Lower Salaries and No Options? On the Optimal Structure of Executive Pay

50 Pages Posted: 7 Aug 2005 Last revised: 10 Aug 2009

See all articles by Ingolf Dittmann

Ingolf Dittmann

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

Ernst G. Maug

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

Abstract

We estimate a standard principal agent model with constant relative risk aversion and lognormal stock prices for a sample of 598 US CEOs. The model is widely used in the compensation literature, but it predicts that almost all of the CEOs in our sample should hold no stock options. Instead, CEOs should have lower base salaries and receive additional shares in their companies. For a typical value of relative risk aversion, almost half of the CEOs in our sample would be required to purchase additional stock in their companies from their private savings. The model predicts contracts that would reduce average compensation costs by 20% while providing the same incentives and the same utility to CEOs. We investigate a number of extensions and modifications of the standard model, but find none of them to be satisfactory. We conclude that the standard principal agent model typically used in the literature cannot rationalize observed contracts. One reason may be that executive pay contracts are suboptimal.

Keywords: Executive compensation, stock options

JEL Classification: G30, M52

Suggested Citation

Dittmann, Ingolf and Maug, Ernst G., Lower Salaries and No Options? On the Optimal Structure of Executive Pay. Journal of Finance, Vol. 62, Issue 1, pp. 303-343, 2007; ECGI - Finance Working Paper No. 32/2003; EFA 2005 Moscow Meetings Paper. Available at SSRN: https://ssrn.com/abstract=472401 or http://dx.doi.org/10.2139/ssrn.472401

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

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

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