The Executive Compensation Controversy - Fondazione Rodolfo ...

THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISOne on hand, our results are intuitive: we know that stock and options are riskier thansalaries (and likely riskier than bonuses), and it is inappropriate to simply add the differentforms of compensation to get a measure of total compensation without regard to risk. Wealso know that executives value stock and options much less than their expected value,suggesting that stock and options should be weighted less than salaries in constructing ameasure of the value of total compensation from the perspective of a risk-averse executive.On the other hand, including the ratio of equity pay to total pay as an explanatory variable isat best a crude way to control for the riskiness of the pay package. Moreover, under plausiblesituations, this ratio may vary mechanically with total compensation for reasons havingnothing to do with risk. 92Conceptually, a better way to evaluate whether risk and pay-composition issues explainthe USA Pay Premium is to compute “certainty equivalent” measures of total compensationas outlined in Section 2.2.2. Constructing these measures require detailed data on stock andoption holdings, and require assumptions about executive risk aversion, outside wealth andtrading behavior (e.g., whether the executive adjusts his current portfolio after receivingmore options, and whether he sells shares acquired through option exercises immediatelyafter exercise). In the spirit of this approach, Conyon, Core and Guay (2009) show that, for areasonable range of parameters, the risk-adjusted pay for USA CEOs is not dramaticallyhigher than the risk-adjusted pay for UK CEOs.3.4. Equity-based Incentives for European CEOsOur finding that the observed USA Pay Premium is in part “explained” by the fact thatUSA CEOs have different pay structures merely shifts the question: Why do Americanexecutives USA receive more incentive compensation (and particularly more equity-basedcompensation) than do European executives?Indeed, while equity-based compensation (and especially stock options) has been astaple of USA compensation contracts for more than a half-century, the use of equity-basedpay in most of Europe is a relatively recent phenomenon. Table 3.10 shows how theimportance of equity-based pay has changed over time in the United States and in nineEuropean countries using Towers Perrin’s Worldwide Total Remuneration (WWTR) surveys92 For example, suppose that compensation consists solely of base salaries and stock, and that base salariesare implicitly capped, either through tax policies (Section 2.4.3) or Bebchuk-Fried “outrage” considerations(Section 2.5.1). In this case, note that Total Pay = (Capped Salary)/(1 - Ratio of Equity/Total Pay); total pay isperfectly predicted by the ratio of equity to total pay.-81-