Executive pay is a high-profile topic on which almost everyone has an opinion. Many shareholders, workers, and politicians believe that the system is broken and requires a substantial overhaul. Despite being well-intentioned, their suggested reforms may not target the elements of pay that are most critical for shareholder value and for society.
Level 1 thinking: The level of pay
Much of the debate is on what I call a Level 1 issue – the level of pay. In September 2013, the SEC mandated disclosure of the ratio of the CEO’s pay to that of the median employee. The European Commission is contemplating going further and requiring a binding vote on this ratio. Separately, proposals to increase taxes – most prominently made by Thomas Piketty – are a response to seemingly excessive pay levels.
While high taxes or ratio caps would indeed address income inequality (an important topic, but beyond the focus of this article), it's not clear that they would do much to improve shareholder (or stakeholder) value. The levels of CEO pay, while very high compared to median employee pay – and thus a politically-charged issue – are actually very small compared to total firm value. For example, median CEO pay in a large US firm is $10 million – only 0.05% of a $20 billion firm. That’s not to say that it isn’t important (a firm can't be blasé about $10 million) but that other dimensions may take precedence.1
Level 2 thinking: The sensitivity of pay
What matters for firm value isn't the level of pay, but the incentives that it provides to CEOs; as Jensen and Murphy (1990) famously argued, “it’s not how much you pay, but how”. Level 2 thinking studies the sensitivity of pay to performance. Specifically, it looks at how much of a manager’s total pay is comprised of stock and options (which are sensitive to firm value) rather than cash salary (which is less so). As the thinking goes, greater stock and options align the CEO’s incentives with those of the shareholders. Indeed, Jensen and Murphy bemoaned the low equity incentives at the time as evidence that CEOs were “paid like bureaucrats”.
While seemingly intuitive, the idea that better-incentivised CEOs perform better is unclear. Of all the banks, Lehman Brothers arguably had the compensation scheme closest to what Level 2 consider ideal: high employee stock ownership. Using a larger sample, Fahlenbrach and Stulz (2011) “find some evidence that banks with CEOs whose incentives were better aligned with the interests of shareholders performed worse and no evidence that they performed better.” Indeed, the European Commission has recently capped banker bonuses at twice the salary, seemingly reducing bankers’ incentives to perform well – but also reducing their punishment if things go badly.
Level 3 thinking: The structure of pay
The concern with high equity incentives is that they encourage CEOs to pump up the short-term stock price at the expense of long-run value – for example, writing sub-prime loans and then cashing out their equity before the loans become delinquent. But, the root cause of this problem isn't the amount of stock and options that the CEO has, but their vesting horizon – whether they vest in the short-term or long-term, and thus whether they align the CEO with short-term or long-term shareholder value. Level 3 thinking thus focuses on the structure of pay.2
There is anecdotal evidence that horizons mattered in the financial crisis. Angelo Mozilo, the former CEO of Countrywide Financial, made $129 million from stock sales in the twelve months prior to the start of the crisis; a Wall Street Journal article documented similar practices among other bank CEOs.3 But we can't form policy based on anecdotes – it's important to undertake a systematic study.
In Edmans et al. (2014), we study how a CEO behaves in years in which he has a significant amount of shares and options vesting. CEOs typically sell their equity upon vesting in order to diversify, and so vesting equity makes them particularly concerned about the short-term stock price. In addition, the amount of equity that you have vesting in 2014 depends on how much you were given in 2011 with a three-year vesting period, and so doesn’t depend on current economic conditions or investment opportunities.
We find that in years in which the CEO has significant equity vesting, he cuts investment in many forms: R&D, advertising, and capital expenditure. Moreover, in these years he's more likely to exactly meet or just beat analyst earnings’ forecasts – if the forecast is $1.27 per share, he reports earnings of $1.27 or $1.28. Indeed, the magnitude of the investment cuts is just enough to allow the CEO to meet the target. Thus, vesting equity induces the CEO to act myopically – to cut investment to meet short-term targets. These results are robust to controlling for the CEO’s other equity incentives, such as his unvested equity and voluntary holdings of already-vested equity.
In Edmans et al. (2014) we show that, in months in which the CEO has vesting equity, he releases more news. This is an easy way to pump up the short-term stock price, as news attracts attention to the stock. This attention also increases trading volume, which allows the CEO to cash out his equity in a more liquid market. Indeed, we find that these news releases lead to significant increases in the stock price and trading volume in a 16-day window, but the effect dies down over 31 days, consistent with a temporary attention boost. The median CEO cashes out all of his vesting equity within seven days – within the window of inflation.
The increase in news releases only relates to discretionary news (such as conferences, client and product announcements, and special dividends), which are within the CEO’s control, and not non-discretionary news (such as scheduled earnings announcements). Moreover, the CEO reduces discretionary news releases in both the month before and the month after the vesting month, suggesting a strategic reallocation of news into the vesting month and away from adjacent months. In addition to releasing more news items during the vesting month, the CEO releases more positive news – media articles immediately following these news releases contain significantly more positive words than normal.
Why do we care?
Both consequences of vesting equity are important.
- Investment is critical to the long-run health of a company. Indeed, in the 21st century, most firms compete on product quality rather than cost efficiency, for which intangible assets – such as brand strength and innovative capabilities – are particularly important. Building such intangibles requires sustained investment, particularly in R&D and advertising.
- Regarding news, many stakeholders – such as employees, suppliers, customers, and investors – base their decision on whether to initiate, continue, or terminate their relationship with a firm on news or stock prices that are affected by news. In addition to these efficiency consequences, news has distributional consequences through its effect on the price at which shareholders trade. Indeed, Regulation FD aims to “level the playing field” between investors by prohibiting selective disclosure of information. Public news releases to all shareholders achieve this goal – but the CEO may delay news until months in which he has vesting equity.
What can be done?
One solution is to lengthen vesting periods. While increasing vesting horizons from (say) three to five years may not be as appealing to voters as targeting the level of pay, it will likely have a greater effect on shareholder value and on society. For example, such a change will now incentivise the CEO to engage in a long-term investment with a four-year horizon.
Can clawbacks achieve the same thing by paying out a bonus upon good short-term performance and then clawing it back if long-term performance lags? Despite being widely heralded and attracting much fanfare, the legality of clawbacks is unclear: we know of no cases in which a clawback has been successfully implemented. The CEO may have spent the money, or transferred it to a spouse or a relative. Trying to claw back a bonus paid prematurely (based on short-term performance) is like shutting the barn door after the horse has bolted. The best solution is not to pay out the bonus in the first place, but wait five years.
Is the lengthening of a vesting horizon simply kicking the can down the road? All equity has to vest at some point, and doesn’t this mean that the CEO will now act myopically in five years’ time rather than three years’ time? I have some sympathy with this concern – indeed, one of the other implications of our papers is that boards of directors, and other stakeholders, should scrutinise CEOs in months (or years) in which they have significant equity vesting. Since most of the current focus is on Levels 1 and 2 of the CEO’s contract, most stakeholders don’t pay attention to vesting horizons. But, the main benefit will be on the CEO’s behaviour today – such a lengthening will now encourage him to take that four year project.
In short, paying CEOs according to long-term performance will ensure they have the long-term interests of the firm at heart.
Edmans, A, V W Fang and K A Lewellen (2014), “Equity Vesting and Managerial Myopia”, Working Paper, London Business School.
Edmans, A, L Goncalves-Pinto, Y Wang and M Xu (2014), “Strategic News Releases in Equity Vesting Months”, Working Paper, London Business School.
Fahlenbrach, R and R M Stulz (2011), “Bank CEO Incentives and the Credit Crisis,” Journal of Financial Economics 99, 11-26.
Jensen, M C and K J Murphy (1990), “CEO Incentives – It’s Not How Much You Pay, But How,” Harvard Business Review, May/June 1990.
1 If high pay is only the tip of the iceberg, and a symptom of a more general corporate governance issue (e.g. the CEO has entrenched himself and captured the board), then the broader corporate governance issue can be significant. But, tackling just the symptom with a cap on pay ratios will not address the underlying problem.
2 In addition to vesting horizons there are other important components of the structure of pay, such as the mix between stock and options, and debt versus equity. This article focuses on horizons.
3 “Before the Bust, These CEOs Took Money Off the Table”.