The Executive Compensation Controversy - Fondazione Rodolfo ...

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THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISAssuming that the executive’s utility over wealth is U(W), we can define theexecutive’s value of n options as the “certainty equivalent” V that equates expected utilities(1) and (2):(3) ∫U(W V T )f(P T )dP T ≡ ∫U(W T )f(P T )dP T .Solving (3) numerically requires assumptions about the form of the utility function,U(W), and the distribution of future stock prices, f(P T ). We follow Hall and Murphy (2002) inassuming that the executive has constant relative risk aversion ρ, so that U(W) ≡ ln(W) when1ρ=1, and U(W) ≡1! " W1! " when ρ ≠ 1. We adopt the Capital Asset Pricing Model (CAPM)and assume that the distribution of stock prices in T years is lognormal with volatility σ andexpected value equal to (r f + β(r m -r f ) - σ 2 /2)T, where β is the firm’s systematic risk and r m isthe return on the market portfolio. 27More to come: Compute risk-adjusted pay for 2008; compare trend lines in riskadjustedand non-adjusted pay.2.3. Measuring Executive IncentivesConceptually, the incentives created by any compensation plan are determined by twofactors: (1) how performance is measured; and (2) how compensation (or wealth) varies withmeasured performance. Most of the executive compensation literature has focused on therelation between CEO and shareholder wealth (or, what Jensen and Murphy (1990b) definedas the pay-performance sensitivity), where CEOs with higher pay-performance sensitivitiesare defined as having better incentives to create shareholder value. Therefore, we begin thissection with an analysis of different ways to measure incentives executives have to increaseshareholder wealth. Next, given the recent focus on excessive risk taking many believecontributed to the financial crisis, we consider two measures of the incentives executiveshave to increase stock-price volatilities. Finally, we discuss a variety of other incentiveproblems not neatly encapsulated in pay-performance or pay-volatility sensitivities, such asincentives to smooth or manage earnings or to pursue short-run profits at the expense oflong-run value.27 For tractability, we assume that the distribution of future stock prices is the same whether the executivereceives options or cash. If the grant provides incentives that shift the distribution, and if the shift is not alreadyincorporated into stock prices as of the grant date, we will underestimate both the cost and value of the option.-19-
THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSIS2.3.1. The Relation Between CEO and Shareholder WealthMost research on CEO incentives has been firmly (if not always explicitly) rooted inagency theory: compensation plans are designed to align the interests of risk-averse selfinterestedCEOs with those of shareholders. Following this framework, most of the focus hasbeen on the relation between CEO compensation (or CEO wealth) and changes in firm value.The most direct linkage between CEO and shareholder wealth comes from the CEO’sholdings of stock, restricted stock, and stock options. However, CEO wealth is also indirectlytied to stock-price performance through accounting-based bonuses (reflecting the correlationbetween accounting returns and stock-price performance), through year-to-year adjustmentsin salary levels, target bonuses, and option and restricted stock grant sizes, and through thethreat of being fired for poor performance. The CEO pay literature has yet to reach aconsensus on the appropriate methodologies and metrics to use in evaluating the “indirect”relation between CEO pay and company stock-price performance. Fortunately, Hall andLiebman (1998) and Murphy (1999) show that virtually all of the sensitivity of pay tocorporate performance for the typical CEO is attributable to the direct rather than the indirectpart of the CEO’s contract, and the direct part can be measured from information available inUSA proxy statements.Since agency costs arise when agents receive less than 100% of the value of output, theCEO’s share of ownership is a natural measure of the severity of the agency problem. Inparticular, the CEO’s percentage holdings of his company’s stock measures how much theCEO gains from a €1 increase in the value of the firm, and how much he loses from a €1decrease. Computing percentage ownership for restricted and unrestricted shares is trivial(simply divide by the total number of shares outstanding). Including stock options in apercentage holdings measure is more complicated, since options that are well out-of-themoneyprovide few incentives to increase stock prices, while options that are well in-themoneyprovide essentially the same incentives as holding stock. Therefore, each stock optionshould count somewhat less than one share of stock when adding the holdings to form anaggregate measure of CEO incentives, and the “weight” should vary with how much theoption is in (or out) of the money. In constructing our aggregate measure of CEO incentives,we weight each option by the “Option Delta,” defined as the change in the value of a stockoption for an incremental change in the stock price. Option Deltas – described more formallyin the Appendix to this Section – range from near zero (for deep out-of-the-money options)-20-
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