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Indexing Executive Compensation Contracts

59 Pages Posted: 5 Jul 2011 Last revised: 30 Apr 2013

Ernst G. Maug

University of Mannheim Business School; European Corporate Governance Institute (ECGI)

Ingolf Dittmann

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE); Tinbergen Institute; Erasmus Research Institute of Management (ERIM); European Corporate Governance Institute (ECGI)

Oliver G. Spalt

Tilburg University - Department of Finance

Date Written: April 25, 2013

Abstract

We analyze the efficiency of indexing executive pay by calibrating the standard model of executive compensation to a large sample of US CEOs. The main finding is that benefits from indexing stock options are small and that fully indexing them would increase compensation costs by more than 50% for plausible scenarios. We show analytically that indexing the strike price of stock options to the stock market induces four different adjustments relative to standard options, which simultaneously affect the risk-sharing and incentive properties of the contract; theoretically, the overall effect is ambiguous. Calibration analysis shows that indexing is generally inefficient, because it destroys incentives for almost all CEOs except those of high-beta, high-volatility firms. This result also applies to a scenario in which CEOs can extract rents. An important implication of our findings is that the prevalence of “pay for luck” in observed equitybased compensation contracts can be explained by the fundamental trade-off between risk and incentives. Standard proposals to index contracts would often not improve the efficiency of compensation.

Keywords: executive compensation, indexed options, relative performance evaluation

JEL Classification: G30, M52

Suggested Citation

Maug, Ernst G. and Dittmann, Ingolf and Spalt, Oliver G., Indexing Executive Compensation Contracts (April 25, 2013). ECGI - Finance Working Paper No. 309/2011. Available at SSRN: https://ssrn.com/abstract=1876765 or http://dx.doi.org/10.2139/ssrn.1876765

Ernst G. Maug (Contact Author)

University of Mannheim Business School ( email )

L9, 1-2
Mannheim, 68131
Germany
+49 621 181-1952 (Phone)

HOME PAGE: http://cf.bwl.uni-mannheim.de/de/people/maug/

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Ingolf Dittmann

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands
+31 10 4081283 (Phone)
+31 10 4089165 (Fax)

HOME PAGE: http://people.few.eur.nl/dittmann/

Tinbergen Institute

P.O. Box 1738
3000 DR Rotterdam
Netherlands

Erasmus Research Institute of Management (ERIM)

P.O. Box 1738
3000 DR Rotterdam
Netherlands

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Oliver G. Spalt

Tilburg University - Department of Finance ( email )

Department of Finance
Tilburg University
Tilburg, 5000 LE
Netherlands
+31 13 466 3545 (Phone)

HOME PAGE: http://www.oliverspalt.com

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