‐ and long‐term compensation and discretionary current and non‐current accruals. The CFO's cash bonus is used as a measure of short‐term incentives and shares plus options is used as a measure of long‐term incentives. The results show a significant and positive association between CFOs’ short‐term compensation and the absolute value of discretionary current accruals. The results also show a significant and positive association between CFOs’ long‐term compensation and the absolute value of discretionary non‐current accruals. STUDY provides evidence that the earnings management behaviour of CFOs is associated with type of CFO compensation.     

Restricting CEO pay

We analyze several proposals to restrict CEO compensation and calibrate two models of executive compensation that describe how firms would react to different types of restrictions. We find that many restrictions would have unintended consequences. Restrictions on total realized (ex-post) payouts lead to higher average compensation, higher rewards for mediocre performance, lower risk-taking incentives, and the fact that some CEOs would be better off with a restriction than without it. Restrictions on total ex-ante pay lead to a reduction in the firm's demand for CEO talent and effort. Restrictions on particular pay components, and especially on cash payouts, can be easily circumvented. While restrictions on option pay lead to lower risk-taking incentives, restrictions on incentive pay (stock and options) result in higher risk-taking incentives.     

Options,option repricing in managerial compensation: Their effects on corporate investment risk

While stock options are commonly used in managerial compensation to provide desirable incentives, they can create adverse incentives to distort the choice of investment risk. Relative to the risk level that maximizes firm value, call options in a compensation contract can induce too much or too little corporate risk-taking, depending on managerial risk aversion and the underlying investment technology. We show that inclusion of lookback call options in compensation packages has desirable countervailing effects on managerial choice of corporate risk policies and can induce risk policies that increase shareholder wealth. We argue that lookback call options are analogous to the observed practice of option repricing.