Replacing Executive Equity Compensation: The Case for Cash for Long-Term Performance

Abstract

I argue that executive equity pay in U.S. public firms is undesirable and should be replaced with cash awards for attaining long-term performance criteria.

Paying top executives in equity (stock and stock options) is the most significant reform of executive compensation in our generation, universally welcomed not only by firms but also by academics, investors, and policy makers. Yet I argue that equity compensation is undesirable. It provides perverse incentives for managers to destroy shareholder value and behave manipulatively and recklessly. It is also economically wasteful, and its wastefulness, which is exacerbated by agency costs and cognitive biases, significantly contributes to the immense explosion of executive compensation.

Instead, I suggest a radical proposal: to replace such equity pay arrangements with carefully designed cash-for-performance schemes in which executives are rewarded in cash for attaining predetermined long-term performance measures. I further recommend that this reform be implemented systemically and that the tax and disclosure rules that are applied to cash incentive remuneration be placed on a level playing field with those that are applied to equity incentive pay. This reform is expected to eliminate the significant costs of equity compensation and make incentive pay more effective, transparent, cheap, and better tied to performance, while retaining the limited incentive benefits generated by current equity compensation arrangements.

Keywords: executive compensation, executive pay, equity-based compensation, corporate governance, agency costs, restricted shares, options, risk-taking, long-term, retention, insider trading, unloading, hedging

JEL Classification: G32, G38, K22