Wednesday, May 06, 2009

A look at Executive Compensation

This semester we really had to rush through executive compensation (market conditions took up quite a bit of class time), so I want to make my classes (and by extension others) aware of some of the debate on CEO pay. So a special post on CEO pay.

First yes CEO pay is high and getting higher over time. But I really do not want to address that to much bust to say that the level of pay appears to be closely tied to firm size and I will ignore level of pay since I am not sure it matters as much as the popular press claims. For a nice review try Jensen, Murphy, and Wruck 2004 or this by BusinessKnowhow 2007.

An important paper that I do want to point out is from Jared Harris that suggests that despite of good intentions (I will give boards the benefit of the doubt), that stock options might actually make agency costs worst:
"At best, incentive compensation has an ambiguous relationship with firm performance that can reward executives for luck (Bertrand & Mullainathan, 2001), or encourage CEOs to manage their personal reputations rather than their organizations (March, 1984). Research indicates that current forms of managerial incentive pay do not effectively align the incentives of managers and shareholders; indeed, a number of studies have had difficulty showing any positive link between executive incentive pay and improved performance of the firm (e.g., Mishra, McConaughy, & Gobeli, 2000; Murphy, 1999), and some work suggests that high CEO incentive pay or perquisites may in fact decrease firm performance (Blasi & Kruse, 2003; Core, Holthausen, & Larcker, 1999; Yermack, 2006).

As a corollary to these troubling results about the disconnect between incentive pay and firm performance, it also appears that incentive alignment does little to alleviate concerns about malfeasance and self-dealing. While incentive pay is traditionally seen as an alternative to monitoring as a way to prevent managerial misconduct (Tosi, Katz, & Gomez-Mejia, 1997; Zajac & Westphal, 1994), empirical results do little to confirm the claim that malfeasance is reduced. Indeed, recent research (Harris & Bromiley, 2007) investigates whether large potential payoffs for managers – contrary to classically formulated incentive theory – do not supply an adequate incentive for the good management practices that scholars typically suppose, but rather provide an enticement to cheat, commit fraud, or otherwise cook the books in an attempt to fabricate the levels of corporate performance that will trigger the payoff."
Supposing for a moment that CEO pay is a problem for more than just jealousy reasons, what can be done? It appears that regulation and increased transparency may not work as well as more active shareholders. Two papers to back this claim.

First that active institutional shareholders do keep pay LEVELS lower. From 2003.
"Hartzell and Starks find that as institutional ownership goes up, the
firm is more likely to use pay for performance plans. Additionally, the
level of CEO pay tends to go down. These findings suggest that
institutional investors make better monitors than ordinary investors do.
Possibly more convincing however, (since it solves the endogenity
problem which is that is the institutional investors may select which
stocks that pay for performance and pay managers less) is their analysis
that finds as managerial ownership goes up, pay goes down relative to
control groups in the periods that follow."
and then the article suggesting regulation and transparency do not lower pay levels

SSRN-How Much Sunlight Does it Take to Disinfect a Boardroom? A Short History of Executive Compensation Regulation by Ian Dew-Becker:
"This paper reviews the history of executive compensation disclosure and other government policies affecting CEO pay, and as well surveys the literature on the effects of these policies. Disclosure has increased nearly uniformly since 1933. A number of other regulations, including special taxes on CEO pay and rules regarding votes on some pay packages have also been introduced, particularly in the last 20 years. However, there is little solid evidence that any of these policies have had any substantial impact on pay. Policy changes have likely helped drive the move towards more use of stock options, but there is no conclusive evidence on how policy has otherwise affected the level or composition of pay"

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