Executive compensation is set by managers themselves to maximise their own pay, rather than by boards on behalf of shareholders. Indeed, many commentators argue that executives\u2019 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 response, President Obama has proposed new executive compensation rules for firms seeking government aid. However, several critics have argued that the recent changes are politically motivated and focus on the level of pay, rather than the incentive structures (e.g. the relative amount of cash versus shares), which have the greatest economic impact.<\/p>\n
Existing schemes have two main problems. First, stock and options typically have short vesting periods, allowing executives to \u201ccash out\u201d 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 \u2013 for instance by originating risky loans, scrapping investment projects, or manipulating earnings \u2013 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 \u201clong-horizon principle.\u201d<\/p>\n
Second, current schemes fail to keep pace with a firm\u2019s changing conditions. If a company\u2019s stock price plummets, stock options are close to worthless and have little incentive effect \u2013 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\u2019s pay is stock. We call this the \u201cconstant percentage principle.\u201d 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.<\/p>\n
Alex Edmans and Xavier Cabaix write that two principles should govern executive pay:\u00a0 Rebalancing to address the constant percentage principle and gradual vesting to satisfy the long-horizon principle.\u00a0 Executive Compensation<\/strong><\/a><\/p>\n Executive compensation is set by managers themselves to maximise their own pay, rather than by boards on behalf of shareholders. Indeed, many commentators argue that executives\u2019 pay schemes were major contributors to the financial crisis, encouraging them to take on … Continue reading ![\"Executive](\"http:\/\/www.w-t-w.org\/en\/wp-content\/uploads\/2015\/01\/Executive-Pay-300x208.jpg\")
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