Board of Director Incentive Alignment and the Design of Executive Compensation Contracts

Abstract

In this paper I empirically examine how cross-sectional and inter-temporal differences in characteristics measuring the board of director's ability to monitor and evaluate top management in the interests of the firm's shareholders ('director incentive alignment') are associated with differences in the design of executive compensation contracts. I first document a significant shift over the past 20 years in board characteristics measuring director ownership, independence, and effectiveness in the direction consistent with a general increase in directors' incentive alignment. This shift in director incentive alignment is also accompanied by an increase in measures of the incentive-intensity of CEO pay. Even after controlling for hypothesized determinants of the firm's monitoring environment and alternative monitoring mechanisms, I find that director incentive alignment and the incentive-intensity of CEO pay have both increased over time and are positively associated with each other. My results suggest that board and compensation structures are complementary monitoring mechanisms that have evolved over time in order to mitigate an increasing managerial moral hazard problem.