The diminishing returns of incentive pay in executive compensation contracts.

• Author: Lund, Andrew C.W.

For the past thirty years, the conventional wisdom has been that executive compensation packages should include very large proportions of incentive pay. This incentive pay orthodoxy has become so firmly entrenched that the current debates about executive compensation simply take it as a given. We argue, however, that in light of evolving corporate governance mechanisms, the marginal net benefit of incentive-laden pay packages is both smaller than appreciated and getting smaller over time. As a result, the assumption that higher proportions of incentive pay are beneficial is no longer warranted.

A number of corporate governance mechanisms have evolved to duplicate incentive pay's positive incentive effects, thereby reducing its marginal benefit. Most significantly, a newly robust CEO labor market has made incentive pay largely redundant in focusing CEO attention on stock prices. In addition, while the marginal benefit of incentive pay has been overstated, its costs are significant and often overlooked. As a result, we believe that the net overall effect of incentive pay on shareholder wealth is now either minimally positive or even negative. We also argue that, given the strength of the corporate governance mechanisms discussed in the Article, attempts to improve company performance by "fixing" incentive pay structures are unlikely to succeed.

Nevertheless, the trend towards greater and greater incentive pay continues unabated. This resiliency, however, is not surprising even in a competitive market. In the past, the incentive pay orthodoxy was justified because corporate governance mechanisms were not as robust. Incentive-laden contracts therefore became a key marker for "good governance" in the compensation context. In addition to the stickiness of that status quo, incentive pay's staying power has been supported by the private interests of those who benefit from the conventional view of its efficacy. As a result of the incentive pay orthodoxy, executives receive greater pay, boards bear less responsibility for that pay, and compensation consultants and experts garner more attention. On the other hand, there is no constituency with a significant incentive to soberly assess the benefit of incentive pay that is not afflicted with informational disadvantages or collective action problems.

INTRODUCTION I. QUESTIONS ABOUT THE PURPORTED BENEFITS OF INCENTIVE PAY A. Complementarity and its Limits 1. The New Managerial Labor Market a. The Labor Market as Ex Post Settling Up b. The Importance of Share Price in Both Incentive Pay and the Managerial Labor Market c. Comparing the Force of Disciplinary Measures d. Sensitivity to Underperformance e. Summary 2. Attempted Improvements to Incentive Pay Practices B. The Likelihood of Arriving at an Optimal Contract II. THE COSTS OF INCENTIVE PAY A. Raising Firms' Compensation Costs 1. Risk Premiums 2. Less Effective Accountability Mechanisms a. Reduced Transparency for Third Parties b. Reduced Salience to Third Parties 3. Bargaining Effects a. Reduced Board Responsibility for Large Payments b. Mental Accounting Difficulties c. Admission of Significant Unchecked Agency Costs and CEO Centrality B. Incentives for Excess 1. Option Awards and Excessive Risk 2. Increased Accounting Fraud III. EXPLAINING THE RESILIENCY OF INCENTIVE PAY A. Status Quo Bias, Herding, and Signaling B. Private Interests of Participants C. The Moral Pull of Incentive Pay CONCLUSION INTRODUCTION

In the aftermath of the financial crisis, executive compensation has received an immense amount of attention. In January 2011, the Financial Crisis Inquiry Commission blamed the crisis, in part, on executive compensation. (1) That report capped two years of governmental, popular, and academic commentary that attributed some measure of the destruction in the financial sector to flawed pay practices. (2) This recent focus on executive compensation follows decades of attention paid to the topic by legal scholars, financial economists, politicians, regulators, and governance activists. Since the early 1980s, when attention to executive compensation design began in earnest, books and articles (in both the popular and academic press) have been written, shareholder campaigns have been waged, and laws and regulations have been promulgated, (3) all focused on how executives should be compensated.

Traditionally, the goal of pay reformers was to more closely link executive compensation with firm performance in order to reduce agency costs. More recent discussion, on the other hand, has focused on the role of executive pay structures in preventing future economic crises. Regardless of the goal--agency cost reduction or financial crisis prevention--the debate over executive compensation has settled on two related principles. First, the precise manner in which companies design executive pay contracts matters deeply. (4) Second, the proper design necessarily includes a very large amount of incentive pay, such as stock options, stock grants and performance-based bonuses. While participants in the corporate governance field quibble over the details, the ability of incentive pay to substantially affect executive and firm performance is largely taken for granted. The result has been the proliferation of incentive-laden contracts, with incentive pay dwarfing fixed salary and benefits across contemporary CEO contracts.

We believe that the incentive pay orthodoxy is no longer warranted. New research suggests that the benefits generated by incentive pay have significantly diminished in recent years, and whatever benefits remain can be expected to only dwindle further. Unfortunately, this erosion has been overlooked by those who still see substantial promise in fixing performance by fixing executive compensation. Instead of being subjected to an ongoing, rigorous cost/benefit analysis, the conventional wisdom regarding incentive pay has become entrenched in the psyches of boards of directors, compensation consultants, governance experts, policymakers, the press, and the public at large.

In this Article, we argue that the benefits of incentive pay are lower than conventionally understood because its effects are largely redundant of incentive effects stemming from newly robust corporate governance mechanisms that discipline executives for poor stock performance. These mechanisms--the activism of institutional investors, the oversight by more demanding boards, and, most significantly, the related reduction in CEO job security--are not new, but were perhaps too weak historically to replicate the incentive effects of performance-based pay. But, in recent years, these mechanisms have substantially gained in strength, and they are likely to continue to do so. The marginal benefit of incentive pay must be evaluated in light of these existing and evolving mechanisms, and we believe that that benefit is both smaller than commonly appreciated and, as importantly, diminishing over time. Meanwhile, incentive-laden compensation arrangements increase firms' compensation costs in numerous ways and have the potential to distort managers' behavior in value-diminishing ways.

Nevertheless, the incentive pay orthodoxy persists and shows no signs of relenting. This resiliency is not surprising. The conventional view was probably justified before corporate governance mechanisms evolved to make incentive pay's effects largely redundant. Incentive-laden contracts therefore became a key marker for "good governance" in the compensation context. The bias in favor of the status quo is very strong in the executive compensation context; this makes it very difficult for firms to offer less incentive pay. At the same time, all of the influential voices in the executive compensation arena have incentives to overstate the benefits of incentive pay. For example, because of the emphasis on incentive pay, executives earn greater compensation, boards bear less responsibility over executive pay outcomes, and compensation consultants and experts enjoy greater demand for their services. Moreover, incentive pay has superficial appeal to the public because it appears to strengthen the relationship between CEO pay and CEO talent level, a result that comports with basic notions of fairness.

Our conclusion that incentive pay is now less effective than commonly believed has two key implications. First, individual boards should be more skeptical of incentive pay's purported benefits and more cognizant of its costs. Before using incentive-laden compensation arrangements, boards should consider the many firm- and executive-specific factors that are relevant to incentive pay's efficacy and take into account the alternative mechanisms that affect executive behavior. Second, policymakers should be dubious of claims that unrelated goals, such as financial industry risk regulation or better corporate performance, can be effectively accomplished by adjusting (through regulation or otherwise) the manner in which firms pay their senior executives.

Even though we offer these prescriptive remedies, we are not sanguine about their prospects in the face of prevailing sentiment. There is deep popular distrust of executives and boards; therefore, any proposal to fundamentally alter pay practices will surely be met with suspicion. Moreover, Congress's recent enactment of Say on Pay (5) is likely to further entrench existing pay practices. Under Say on Pay, the conventional view of incentive pay will cause boards to cling to incentive-laden structures in order to minimize the risk that their compensation arrangements will be criticized by newly empowered shareholders. Thus, a final tentative implication of our analysis is the somewhat counterintuitive one that the best results in pay design may be achieved by insulating boards from pressure exerted by shareholders.

This Article proceeds in four parts. Part I examines the traditional agency-cost case in favor of incentive pay and explains...