Having regulated CEO pay in firms that have received bailout money, the Obama administration is now in serious discussions about overhauling compensation practices across the entire financial services industry.
A working paper by Alex Edmans, Assistant Professor of Finance at the Wharton School of the University of Pennsylvania, and Xavier Gabaix, Associate Professor of Finance at NYU Stern, coauthored with Tomasz Sadzik of NYU and Yuliy Sannikov of Princeton, proposes a solution to executive compensation that will address a number of problems that led to the current crisis.
It claims that there are two main problems with existing schemes: they are typically short-term focused and they fail to keep pace with a firm’s changing conditions. For example, it says that if a firm’s stock plummets, options are close to worthless and have little incentive effect.
The authors’ proposed solution aims to solve both of these issues. Their proposal involves creating ‘dynamic incentive accounts’ to ensure that top management has a stake in the long-term success of the firm at all times. Dynamic incentive accounts would:
- Escrow the manager’s compensation in an ‘incentive account.’ A given fraction of the account is invested in company stock with the remainder in cash;
- Rebalance the account each month to ensure that the fraction in stock remains above the minimum level (e.g., if the stock price falls, cash in the account is exchanged for stock);
- Pay out only a fraction of the account each month to the manager. The account continues to vest gradually, even when the manager leaves the firm.
Since the manager is ‘reloaded’ with new shares after the stock falls, his incentives remain strong. Importantly, unlike the current practice of repricing options that have become worthless, this reloading is not for free – the additional shares are paid for by reducing the cash in the account. The authors explain that “Compensation schemes should tie a manager to long-term performance, and provide strong incentives to improve shareholder value in both good and bad times.”