Debt-like Compensation Research Articles

CEO Inside Debt Incentives and Corporate Tax Policy

This paper examines the relation between CEO inside debt holdings (pension benefits and deferred compensation) and corporate tax avoidance. Because inside debt holdings are generally unsecured and unfunded liabilities of the firm, CEOs are exposed to risk similar to that faced by outside creditors. As such, theory suggests that inside debt holdings negatively impact CEO risk-appetite. To the extent that aggressive tax policies involve significant cash flow shortfalls, high cash flow volatility, and losses in firm and CEO reputation in the future, we expect that inside debt holdings will curb CEOs from engaging in risky tax strategies. Consistent with the prediction, we document a negative association between CEO inside debt holdings and tax avoidance. Overall, our results highlight the importance of investigating the implication of CEO debt-like compensation for firm tax policies.

Are Executive Pensions and Deferred Compensation Inside Debt? Evidence from Corporate Private Loan Contracts

Theory posits that managerial holdings of debt (“inside debt”) align managers’ incentives with those of outside debtholders. Executive pensions, which consist of ERISA-qualified rank-and-file (RAF) plans and Supplemental Executive Retirement Plans (SERPs), and other deferred compensation (ODC) have debt-like payoffs, and could therefore function as inside debt. However, while SERPs are often unfunded and unsecured, RAF plans are funded and secured to some extent, and ODC may be invested in equity and withdrawn flexibly pre-retirement. Special arrangements in executive debt-like compensation could weaken or even nullify the incentive-alignment effect. We find that larger CEO debt-like compensation leads to lower promised yield and fewer covenants in a sample of loans originated in 2006-2008. This effect is driven entirely by benefits accrued under SERPs, consistent with SERPs more closely resembling risky corporate debt; balances accrued under RAF and ODC plans do not provide similar effects. Further, promised yields are lower when debt-like compensation claims can be withdrawn only after outside debt claims settle. Our findings persist after accounting for endogeneity using state personal income tax rates as an instrument for CEOs’ willingness to defer compensation. Overall, the evidence suggests that executive debt-like compensation is only effective at resolving stockholder-debtholder conflicts when its payoffs are truly debt-like, and that lenders’ perceptions are affected not only by the magnitude of debt-like compensation but also by its seniority.

CEO inside debt and hedging decisions: Lessons from the U.S. banking industry

Theoretical literature (Jensen and Meckling, 1976; Edmans and Liu, 2011) argues that inside debt – pension benefits and deferred compensation – has debt-like payoffs, and can therefore curb executives’ excessive risk-taking incentives created by equity holdings. We test this theory in the banking sector by investigating whether CEOs with larger inside debt holdings compared to their equity-based compensation hedge more their banks’ interest rate risk. Our results show that CEO inside debt holdings have a positive effect on the extent to which a bank uses interest rate derivatives for hedging purposes, implying that debt-like compensation mitigates bank executives’ risk-taking incentives. Our results have important implications for financial regulation attempting to prevent financial crises due, at least partially, to perverse incentives provided to bank executives through compensation.

Capital structure, executive compensation, and investment efficiency

This paper examines how the similarity between the executive compensation leverage ratio and the firm leverage ratio affects the quality of the firm’s investment decisions. A larger leverage gap (i.e., a bigger difference between these two ratios) leads to more investment distortions. Managers with more debt-like compensation components tend to under-invest, whereas managers with larger equity-based compensation engage more in over-investment. Furthermore, investment distortion is likely to increase the equity (debt) value when compensation leverage is lower (higher) than firm leverage. These findings suggest that managers can deviate from an optimal investment policy to increase the value of their portfolio, and that a lower leverage gap can reduce agency costs.

Is Inside Debt Efficient? Theory and New Evidence from Executive Pensions and Deferred Compensation

The average publicly-traded firm pays its CEO millions of dollars in deferred compensation and defined-benefit pension commitments. Scholars debate whether firms use these payments to efficiently align managerial interests with those of creditors, or whether instead they represent “hidden” forms of rent extraction. Yet others recommend these forms of debt-like incentive compensation, sometimes called “inside debt,” as a way of controlling risk-taking in systemically important financial institutions. We argue instead that inside debt is unlikely to be efficient in either setting. Inside debt is costlier and more complex than other tools for managing risk, such as covenants or simply cutting back on option pay, and gives managers opportunities to hedge their equity positions without revealing that fact to investors. Drawing on the behavioral literature, we also show that increasing pay complexity is likely to reduce the efficacy of all forms of manager incentives. . To test these hypotheses, we conduct a series of panel regressions utilizing matched CEO and firm data covering over 1300 firms during the period 2007 to 2009. Under most specifications, we find little evidence that current borrowing needs correspond with executive pay structures. We do find, however, significant relations between the use of pensions and markers of managerial power, markers of board risk aversion (such as the presence of female directors), and lagged firm debt levels.

Executive Compensation and Risk Taking

This paper studies the connection between risk taking and executive compensation in financial institutions. A theoretical model of shareholders, debtholders, depositors, and an executive suggests that 1) in principle, excessive risk taking (in the form of risk shifting) may be addressed by basing compensation on both stock price and the price of debt (proxied by the credit default swap spread), but 2) shareholders may be unable to commit to designing compensation contracts in this way and indeed may not want to because of distortions introduced by either deposit insurance or naive debtholders. The paper then provides an empirical analysis that suggests that debt-like compensation for executives is believed by the market to reduce risk for financial institutions.

Executive Compensation and Risk Taking

This paper studies the connection between risk taking and executive compensation in financial institutions. A theoretical model of shareholders, debtholders, depositors, and an executive suggests that 1) in principle, excessive risk taking (in the form of risk shifting) may be addressed by basing compensation on both stock price and the price of debt (proxied by the credit default swap spread), but 2) shareholders may be unable to commit to designing compensation contracts in this way and indeed may not want to because of distortions introduced by either deposit insurance or naive debtholders. The paper then provides an empirical analysis that suggests that debt-like compensation for executives is believed by the market to reduce risk for financial institutions.

The Economic Function of Underfunded Pension Plans

The Economic Function of Underfunded Pension Plans