Restoring the Link Between Pay and Performance: Evaluating the Costs of Relative-Performance-Based (Indexed) Options

Abstract

Conventional stock options, say their critics, do not adequately discriminate between strong and weak managers because their value fluctuates with the performance of the overall market. Such critics propose replacing conventional stock options with options whose payoff depends on firm performance relative to some market or industry benchmark. While these relative-performance-benchmarked options (also referred to as options) offer the benefits that accrue from a tighter link between managers' pay and their performance, they also have costs. This paper compares the of relative-performance-benchmarked options to those of conventional options. By cost, I mean the gap between the firm's cost of granting the option and the value of that option to less-than-fully-diversified managers. This gap arises because managers compelled to hold stock or options to align incentives cannot fully diversify their portfolios, and must therefore bear more risk than would well-diversified investors. The less-than-fully-diversified managers will therefore always value their stock and option-based compensation at less than its market value. I estimate the cost of this lost diversification, and find that, perhaps surprisingly, the gap between the firm's cost (the market value) and the manager's private value of an option is 57% greater for relative-performance-based options than for conventional options. The relative-performance-based options have larger deadweight costs because, by design, they strip away the manager's exposure to all systematic risk, leaving her with a portfolio with an expected return no better than the risk-free rate. One practical implication of this insight is that firms implementing a relative-performance-based compensation system should not boost the number of options awarded over the number that they would have otherwise awarded in a conventional stock option plan, even though indexed options have a lower market value than conventional options. Instead, firms should increase the cash component of managers' pay, which has the effect of decreasing the deadweight losses of the compensation plan while maintaining or even improving its power to align incentives.