The Way We Pay Now: Understanding and Evaluating Performance-Based Executive Pay

Abstract

Over the last ten years, performance-based equity pay, and particularly performance shares, have displaced stock options as the primary instrument for compensating executives of large, public companies in the U.S. This article examines that transformation, analyzing the structure and incentive properties of these newly important instruments and evaluating the benefits and risks from an investor’s perspective. Notable observations include the following: Although technically “stock” instruments, performance shares mimic the incentive characteristics of options. But performance shares avoid the tax, accounting, and other constraints that have led to uniform grants of non-indexed, at the money options. Performance share plans can be designed to be effectively in, at, or out of the money and these plans often employ relative performance measurement that makes them analogous to rarely observed indexed stock options. But the opacity of performance share plans creates risks for investors, and the two accounting approaches applicable to these instruments both result in systematic undervaluation for executive pay disclosure and financial reporting purposes. Given the growing dominance of these instruments, this article advocates the adoption of a mark-to-market accounting regime for all equity compensation.