Better to Base CEO Pay on Trust Than Stock Incentives, Study Says

The best way for directors to align the company’s interests with the CEO’s is to max out stock incentives, right? Not necessarily. New research published in the Review of Financial Studies recommends a different approach to incentives that results in a more effective relationship between the CEO and board.

Their model shows that “if regulation limits executive compensation, this can make it possible for the board to give the CEO incentives that are both more effective and less costly, and for the two parties to create a relationship that is more collaborative,” the authors wrote.

They go on to say that, “Ironically, the necessary trust is easier to establish when the alternative of using stock-based pay is less powerful.” Their research found that government-imposed limits on contingent compensation make stock-based pay a worse alternative, facilitating superior trust-based incentives.

“Some companies are good at reinvesting in employees, but it’s about helping them become better employees.”

Among the implications of their findings is that a more collaborative relationship based on trust makes it “more attractive for the CEO to pursue long-run strategies (e.g., organic growth) that are more profitable than the short-run strategies (e.g., mergers and acquisitions) they would have pursued if firms had to rely on stock-based compensation for their executives.”

The idea behind the researchers’ results is that ideally, boards would like to pay CEOs based on their actions, not their outcomes. But “informational friction” prevents that: although the directors can observe the executives’ actions, those observations cannot be used to enforce a formal contract. Relational contracts, those that rely on other parameters of CEO performance and rewards rather than just stock incentives for achieving particular metrics, can be effective in this setting, and boards should want to be perceived as honoring such arrangements.

“A board that reneges today can’t enter into similar agreements, with their attendant benefits, in the future—future executives would not see offers of such agreements, known as relational or informal contracts, as credible,” the researchers say.

Will such an approach replace an easier reliance by boards on stock incentives to keep a CEO’s head in the game? The report’s Hermalin and Cebon propose that more boards should try to find out, and that regulation of executive pay might create more circumstances that would necessitate they do so.


MORE LIKE THIS

  • Get the CEO Briefing

    Sign up today to get weekly access to the latest issues affecting CEOs in every industry
  • upcoming events

    Roundtable

    Strategic Planning Workshop

    1:00 - 5:00 pm

    Over 70% of Executives Surveyed Agree: Many Strategic Planning Efforts Lack Systematic Approach Tips for Enhancing Your Strategic Planning Process

    Executives expressed frustration with their current strategic planning process. Issues include:

    1. Lack of systematic approach (70%)
    2. Laundry lists without prioritization (68%)
    3. Decisions based on personalities rather than facts and information (65%)

     

    Steve Rutan and Denise Harrison have put together an afternoon workshop that will provide the tools you need to address these concerns.  They have worked with hundreds of executives to develop a systematic approach that will enable your team to make better decisions during strategic planning.  Steve and Denise will walk you through exercises for prioritizing your lists and steps that will reset and reinvigorate your process.  This will be a hands-on workshop that will enable you to think about your business as you use the tools that are being presented.  If you are ready for a Strategic Planning tune-up, select this workshop in your registration form.  The additional fee of $695 will be added to your total.

    To sign up, select this option in your registration form. Additional fee of $695 will be added to your total.

    New York, NY: ​​​Chief Executive's Corporate Citizenship Awards 2017

    Women in Leadership Seminar and Peer Discussion

    2:00 - 5:00 pm

    Female leaders face the same issues all leaders do, but they often face additional challenges too. In this peer session, we will facilitate a discussion of best practices and how to overcome common barriers to help women leaders be more effective within and outside their organizations. 

    Limited space available.

    To sign up, select this option in your registration form. Additional fee of $495 will be added to your total.

    Golf Outing

    10:30 - 5:00 pm
    General’s Retreat at Hermitage Golf Course
    Sponsored by UBS

    General’s Retreat, built in 1986 with architect Gary Roger Baird, has been voted the “Best Golf Course in Nashville” and is a “must play” when visiting the Nashville, Tennessee area. With the beautiful setting along the Cumberland River, golfers of all capabilities will thoroughly enjoy the golf, scenery and hospitality.

    The golf outing fee includes transportation to and from the hotel, greens/cart fees, use of practice facilities, and boxed lunch. The bus will leave the hotel at 10:30 am for a noon shotgun start and return to the hotel after the cocktail reception following the completion of the round.

    To sign up, select this option in your registration form. Additional fee of $295 will be added to your total.