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Alex Edmans, WhartonXavier Gabaix, NYU Stern

Executive Compensation Policy Lab, May 2010

Executive Compensation: What’s Right and What Could Be Fixed

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Overall Approach Many high-profile examples of inefficiency

(e.g. golden parachutes, cashing out early, rewards for failure)

Policymakers: “first do no harm” Role of academic research: are the above

inefficiencies limited to a few high-profile examples, or generally true?

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Sensitivity of Pay CEOs get guaranteed bonuses, irrespective of

performance; salary and new stock/option grants are also performance-insensitive

But, the bulk of a CEO’s incentives come from changes in previously-granted stock and options

Jensen and Murphy (1990) found CEOs only lose $3.25 for a $1,000 loss of shareholder value

But, CEOs have a multiplicative effect on firm value (Hall and Liebman 1998, Baker and Hall 2004, Edmans, Gabaix and Landier 2009)

Frydman and Jenter (2010): CEOs lose $284,000 for a 1% loss in shareholder value

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What Could Be Fixed While level of incentives is generally sufficient,

incentives may be low at the wrong times When firm value falls, stock and especially options become

worthless – precisely at the time the firm is in most danger Repricing options rewards the CEO for failure

Incentives typically have short vesting periods, allowing CEOs to cash out early

Countrywide CEO sold $129m of stock in 12m before 8/07 “Before the Bust, These CEOs Took Money Off the Table”

(Wall Street Journal, 11/20/08) Bebchuk, Cohen and Spamann (2010): top management at

Bear Stearns and Lehman earned $1.4bn and $1bn from cash bonuses and equity sales in 2000-8

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The Dynamic Incentive Account Edmans, Gabaix, Sadzik and Sannikov (2010) Escrow the CEO’s pay into an account, of

which (say) 60% is in stock, the remainder is in cash

“Long horizon principle” – account vests gradually, including after retirement

Superior to clawbacks: prevention, not cure; runs on auto-pilot “Constant percentage principle” – rebalance the

account so that % of stock at all times remains 60% Re-incentivizes the CEO after the stock price drops, without

rewarding him for failure

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The Role of Rebalancing CEO is considering whether to forgo holiday

Working increases firm value by 10% Holiday is worth 6% of salary to him

Salary is $10m, so holiday is worth $600,000 to him Need $6m of stock to deter holiday; remaining $4m is cash

Assume stock price halves, so stock is worth $3m, so salary is $7m

Working increases equity by $300,000 but holiday is worth $420,000

Need $4.2m of stock to deter holiday; remaining $2.8m is cash so $1.2m of rebalancing