Hidden Costs of Mandatory Long Term Compensation

Abstract

After the 2008 financial panic, long term compensation measures have gained favor as a way to limit managerial opportunism and excessive risk-taking. These measures, which may become mandatory for systemically important institutions, include restriction (i.e., deferral) of stock grants for a period of years, and, in the event of performance reversals, divestment of deferred stock and clawbacks of bonus compensation. These measures are considered uncontroversial enough that some have suggested that all public companies, not just systemically important firms, should adopt them.

In this article, I argue that benefits of long term compensation have been overstated while the potential downsides have been largely ignored. Restricted periods for equity grants must be large compared to the executive’s tenure in order to have a great effect upon behavior overall, and mandatory clawback provisions end up transferring what would have been bonus pay into salary. Further, to the extent that long-term compensation does affect behavior, these consequences are not necessarily good. I show that given fairly reasonable assumptions of executive risk aversion, information content of long term and short term price signals, and managerial control over the timing of project execution and disclosure, a long-term focus can have significant negative effects.

Keywords: long term compensation, clawback