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.


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