You Get What You Pay For

In a recent New Yorker article titled “The Sure Thing,” Malcolm Gladwell makes the case that successful entrepreneurs are not the high-wire acts that they are mythologized to be. Rather, they are highly risk-averse individuals who happen to be blessed with the instinct to spot opportunities others miss. In fact, seeking excessive risk doesn’t necessarily correlate with success at all.

Gladwell recalls a famous experiment in the 1950’s in which the Harvard psychologist David McClelland observed a group of children playing a game that involved throwing a hoop over a pole. The children who took the greatest risk — standing so far from the pole that success was unlikely — also scored lowest in testing that measured their desire to succeed. McClelland concluded that those children were actually pursuing a psychologically protective strategy: the greater the risk, the less they could be blamed for failure.

“That’s what companies are buying with their bloated CEO stock-option packages,” Gladwell writes, “gambles so wild that the gambler can lose without jeopardizing his standing in the corporate world.” That’s hard to refute. The past few years have made painfully clear what can happen when compensation for a chief executive is structured to encourage inordinate risk and short-term gains and offers no penalties for failure and, in fact, often rewards it. This has spawned a good deal of debate about whether executives are paid too much and for the wrong things.

To the latter point, the Harvard Law School professors Lucian Bebchuk and Jesse Fried sounded an early warning in their 2004 book, Pay without Performance: The Unfulfilled Promise of Executive Compensation, asserting that standard executive pay arrangements were leading executives to focus excessively and detrimentally on the short term. Since then, the authors have produced a steady stream of incisive work on the subject, including a recent (December 2009) paper, “Paying for Long-Term Performance,” that offers clear guidelines for a better approach to equity-based compensation.

Bebchuk and Fried assert that a typical stock option plan imposes two types of costs on shareholders. First, when executives are free to unload a specified number of options that vest each year, the corporation must give them fresh equity to replenish their holdings. This dilutes the ownership of the public shareholders. Second, executives may take actions, both legal and illegal, that increase the stock price and their payout in the short run, even if those actions would destroy company value in the long run. The remedy? Executives should be blocked from cashing out their equity at the time of vesting.

Although some firms do postpone executives’ cash-outs until their retirement dates, that approach has its own shortcomings; it could perversely induce the most successful executives to retire prematurely, and it still does nothing to discourage short-term thinking in the years preceding retirement. The solution that Bebchuk and Fried propose is to allow the unloading of equity only after a specified period of time has elapsed from the vesting date of each equity grant. Since both the equity grants and their cash-out dates would be spread out over time and extend past retirement, an executive’s decision to retire would not be affected by the prospect of being able to unwind large amounts of equity, and he would still have incentive to think about long-term considerations even as retirement approaches. The authors further argue that such holding requirements are not enough. Citing a study indicating that in 1996 to 2006, more than 1,000 corporate insiders hedged at least 30 percent of their stock positions, they recommend that firms hold the blocked stock in an escrow account and, before releasing it, require the executive to sign an affidavit indicating that he did not engage in any hedging transactions.

Executives can also use various types of tactics to increase the value of their options at public shareholders’ expense. “A number of studies,” Bebchuk and Fried write, “find companies are more likely to release bad news and less likely to release good news just before options are granted.

To eliminate the incentive for such manipulation, the authors suggest that all equity payouts be based upon the average price of the stock calculated over a sufficiently long period. Executives could be required to announce their intentions to unwind equity in advance, giving any inside information on which the executive may be trading more time to emerge and become incorporated into the stock price and also intensifying scrutiny upon the firm and its managers during the period. Of course, the most effective of all deterrents to manipulation would be the use of “hands off” arrangements under which all restricted stock and stock options are automatically sold according to a fixed, gradual and preannounced schedule.

A number of other recent studies have offered compensation models similar to Bebchuk and Fried’s, but with different wrinkles. For example, in a rigorous August 2009 paper, Alex Edmans of Wharton, Xavier Gabaix and Tomasz Sadzik of New York University, and Yuliy Sannikov of Princeton propose the use of “dynamic incentive accounts.” With their approach, an executive’s pay is escrowed into an account, a fraction of which is invested in the firm’s stock and the remainder in cash. Like the Bebchuk and Fried model, this account vests gradually both during and after employment. In addition, the portfolio is continually rebalanced to reflect a firm’s changing value over time. The rebalancing and vesting are separate events, designed to reduce the executive’s risk while at the same time discouraging manipulation.

Inevitably, the many systemic failures of recent years and the specter of more to come have prompted a number of urgent questions — many of them legitimate — about the need for regulation and reform. But when it comes to executive performance, the question that is attracting the most attention is quintessentially free-market in nature: Are we getting what we pay for?