CEO pay is a controversial topic as some executives have benefited massively from stock options even when their firms have not been performing well.

Over the past three decades or so, firms have increasingly looked to stock options as an incentive for executives to make decisions which will enhance the performance of businesses.

While there has been a great deal of adverse publicity and shareholders have expressed concerns about excessive pay, shareholders also want to make sure that the interests of management are aligned with their own.

In a recent article in Applied Economics, I analyze the effect of share price targets on executive compensation. Using data sets of forecasts about share price movements of U.S. firms, I explore the impact of such forecasts on the structure of CEO compensation.

Shareholders hire executives to act in their best interests but the personal interests of the firm’s managers may not be fully aligned with those of the shareholders. In essence, they have access to information that the shareholders do not have and can exploit that information for their own benefit.

Boards seek to motivate executives and enhance the firm’s performance by providing incentives to the senior management. In doing so, they should weigh the marginal cost of additional forms of compensation with the extra benefits to be gained from encouraging senior executives to make decisions which would be in the shareholders’ interests.

Given the link to performance, managers who are more capable will be more eager to accept stock options tied to a firm’s performance than less-skilled counterparts.

Among scholars, there are several opposing camps:

  • the ‘arm’s-length’ bargaining model, by which boards try to maximise shareholders’ interests, subject to constraints set by executives’ pay;
  • the managerial-power model, by which boards seek the most favorable compensation for executives, subject to possible market penalties and costs;
  • and the ‘perceived-cost view’, by which managers ask for a risk premium for holding stock options.

While it is not necessary to go into detail about the models here, in the article I find that the managerial-power model more readily explains the CEO pay issue because senior executives will always seek to increase their income – either by trying to buy stock options when share prices are expected to rise, or by opting for cash when prices are likely to fall.

As stock options might end up underwater if the share price drops significantly, they are particularly risky for managers. On the other hand, if the share price soars, stock options would be particularly attractive and that in itself would be a greater incentive for the CEO to drive the share price as high as possible.

Other forms of compensation lack the same impact. Restricted stocks – unregistered shares which are not fully transferable – may still be profitable even if the share price falls and, in most cases, cash-based compensation is not linked to the share price.

No matter how much the managers’ skills are worth, boards still need to align the interests of shareholders with those of the CEO. So boards need to determine the right amount of stock options that would maximize the CEO’s incentives, while promoting the interests of shareholders.

My study shows that analysts’ forecasts of share prices do affect the structure of CEO compensation. When share prices are expected to rise, CEOs will favor stock options as part of their compensation package. When share prices are forecast to fall, cash and restricted stock will be king.

Giuliano Bianchi is Assistant Professor of Economics at EHL.

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