The Tradeoff Between Employee Ownership and CEO Compensation: Evidence from Defined Contribution Pension Plans

Abstract

This paper examines the executive compensation schemes of firms whose employees invest in company stocks in the defined contribution (DC) pension plan. In sum, I find that during the period 1992 to 2007, firms with higher employee ownership in the DC plan are more likely to reduce the level and fraction of CEO pay in the form of stock options. The CEO interest alignment (Delta) and risk-taking incentives (Vega) are significantly suppressed in these firms. Moreover, these results are more evident for subsamples of firms in more unionized industries, firms whose employees are more difficult to retain, firms with weaker free-riding problems among employees, and firms that adopt broad-based employee stock ownership plans. The results are also more pronounced for a subsample of firms with higher capital intensity. These findings suggest that employee ownership in the DC plan enhances the mutual monitoring of and coordination among rank-and-file employees, thereby reducing the demand for intensive managerial monitoring induced by high-powered CEO stock option. These findings also indicate that when employees bear large amounts of undiversified risk by holding employer stocks in the DC plan, firms tend to lower managerial risk-taking incentives so as to avoid costly labor costs and litigations.

Keywords: Employee ownership, executive compensation, mutual monitoring and cooperation

JEL Classification: G32, G34, J33, J53