This hack is one of 24 outstanding entries selected as finalists in the Long-Term Capitalism Challenge, the third and final leg of the Harvard Business Review / McKinsey M Prize for Management Innovation.
When determining executive performance, traditional models of CEO compensation consider relatively short time frames. This increases the likelihood that CEOs make strategic organizational decisions at odds with the long-term value of shareholder equity and the overall financial health of a corporation.
We propose a compensation structure based on a system that escrows compensation for a set period of years stretching into the executive's retirement. The longer time frame is designed to prevent the executive from taking short-term actions that may enrich the manager at the expense of the firm's future profits. The plan also provides a rebalancing mechanism to maintain a constant percentage of compensation in cash and stock, so that the executive always has sufficient equity in the firm to provide performance incentives -- even if the stock price falls.
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. 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.
Specifically, there are two major issues:
- Most compensation systems fail to adapt to changing conditions in the firm and its share price. If the firm is in trouble and the share price falls, stock options are worth little. Consequently, the executive loses an important incentive to perform just at the time when it is most important to be working at full throttle. So, to keep managers working hard at troubled times, boards typically give the executives more shares for free or they re-price existing options. That's highly controversial because, in effect, the CEO is being rewarded for failure.
- Existing compensation schemes typically have short vesting periods that allow executives to reap the rewards of their actions before their full effect may be realized. For instance, Angelo Mozilo, the former CEO of Countrywide Financial, made $129 million from stock sales in the 12 months prior to the start of the subprime crisis, which sent Countrywide shares tumbling and led to the firm's acquisition by Bank of America. Other executives have manipulated corporate accounting to boost the share price, then sold their stocks at the peak, as did Enron executives through the creation of shell subsidiaries in which they hid losses. In addition, executives could take other actions, such as cutting investment in research and development which would lead to short-term earnings spikes and an increase in share price, but cripple the firm in the future.
We believe that there is a creative yet practical way to tie executives' fortunes to the long-term health of their companies: The Dynamic Incentive Account (DIA). The DIA places top managers' compensation in escrow accounts invested in company stock and cash, and has two defining features:
- It updates the compensation package to reflect changing conditions in the market to ensure that managers' interests are always aligned with those of the company and its shareholders
- It includes longer, post-retirement vesting of stock and options to give executives them a powerful incentive to think long term
1. Updating the compensation package to reflect changing conditions
Even a compensation plan that's well-designed at the outset can fail to keep pace with the market and the company's fortunes. Take the case of a corporation that pays its boss in stock options. If the company hits a rough patch and its shares plummet, an executive's stock options become close to worthless and lose much of their incentive effect. This problem may still exist even if the executive has all stock and no options.
Let's say the CEO is paid $4 million in deferred cash and $6 million in restricted stock. At the outset, boosting the value of the company by, say, 1% is worth $60,000 to him—a good inducement to put in more effort or drop a costly pet project. But if the share price halves, his restricted stock is now $3 million. So, this incentive is slashed to $30,000.
To maintain the power of the incentives, the CEO must be required to hold more stock after a stock-price decline. How much more? In the paper with Profs. Xaviier Gabaix, Tomasz Sadzik and Yuliy Sannikov, we show that the CEO's stock should remain a roughly constant percentage of compensation.
In the example above, this target was 60%. At the start of the CEO's contract, that meant $6 million out of $10 million total compensation. We call this the CEO's "incentive account." Now that the stock has halved, the incentive account is worth only $7 million—$4 million in cash and $3 million in stock. To keep the equity level at 60%, the CEO must have $4.2 million of stock. This is achieved by rebalancing the CEO's incentive account: exchanging $1.2 million of cash for stock, so that the executive now has $2.8 million of deferred cash.
The account is therefore “reloaded” when the stock price goes down, and it makes sure the CEO has enough skin in the game. Critically, the reloading is not for free, unlike the current practice of re-pricing options or granting additional shares after stock price declines. Instead, the additional equity is purchased with cash in the account. This addresses a major concern with the repricing of stock options after company value falls: repricing rewards the CEO for failure by giving him a lower stock-price target to reach. (Note that the CEO cannot “undo” the incentive effect of stock by purchasing put options on his own shares, because such purchases are illegal.)
2. Post-retirement vesting
Another critical change companies should implement is to lengthen the time that executives must wait before they can cash in their shares and options. All too often, stock and options have short vesting periods, sometimes as little as two to three years. This encourages managers to pump up the short-term stock price at the expense of long-run value, since they can sell their holdings before a decline occurs. A CEO can, for instance, write subprime loans to boost short-term revenue and leave before the loans become delinquent, or scrap investment in R&D. This is possible since, in many cases, stock and options immediately vest when the CEO leaves the company.
The proposed Dynamic Incentive Account would have a longer-term time horizon, and vests gradually even after the executive's retirement. Since the proceeds from stock sales must remain within the account, this deters the executive from manipulating the share price upwards to trigger a sale and immediately withdrawing the proceeds. Instead, if the stock price subsequently falls, the cash proceeds are converted back to stock.
The length of the vesting period depends on the kind of company. For instance, the waiting period should be longer in businesses where the CEO can take actions with very long-term consequences. It might be seven years or more at a drug company with a lengthy product pipeline. For a banking executive overseeing a portfolio of credit default swaps with 7 year expiration dates, the full vesting ought to be completed slightly after the last of these contracts expire. But the wait might be shorter at, say, a commodity chemical company, where CEO decisions usually don't have an impact more than a few years ahead.
Of course, there is a trade-off. If companies make CEOs wait too long to collect, the former bosses might be exposed to risks outside their control, such as regulatory changes that eat into profits. Companies need to find a balance that works best for their situation.
The DIA has two major benefits, detailed more fully above:
- It ensures that executives are aligned with shareholders at all times – even if firm conditions change
- It ensures that executives don’t harvest the future for near-term gain
One big attraction of this hack is that it is very easy to implement. It uses the basic building blocks of executive compensation that are currently widely employed – cash and equity. The implementation only requires extending the vesting period of the executive’s equity, and making the mix of cash and equity in a given year depend on the firm’s performance in the prior year. A related attraction is that the Dynamic Incentive Account is easy to value. The board knows how much it is paying the CEO, since both stock and cash are simple to price. This clarity contrasts with compensation proposals that involve more complex instruments (e.g. indexed options with performance-vesting provisions) which are more difficult to value, so the board does not know how much it is paying the CEO.
However, we recognize that a potential challenge to implementation is the idea’s novelty – innovations typically lead to resistance. There are two solutions to this issue. First, the DIA can be initially applied only to part of the CEO’s compensation. For example, the DIA could be used for 25% of the CEO’s compensation, whereas the remaining 75% can be paid in traditional ways. This “gradual” implementation can allow the board to test both the pros and cons of the DIA in a non-committal way. If the DIA indeed leads to superior managerial decisions, the board can then increase the percentage of compensation that is comprised of the DIA over time.
Second, there exists a simple way to implement the DIA’s principles that does not involve creating an escrowed account. One potential issue with the “literal” implementation of the DIA (creating an escrowed account and rebalancing the CEO’s stock according to firm performance) is that the board may be reluctant to amend the terms of previously awarded compensation by exchanging stock for cash. Therefore, an alternative implementation would be not to set up an escrowed account, but continue to pay the CEO with the traditional building blocks of cash and restricted stock each year. The desired rebalancing can still be easily implemented without altering the CEO’s previously granted stock – if the stock price falls in a given year, next year the CEO is simply paid more restricted stock and less cash. An example is presented below.
Boards can also explain the attractions of the DIA to CEOs to obtain their buy-in. Since options can expire worthless, they are riskier than stock, so the DIA exposes the CEO to less risk than traditional packages that involve options. In addition, the CEO gets an additional reward from good performance compared to standard packages – not only does the value of his stock go up, but he is allowed to sell some of his stock to reduce his risk. In contrast, with traditional restricted stock, the vesting period of the stock is not accelerated by good performance.
Xavier Gabaix (NYU-Stern), Tomasz Sadzik (NYU), and Yuliy Sannikov (Princeton), the coauthors of the "Dynamic CEO compensation" included in the materials section below