Understanding High-Powered Incentives

Abstract

This paper analyzes the effect of restricted stock options and restricted stock grants on managerial effort incentives. The combination of low managerial valuations of options and inefficient incentive creation makes options inferior means of inducing managerial effort incentives. The negative covariance of the option delta or pay-for-performance with marginal utility reduces ex-ante effort incentives substantially, and the more so the higher the volatility of stock returns.

Pay-for-performance is shown to be a biased measure of managerial incentives. It systematically understates the incentives generated by equity holdings relative to the incentives generated by option grants. The bias is again increasing in the volatility of stock returns, offering a potential explanation for the empirical finding that pay-for-performance does not decrease with volatility as predicted by the optimal contracting framework.

The private trading behavior of managers is shown to be crucial for the optimal design of compensation contracts. Assuming that managers invests only into the riskless asset makes option compensation look considerably more effective than it is: The cost of compensating the executive is underestimated, and incentive effects are overestimated. The benefit of indexing compensation schemes to market or industry returns is reduced or even eliminated when the manager is able to freely trade the index through her private account.

Keywords: Executive Compensation, Incentive Options, Pay-for-Performance

JEL Classification: J33, J44, G13, G32, M12