Long-term Incentive Compensation Research Articles

Corporate social responsibility and the executive-employee pay disparity

We examine the impact of employee-related Corporate Social Responsibility (ER-CSR) on pay disparity between top management and the average worker. Firms with higher ER-CSR ratings have a lower pay disparity and the effect is greatest when executives are paid the most. ER-CSR is associated with a lower ratio of top management's cash and long-term incentive compensation, relative to the average employee's pay. We find that the negative relation is driven by socially responsible firms paying their average employees more. Finally, we document that CSR activities related to employee relations and diversity are those leading to a significant pay disparity reduction.

Not Just One Bet: Portfolio Managers' Cross Fund Risk-Taking

This paper documents that mutual fund managers who experience distress in one fund tend to subsequently take on more risk in other funds they manage. Specifically, portfolio managers decrease the cash holdings and increase the systematic risk component in their linked funds. This increased risk-taking appears to be primarily motivated by managers' compensation contracts and is value-destroying for fund investors. The response to the distress shock is smaller for portfolio managers with long-term incentive compensation contracts, longer-tenured managers, and teams with female managers. These results highlight fund spillover effects through common portfolio managers and agency conflicts in the mutual fund industry.

Green Leaf Grocery - Executive Compensation Case Study

The primary purpose of this teaching case is to aid students in understanding how executive compensation plans are utilized to achieve organizational goals and to then construct their own executive compensation plan for the CEO of Greenleaf Grocery, a fictional retail business based on an actual company.
 Students have the opportunity to create a comprehensive executive compensation plan using salary, bonuses, stock options, benefits, and other compensation tools. Additionally, the case provides the opportunity to discuss the use of both short-term and long-term incentive compensation. The company in this case is poised to undertake an initial public offering of stock and retaining the current CEO is viewed as critical for this next phase. 
 The case affords the class the opportunity to explore ethical issues in executive compensation as well as other aspects of the organization’s overall compensation structure.

Do Stock Options Influence CSR Activity?

This paper investigates the impact of stock option of board of directors on Corporate Social Responsibility (CSR) activities using 336 of Korean firms in 2013. Stock options are the most typical form of long-term incentive compensation and are contingent on the value of the stock in the future. We develop and analyze hypothesis, based on stakeholder theory. We find a significant relationship between the stock option and CSR activities, after controlling for various firm characteristics. Our findings are that long-term compensation for executives is positively associated with CSR activities and it attempts to focus executives’ efforts on optimizing the longer term. It also implies that the structure of executive compensation could be used as an effective tool to encourage management to undertake socially responsible actions, therefore resulting in more socially responsible firms.

CEO compensation, customer satisfaction, and firm value

Purpose– The purpose of this article is to examine whether the design of chief executive officer (CEO) compensation generates incentives to engage in managerial behavior that enhances customer satisfaction and whether these incentives, in turn, lead to higher firm value.Design/methodology/approach– A unique dataset combining customer satisfaction and executive compensation data was used, and the relationship between option sensitivity, customer satisfaction and performance was modeled using simultaneous equations modeling with industry and year fixed effects.Findings– Findings suggest that CEO compensation plays an important role in explaining the variation in customer satisfaction and firm value. Specifically, CEO short-term compensation (salary or bonus) has no affect on customer satisfaction or firm value; the sensitivity of CEO wealth from long-term incentive compensation to stock price changes is positively related and also exhibits an inverted U-shaped relationship with customer satisfaction; the sensitivity of CEO wealth from long-term incentive compensation to stock price changes interacts negatively with CEO longevity and industry concentration but positively with advertising expenses in affecting customer satisfaction; the sensitivity of CEO wealth from long-term incentive compensation to both stock price changes and customer satisfaction positively affect firm value; and the sensitivity of CEO wealth from long-term incentive compensation to stock price changes interacts positively with customer satisfaction to affect firm value.Research limitations/implications– This study suffers from several limitations. First, the sample is limited to firms with ACSI scores available. Second, this study is limited to only publicly traded firms, which limits our ability to generalize regarding customer satisfaction, option sensitivity and firm value.Practical implications– This study has several important implications for researchers and managers. The first is that the corporate board appears to view investment in customer satisfaction as similar to an investment in other intangible assets or technology, in that they reward managers with a nonlinear payoff profile. To encourage managers to invest discretionary funds wisely, incentive compensation is important. Second, compensation committees of corporate boards should not allow the option sensitivity to reach extreme levels because, at some point, managers’ incentives appear to shift more toward short-term earnings objectives and away from investment in intangibles, which have a longer-term payoff. Third, if boards are concerned about customer satisfaction and market value, when designing compensation packages, they should shift their focus from the structure of pay to the sensitivity of pay to performance. The exception to this is that for CEOs with very long tenures (or for those close to retirement), high levels of option sensitivity may distort incentives away from a focus on customer satisfaction. Finally, our results indicate that strategies that enhance customer satisfaction provide an incremental benefit in terms of firm value, beyond incentive compensation strategies.Social implications– The results indicate that a “stakeholder focus” which includes customers is value adding for shareholders as well. The results also imply that perhaps using a “balanced scorecard” approach to assessing performance in terms of customer satisfaction outcomes, or at least acknowledging the drives of customer satisfaction explicitly, could be an alternative to using highly sensitive incentive-based compensation when such compensation schemes are less desirable.Originality/value– Prior research has found that the structure of fixed versus incentive-based compensation impacts customer satisfaction. However, this is one of the first papers to investigate the relationship between the sensitivity of CEO compensation and customer satisfaction. Findings have important implications for boards who seek to structure CEO pay so that CEOs have incentives to enact policies that benefit customers and, in turn, firm performance.

Bank executive compensation structure, risk taking and the financial crisis

This paper investigates (1) how the composition of executive compensation is related to a bank’s incentive to take excessive risk, (2) whether executive compensation in larger banks, especially the too-big-to-fail (TBTF) banks, induces more severe moral hazard behavior, and (3) how the relation between bank executive compensation and risk taking changes before and during the recent financial crisis. We find that bank risk measured by the Z-score and the volatility of stock returns increases with both the percentages of short-term and long-term incentive compensation. However, greater proportion of incentive pay decreases the likelihood for a bank to become a problem or failed institution. This result holds for the periods before and during the recent financial crisis. The distress-mitigating effects of incentive compensation are further confirmed by our finding that both the proportions of bonus and long-term incentives are positively related to bank valuation and performance. Interestingly, we find that TBTF banks experience greater risk taking (lower Z-score) and are more likely to be in financial distress than smaller banks. However, greater incentive compensation in TBTF banks helps reduce their insolvency risk relative to smaller institutions.

Total Shareholder Return (TSR) and Management Performance: A Performance Metric Appropriately Used, or Mostly Abused?

This article identifies the complex issues associated with the unconsidered use of total shareholder return (TSR) as a metric to represent the gains (or otherwise) in shareholder wealth and in contexts such as long-term incentive compensation and proxy voting by shareholders (including “say on pay”). Not all TSR is created equal. Other measures, such as economic profit (EP), return on invested capital (ROIC), and future value (FV), need to be introduced to effectively interpret the quality of TSR. There are not one but eight states of the quality of TSR, and this has implications for effectively evaluating true pay-for-performance alignment and considered say-on-pay voting by institutional investors everywhere, including under the new Dodd–Frank legislation in the United States.

Audit Committee Compensation, Fairness, and the Resolution of Accounting Disagreements

SUMMARYAn emerging body of research examines the relation of incentive-based audit committee compensation with accounting outcomes (e.g., Archambeault et al. 2008; Magilke et al. 2009). We extend this literature by examining the effects of audit committee compensation and perceived fairness to shareholders on actual public company audit committee members' judgments in accounting disagreements. Fifty-six highly experienced public company audit committee members participated in an experiment involving an accounting disagreement between management and the external auditor, with three types of audit committee compensation (i.e., cash only, cash and short-term stock options, or cash and long-term stock options) manipulated between subjects. We further measured the participants' perceptions of the fairness to shareholders if the auditor's adjustment is not recorded. We find evidence that audit committee members are more likely to support the auditor in an accounting disagreement when audit committee compensation includes long-term stock options and when members perceive that the failure to record the auditor's adjustment is less fair to shareholders. Moreover, we find that the relation between long-term incentive compensation and support for the auditor is fully mediated by a sense of fairness to shareholders. We offer implications and suggestions for future research.

Bank Executive Compensation Structure, Risk Taking and the Financial Crisis

This paper investigates (1) how the composition of executive compensation is related to a bank’s incentive to take excessive risk, (2) whether executive compensation in larger banks, especially the too-big-to-fail (TBTF) banks, induces more severe moral hazard behavior, and (3) how the relation between bank executive compensation and risk taking changes before and during the recent financial crisis. We find that bank risk measured by the Z-score and the volatility of stock returns increases with both the percentages of short-term and long-term incentive compensation. However, greater proportion of incentive pay decreases the likelihood for a bank to become a problem or failed institution. This result holds for the periods before and during the recent financial crisis. The distress-mitigating effects of incentive compensation are further confirmed by our finding that both the proportions of bonus and long-term incentives are positively related to bank valuation and performance. Interestingly, we find that TBTF banks experience greater risk taking (lower Z-score) and are more likely to be in financial distress than smaller banks. However, greater incentive compensation in TBTF banks helps reduce their insolvency risk relative to smaller institutions.

Firm Financial Performance Following Mergers

This study, using a sample of 162 firms and industry-adjusted cash flow returns on market value of assets as performance criteria, examines the financial performance of the combined target and acquiring firms over a 5-year post-merger period in relation to the corresponding pre-merger period. We find that post-merger performance is negatively associated with relative target size and positively associated with long-term incentive compensation plans. Firms that are in dissimilar industries also show improved performance, as do firms that merged prior to 1983.

Compensation Policy and the Investment Opportunity Set

We analyze the proportions of executive pay derived from salary, bonus, long-term incentive compensation, and stock-based compensation for a sample of 321 Fortune 1,000 firms in 1992. We find that firms with abundant investment opportunities pay higher levels of total compensation to their executives. Executives of growth firms receive a larger portion of their compensation from long-term incentive compensation (such as performance awards, restricted stock grants, and stock option grants), while those of non-growth firms receive a larger portion of their pay from fixed salary. An implication is that long-term incentives contracts reduce agency costs associated with manager-shareholder information asymmetries in growth firms.

Market reaction to long-term incentive plan adoption: Equity dilution as an explanatory variable

Long-term incentive plans are instituted to motivate top corporate executives and align principal-agent interests. Among others, forms of long-term incentive compensation include cash and stock awards, stock options, performance shares, stock appreciation rights, phantom stock, and participating units. The general contention behind instituting these awards is that they increase long-term shareholder wealth. Preliminary studies by Brickley, Bhagat & Lease (1985) , and Tehranian & Waeglein (1985) , support this contention. However, Jones, 1980a , Jones, 1980b documents evidence to show that shareholder groups do not view the impact of all incentive plans favourably. This paper focuses on the market reaction to the adoption of long-term incentive plans that reward executives through stock options. Analysing from an event-study perspective, our results provide some evidence that beyond a point incentive effects are offset by effects of equity dilution through stock options and shareholder wealth is reduced. Hence, it appears that a blanket endorsement of all long-term incentive plans as being in the interest of shareholders is not warranted. This study adds to existing literature on principal-agent relationships, and shows that equity dilution can be used as a variable to assess market reaction to long-term incentive plan adoption.

Long-Term Incentives for Management, Part 6: Plan Administration and Grant Usage

The success of a company's long-term incentive compensation program depends in large part on how well the plan is administered and how the grants are structured.

Taxes and executive stock options

In the Sixties, the qualified stock option was the predominant form of long-term incentive compensation contract for major industrial firms in the U.S. In the early Seventies these same firms replaced their tax-qualified stock option plans with non-qualified sttock options and later modified these plans to include a variety of new contingent compensation arrangements, some of which were based on accounting numbers instead of stock prices. This paper develops the hypothesis that tax considerations play an important role in explaining the form of compensation contracts. The pattern and timing of changes in the compensation plans of the top 100 industrial firms provides evidence consistent with the tax hypothesis.