Indexing Executive Compensation Contracts

Abstract

We analyze the efficiency of indexing executive pay by calibrating the standard model of executive compensation to a large sample of US CEOs. The main finding is that benefits from indexing stock options are small and that fully indexing them would increase compensation costs by more than 50% for plausible scenarios. We show analytically that indexing the strike price of stock options to the stock market induces four different adjustments relative to standard options, which simultaneously affect the risk-sharing and incentive properties of the contract; theoretically, the overall effect is ambiguous. Calibration analysis shows that indexing is generally inefficient, because it destroys incentives for almost all CEOs except those of high-beta, high-volatility firms. This result also applies to a scenario in which CEOs can extract rents. An important implication of our findings is that the prevalence of “pay for luck” in observed equitybased compensation contracts can be explained by the fundamental trade-off between risk and incentives. Standard proposals to index contracts would often not improve the efficiency of compensation.