Executive compensation has come under fire for years. Criticism is unlikely to let up, given the contribution it probably made to the current financial crisis. Some critics will never be satisfied since they are offended simply by what they see as excessively high pay. But even those of us not driven by envy or egalitarian ideals can see that the structure of executive compensation could be improved. Doing so would both bring individual incentives better in line with long-term profitability of companies and also deflect some of the renewed attack on the market economy. The authors of this paper believe they have come up with a better system: A compensation structure based on long-term escrow accounts.
Existing compensation schemes may have encouraged Wall Street executives to take on excess risk. That’s because the short vesting period of these schemes allow executives to cash in on the results of their actions before the longer-term consequences have been realized. The same incentive exists to boost share price by manipulating corporate accounting, then sell at the peak, or to cut investment in research and development and other factors necessary for long-term profitability. The authors plausibly contend that these perverse incentives can be largely avoided by linking an executive’s compensation to the performance of the firm over a longer horizon and by taking into account changing conditions within the firm.
The specific method the authors propose for doing this involves putting compensation in escrow for a certain number of years (typically five) extending into the executive’s retirement. This “Dynamic Incentive Account” includes both the firm’s stock and cash. The account features state-dependent rebalancing and time-dependent vesting. It is constantly rebalanced so that the equity fraction remains above a certain threshold; this threshold sensitivity is typically increasing over time even in the absence of career concerns. The account vests gradually both during the CEO’s employment and after he quits, to deter short-termist actions before retirement.
This plan includes a rebalancing mechanism to maintain a constant percentage of compensation in cash and stock (the constant percentage principle”) in the escrow account, so that the executive always has sufficient equity in the firm—even if the stock price falls—to generate performance incentives. This paper explains how the standard compensation system rewards failure by issuing more shares for free or by re-pricing existing options. The proposed scheme does better by adapting to changing conditions in the firm and its share price. When the stock price declines, the escrow account is reloaded but not without cost: the additional equity is purchased with cash in the account.
The authors argue that their proposal is preferable to the bonus clawbacks introduced by Credit Suisse, Goldman Sachs, UBS and Morgan Stanley. They also explain how the model can be modified to work for lower-level employees by including account measures other than share price that more accurately reflect whether an individual is performing effectively. Finally, the authors point out unintended problems that arise when government regulators oversee compensation. For instance, the Clinton administration’s imposition of a cap of $1 million on cash payouts to be eligible for corporate tax deduction probably led many companies to shift compensation to guaranteed bonuses, such as the controversial AIG payouts.