Options in Compensation: Promises and Pitfalls

• Author: CLAUS MUNK,HANS FRIMOR,CHRISTIAN RIIS FLOR
• DOI: http://doi.org/10.1111/1475-679X.12049
• Date: 01 June 2014
• Published date: 01 June 2014

DOI: 10.1111/1475-679X.12049

Journal of Accounting Research

Vol. 52 No. 3 June 2014

Printed in U.S.A.

Options in Compensation: Promises

and Pitfalls

CHRISTIAN RIIS FLOR,

∗HANS FRIMOR,

†AND CLAUS MUNK

‡

Received 2 November 2012; accepted 16 December 2013

ABSTRACT

We derive the optimal compensation contract in a principal–agent setting

in which outcome is used to provide incentives for both effort and risky in-

vestments. To motivate investment, optimal compensation entails rewards for

high as well as low outcomes, and it is increasing at the mean outcome to mo-

tivate effort. If rewarding low outcomes is infeasible, compensation consisting

of stocks and options is a near-efficient means of overcoming the manager’s

induced aversion to undertaking risky investments, whereas stock compensa-

tion is not. However, stock plus option compensation may induce excessively

risky investments, and capping pay can be important in curbing such behav-

ior.

1. Introduction

An important element in corporate governance is the set of mechanisms

that serve to influence management decisions when ownership and con-

trol are separate. One important and hotly debated mechanism is the com-

pensation of managers. The current crisis has been blamed on common

pay practices, which allegedly have led to greediness, excessive risk-taking,

and short-sightedness in the financial sector, and the political systems in

the United States and the European Union have responded by regulating

∗University of Southern Denmark; †Aarhus University; ‡Copenhagen Business School.

Accepted by Haresh Sapra. We appreciate comments from an anonymous referee, Anil

Arya, Peter Ove Christensen, Joel Demski, John Fellingham, Steven Huddart, Brian Mitten-

dorf, and Richard Young as well as participants at the 2011 Chicago-Minnesota Accounting

Theory Conference.

703

Copyright C, University of Chicago on behalf of the Accounting Research Center,2014

704 C.R.FLOR,H.FRIMOR,AND C.MUNK

executive compensation.1The regulation ranges from increased disclosure

requirements and “say-on-pay” votes over mandatory deferral of compensa-

tion and performance-based vesting to capping of bonuses and an outright

ban on options. An important objective is to balance incentives for risk-

taking either by ensuring that decision makers share equally in success and

failure or by capping the upside. The regulation has been intensely dis-

puted and especially so the cap on bonuses, while the attempts to ensure

that decision makers share in failure have received less attention.

In an agency setting with induced moral hazard, we show that capping

of bonuses can be optimal, whereas forcing managers to share equally in

failure and success in general cannot. Specifically, we show that options—

often combined with stocks—closely resemble the optimal contracts de-

signed to overcome a manager’s aversion to undertaking risky investments.

We demonstrate that the expected payoff generated under such compensa-

tion is often very close to the payoff generated under the optimal contract.

However, we also show that option compensation can be highly inefficient.

The inefficiency arises from the fact that option compensation can give the

agent an incentive to take on excessive risk, and an obvious question is how

to curb such incentives. We find that restricting compensation to the class

of linear contracts to consist of, for example, fixed salary plus restricted

stock, can be a very costly solution. We show that an alternative and much

more efficient solution is to use option compensation where total remu-

neration is capped. That is, the agent is not additionally compensated for

extreme outcomes, so the upside of the contract is removed.

We employ a hidden action model or principal–agent model where a

risk-neutral principal (representing the shareholders of the company) mo-

tivates an agent (the manager) to undertake hidden actions through com-

pensation based on a measure of performance (e.g., earnings or stock

price). We extend the typical principal–agent setting with unobservable ef-

fort by assuming that, in addition to effort affecting the mean, the agent

decides on risky investments affecting both the mean and the variance of

the outcome. The agent has no direct preferences over investments, but,

as compensation is used to induce preferences over effort, the investment

decision is subject to induced moral hazard. When hidden actions affect

only the mean, the optimal compensation scheme is increasing and con-

cave in outcome, and consequently compensation involving stock options

is inefficient. If investments must also be motivated and investments affect

variance, then the optimal unrestricted compensation scheme has a “short

1See, for example, Blinder [2009] and Bebchuck and Spamann [2009] as well as the mem-

orandum “Interagency Guidance on Sound Incentive Compensation Policies” by the U.S. De-

partment of the Treasury and the European Union Commission proposal COM(2009)0362

available, respectively, at http://www.occ.gov/news-issuances/federal-register/75fr36395.pdf

and http://www.ipex.eu/ipex/cms/home/Documents/doc˙COM20090362FIN. Further,see,

for example, Cassidy [2002] and Madrick [2003] regarding the alleged role of stock-based

compensation in earlier corporate scandals.