The false promise of risk-reducing incentive pay: evidence from executive pensions and deferred compensation.

• Author: Alces, Kelli A.

1. INTRODUCTION II. EXECUTIVE COMPENSATION AND INSIDE DEBT A. Traditional Incentive Compensation and Agency Costs B. Proposals to Pay with Inside Debt 1. Inside Debt Compensation in Non-Financial Firms 2. Inside Debt Compensation in Financial Firms III. WHY COMPENSATION WITH INSIDE DEBT IS INEFFICIENT A. Inferior to Alternatives B. Misaligns Incentives C. Inefficient Way to Adjust Incentives as Firm Changes IV. A BEHAVIORAL THEORY OF COGNITIVELY COMPLEX PAY PACKAGES A. Bounded Rationality and Cognition B. Bounded Rationality and Investment Decisions C. Bounded Rationality and Complex Pay D. Some Objections Considered V. EXISTING EVIDENCE OF DEBT COMPENSATION EFFICIENCY VI. ORIGINAL EMPIRICAL EVIDENCE ON PENSIONS AND DEFERRED COMPENSATION VII. CONCLUSION VIII. METHODOLOGICAL APPENDIX I. INTRODUCTION

   Incentive-based pay for corporate executives has been at the center of many recent controversies. Although "pay for performance" is supposed to help shareholders control managers by aligning the financial interests of the two sides, some blame it for the sky rocketing total pay taken home by top executives. (1) In the wake of the 2008-2009 financial crisis, government regulators and legal scholars blame incentive compensation for causing, or at least not preventing, the climate of excessive risk taking that led to the meltdown. (2) As a result, scholars and regulators are working on designing optimal incentive compensation schemes that properly set executive incentives to maximize profits to the extent possible while also constraining excessive risk seeking. (3)

   We disagree with these approaches, and in this Article, argue that packing compensation with yet more incentives is unlikely to solve the problems of incentive-based pay. The scholarly proposals have grown more complex as various baskets of securities and mixes of salary, bonuses, and pensions combine to form grand compensation schemes under which, it is hoped, rational managers will have almost no choice but to manage the firm with the optimal degree of risk. The corporate managers of the executive compensation literature are like machines whose incentives can be finely adjusted in a number of directions with measured changes to the sources of their compensation. We argue here that this cannot be so, and that there is a limit to the amount of information a corporate executive can process when making a decision on behalf of the firm.

   In particular, we are skeptical of recent proposals favoring the use of "inside debt," or corporate debt held by the debtor firm's insiders, (4) as a solution not only to the traditional agency problems between creditors and managers, but also to the dangers of unrestrained risk in the financial sector. Inside debt in the form of executive pensions or deferred cash has become an important part of the mix of mechanisms used to compensate corporate managers. (5) Recent commentators argue that pensions align managerial self-interest with the interests of creditors, thereby encouraging conservative investment decisions and lowering the cost of debt. (6) Similarly, because excessive risk taking by financial firms bears much of the responsibility for the recent financial crisis, some scholars suggest that the managers of financial firms be compensated with debt securities. (7) The arguments supporting this compensation scheme derive from the same reasoning supporting the use of inside debt in other firms--that it will temper risk seeking and align managerial self-interest with the interests of those who bear the downside risk of firm failures. (8)

   We argue, in contrast, that compensation with inside debt is often inefficient, and at times not even effective at influencing managerial behavior in the direction stakeholders prefer. We argue that inside debt unnecessarily complicates managers' incentive structures and can therefore have perverse incentive effects or none at all. We present evidence from the behavioral economics literature that individuals are incapable of constantly balancing financial consequences of their decisions, particularly as those financial outcomes become more complex and depend on more variables. Highly complex pay structures can lead managers to take mental "shortcuts" that reduce the quality of all their decisions. (9)

   Complex compensation schemes also require constant recalibration, making them less effective and less reliable methods of incentivizing managers. Legacy costs and cross-monitoring costs contribute to this problem. The use of inside debt to pay executives imposes legacy costs because inside debt payments are difficult to reverse or terminate. Pension and deferred salary obligations can remain even after the firm's debt has been repaid or its financial position or capital structure changes. (10) At that point, the executive's incentives would no longer align with any interested party and may be inefficiently misaligned with the interests of shareholders.

   Paying with inside debt additionally presents cross-monitoring problems because different creditors have different risk preferences, monitoring abilities, and interests. The interests of creditors may also differ dramatically from the interests of shareholders when the firm is experiencing financial difficulty. The differing interests of those various investors and monitors make it difficult to choose what payment scheme to use in order to align managerial incentives, and it leads to uncertainty about which interests managers should consider paramount. A company may have to rebalance the compensation package in order to realign incentives as its financial circumstances or capital structure change. That increases the complexity of the compensation scheme and so, as we demonstrate, makes it less effective at influencing managerial decision making at all.

   To test our hypothesis that inside debt is not strongly connected to any efficient contracting goal, we collected original empirical evidence on the determinants of CEO pensions and deferred compensation plans. As proponents of inside debt have themselves argued, if inside debt were an effective tool for aligning managers with creditor interests, we should find a correlation between firm borrowing and the prevalence of inside debt payments. (11) We find, to the contrary, relatively little evidence for the efficient contracting story. We do, however, find considerable evidence that managerial power, legacy costs, and the makeup of the board of directors play a significant role in firms' decisions to use inside debt. For example, we find that as the portion of independent directors on a board increases, so too does the firm's use of inside debt, a result we explain as likely implying an important role for directors' personal risk preferences in the setting of executive pay. We argue that these findings suggest that actors in the best position to judge the efficacy of inside debt so far have not found it a useful tool for shaping managerial incentives.

   Overall, we make several notable new contributions to the literature. Pensions, as this Article explains, are a key piece of evidence in the debate over whether executive pay is strictly optimal, or whether instead it is the result of "managerial power." Because our results cast doubt on the optimal contracting story for pensions, we offer substantial support for the managerial power theorists. We also contribute the first skeptical notes on proposals for using pay to constrain banker risk taking. And, more generally, we are the first to apply the insights of behavioral economics to the question of the efficacy of incentive-based pay.

   Part II introduces the basic theory of incentive-based pay and reviews the recent literature calling for compensation with inside debt. Part III begins our critique of inside debt, arguing that even if all actors are fully rational, inside debt still needlessly creates costs that could be avoided simply by using other governance tools. Part IV relaxes the rationality assumption, applying the literatures on behavioral household finance and bounded rationality in firms to the workings of pay-for-performance mechanisms. Part V reviews existing research on the efficacy of inside debt, noting some significant holes in studies to date. Part VI presents the results of our original empirical investigation. The Article also includes a brief appendix describing our methodology.

2. EXECUTIVE COMPENSATION AND INSIDE DEBT

   Executive compensation has become one of the primary tools of corporate governance. (12) It is also one of the most significant tools managers have at their disposal to extract value or "rents" from the firm. (13) This tension between the two opposing uses of executive compensation permeates the academic debate and complicates attempts to decide what compensation schemes are most appropriate. Those who find compensation effective in controlling agency costs argue that it is the product of "optimal contracting," while those who see it as an opportunity for executives to extract rents explain compensation arrangements as the result of inappropriate "managerial power." (14) Part II.A briefly introduces the basic contours of this debate to readers who may be unfamiliar with it. Part II.B explains the possible role of debt in incentive-based pay and summarizes recent proposals on that front.

   1. Traditional Incentive Compensation and Agency Costs

      Because widely dispersed shareholders cannot exercise meaningful control over a public corporation, they elect directors to oversee the managers who run the day-to-day business of the firm. (15) Thus, the owners of the business are not the managers, and the managers are controlling assets that do not belong to them. This separation of ownership from control in the public corporation was brought to light by Berle and Means 80 years ago, and the agency costs it creates remain the fundamental problem confronting corporate governance. (16)

      One important way in which...