A creative approach to executive pay

2009

Knee-jerk curbs on executive compensation and bonuses might make politicians and the public feel good, but in the long term what will be needed is a more imaginative, creative approach by boards of directors to how bonuses are actually released.

One way to assuage public anger over executive compensation, for example, might be to ensure that bonuses are always paid into special account where they cannot be released until longer term goals or objectives have been fulfilled.

According to a study by academics at the University of Pennsylvania's Wharton Business School greater use of so-called "escrow accounts" could help to remove some of the risk-fuelled short-termism aorund bonuses that has been so heavily criticised as a factor in last year's meltdown within the financial services sector.

Wharton professor of finance Alex Edmans has argued that a compensation structure based on long-term escrow accounts could be better for a company's future (if not the individual manager's) than the common practice of rewarding short-term changes in share price.

In his paper, Edmans, along with academics from New York and Princeton universities, argues that the use of such accounts would better link executive compensation to the performance of a firm over a longer horizon, as well as taking more account of changing conditions within the firm.

The longer timeframe used by escrow accounts would also prevent executives from taking short-term actions that could simply enrich themselves at the expense of a firm's future profits, he has said.

They could also provide a rebalancing mechanism to maintain a constant percentage of compensation in cash and stock, so that the executive always had sufficient equity in the firm to provide performance incentives – even if the stock price fell, he added.

"Linking compensation to share price has been viewed as a way to make sure the interests of the CEO and other top managers are aligned with those of shareholders," he pointed out.

"In recent years, however, the system has encouraged executives to take actions that boost share price in the short term but hurt shareholders and other stakeholders later, after the executive has cashed out," he added.

As has become all too clear during the banking and economic crisis, existing compensation schemes have traditionally had short vesting periods that had the potential to allow executives to reap the rewards of their actions before their full effect was sometimes realised.

Other criticisms of the current system include that it can allow executives to manipulate corporate accounting to boost share price, then sell at the peak (as happened at Enron) through the creation of shell subsidiaries in which they hid losses.

Or, executives might take actions, such as cutting investment in research and development that would lead to short-term earnings spikes and an increase in share price, but cripple the firm in the future.

Placing compensation in escrow accounts with a longer-term horizon of around five years, Edmans suggested, would help prevent such destructive short-term actions.

Motivating a manager, Edmans has calculated, requires rewarding a given percentage increase in firm value, perhaps 10 per cent, along with a sufficiently high percentage increase in pay, perhaps six per cent.

Using those hypothetical figures, a company would therefore need to reward 60 per cent of the executive's compensation in stock.

"If the CEO earns $5 million, he would be given $3 million in stock and the remainder in cash. If firm value rises by 10 per cent, his stock will now be worth $3.3 million and the cash remains at $2 million. Total pay rises from $5 million to $5.3 million, an increase of 6 per cent," pointed out Edmans.

Under this incentive account approach the escrow accounts would also need to be rebalanced each month to maintain the percentage of compensation in cash and stock.

So, for example, if the percentage was set to maintain 60 per cent in stock, cash would be drawn down in the account to buy more stock when the share price fell, to keep the proportion at 60 per cent.

"The [account] is reloaded when the stock price goes down, and it makes sure the CEO has enough skin in the game," said Edmans.

Critically, the reloading would not be for free, unlike the current practise of repricing options or granting additional shares after stock price declines, he added.

Instead, the additional equity would be purchased with cash in the account. On the other hand, if the stock price went up and the CEO had a lot of stock, he could sell it for cash to make sure he was not subject to unnecessary risk. However, the cash proceeds could not be immediately withdrawn and the account would vest gradually.

This vesting would continue until a number of years after the executive's retirement. Since the proceeds from stock sales would need to remain within the account, this would deter the CEO from manipulating the share price upwards to trigger a sale and immediately withdrawing the proceeds. Instead, if the stock price subsequently fell, the cash proceeds would be converted back to stock.

But while ideas such as this are all well and good, the only way the poison around executive compensation will truly be drawn is if boards of directors take, and are seen to be taking, a much greater lead in putting such schemes into place and enforcing them, stresses Edmans.

"The scheme should be up to the board of directors who should be deciding the compensation scheme. It should be important to set the scheme in the long-term interest of the shareholders," he emphasises.

This is largely because only an individual board of directors can decided what, in the context of that organisation, is best meant by "long term".

Given the continuing public anger over executive compensation, a good definition of long term in this context should simply be how long it takes for key actions to be reflected in operations and share price, but such a time-frame, pointed out Edmans, would likely be very different between, say, a research-based pharmaceutical firm or a concrete company.