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The concern that out-of-the-money stock options are not an effective way to motivate managers has led boards of directors to consider measures such as lowering the exercise price of underwater options, or issuing new option grants, to restore the incentive managers have to increase shareholder value. This paper explores whether such measures are needed: do out-of-the-money options lose their power to align incentives? We address this question by estimating how the incentive-alignment power of options changed over the course of the year 2000, a year that for many firms marked the derailment of the long-running bull stock market. Examining the sensitivity in the value of the manager's stock option to changes in the firm's stock price (one metric for incentive-alignment power), we find that in general the ability of options to align incentives remained remarkably intact. This resilience in incentive-alignment power stems from the long maturity of executive stock options, the relatively high stock price of firms that experienced stock price declines, and to a lesser extent, the increase in volatility levels that accompanied weakening stock prices. We test the robustness of these results to the metric of incentive-alignment power, replacing market values with the value that managers place on their stock and option holding, adjusting for managers' inability to fully diversify their portfolios.
The third installment in the Pathways to Quality Health Care series, Rewarding Provider Performance: Aligning Incentives in Medicare, continues to address the timely topic of the quality of health care in America. Each volume in the series effectively evaluates specific policy approaches within the context of improving the current operational framework of the health care system. The theme of this particular book is the staged introduction of pay for performance into Medicare. Pay for performance is a strategy that financially rewards health care providers for delivering high-quality care. Building on the findings and recommendations described in the two companion editions, Performance Measurement and Medicare's Quality Improvement Organization Program, this book offers options for implementing payment incentives to provide better value for America's health care investments. This book features conclusions and recommendations that will be useful to all stakeholders concerned with improving the quality and performance of the nation's health care system in both the public and private sectors.
The numerous incentive approaches and combinations and their implications can be dizzying even to the compensation professional. Pay for Results provides a road map for developing and implementing executive incentives that drive business needs and strategy. It is filled with specific analytic tools, including tables, exhibits, forms, checklists. In addition, it uncovers myths in performance measurement strategy and design. Timely and thorough, this book expertly shows businesses how to drive their specific needs and strategy. Human resources and compensation officers will discover how to apply performance metrics that align with shareholder investment.
The concern that out-of-the-money stock options are not an effective way to motivate managers has led boards of directors to consider measures such as lowering the exercise price of underwater options, or issuing new option grants, to restore the incentive managers have to increase shareholder value. This paper explores whether such measures are needed: do out-of-the-money options lose their power to align incentives? We address this question by estimating how the incentive-alignment power of options changed over the course of the year 2000, a year that for many firms marked the derailment of the long-running bull stock market. Examining the sensitivity in the value of the manager's stock option to changes in the firm's stock price (one metric for incentive-alignment power), we find that in general the ability of options to align incentives remained remarkably intact. This resilience in incentive-alignment power stems from the long maturity of executive stock options, the relatively high stock price volatility of firms that experienced stock price declines, and to a lesser extent, the increase in volatility levels that accompanied weakening stock prices. We test the robustness of these results to the metric of incentive-alignment power, replacing market values with the value that managers place on their stock and option holdings, adjusting for managers' inability to fully diversify their portfolios. We also test how sensitive our results are to volatility assumptions. We conclude that even a steep decline in stock price can leave incentive levels intact, so restoring incentive-alignment is seldom a good justification for resetting the stock price or issuing new option grants. Before rejecting such measures, however, boards must examine whether the ability of stock and option holdings to retain key managerial talent deteriorated as the stock price declined, for our findings suggest that in selected firms or industries, the value of those holdings declined substantially.
The scholarly literature on executive compensation is vast. As such, this literature provides an unparalleled resource for studying the interaction between the setting of incentives (or the attempted setting of incentives) and the behavior that is actually adduced. From this literature, there are several reasons for believing that one can set incentives in executive compensation with a high rate of success in guiding CEO behavior, and one might expect CEO compensation to be a textbook example of the successful use of incentives. Also, as executive compensation has been studied intensively in the academic literature, we might also expect the success of incentive compensation to be well-documented. Historically, however, this has been very far from the case. In Too Much Is Not Enough, Robert W. Kolb studies the performance of incentives in executive compensation across many dimensions of CEO performance. The book begins with an overview of incentives and unintended consequences. Then it focuses on the theory of incentives as applied to compensation generally, and as applied to executive compensation particularly. Subsequent chapters explore different facets of executive compensation and assess the evidence on how well incentive compensation performs in each arena. The book concludes with a final chapter that provides an overall assessment of the value of incentives in guiding executive behavior. In it, Kolb argues that incentive compensation for executives is so problematic and so prone to error that the social value of giving huge incentive compensation packages is likely to be negative on balance. In focusing on incentives, the book provides a much sought-after resource, for while there are a number of books on executive compensation, none focuses specifically on incentives. Given the recent fervor over executive compensation, this unique but logical perspective will garner much interest. And while the literature being considered and evaluated is technical, the book is written in a non-mathematical way accessible to any college-educated reader.
This commentary, a contribution to the Harvard Business Review Online Forum on the CEO's role in fixing the capitalist system, makes the argument that for an incentive system to usefully support a firm's long-term, society focused agenda, companies need to lessen their reliance on financial rewards to motivate top management, strengthen share-ownership requirements and stock-vesting conditions for senior executives and board members, and change CEOs' perception of compensation as a tool to "keep score" vis-à-vis their peers and bolster their own egos.
We study the relationship between CEO pay-performance sensitivity, pay-risk sensitivity, and shareholder voting outcomes as part of the "say-on-pay" provision of the 2010 U.S. Dodd-Frank Act. Consistent with our hypothesis, we provide evidence that shareholders tend to approve of compensation packages that are more sensitive to changes in stock price (pay-performance sensitivity). Our findings are consistent with theoretical predictions that outside owners approve of equity incentives as a means of aligning managers' interests with those of shareholders. We also document that future changes to equity-based incentives are related to voting outcomes and that shareholders incorporate CFO incentives into their votes. Collectively, these results provide evidence of the importance of equity-based incentives from the perspective of those most concerned with firm value and of the effectiveness of say-on-pay as a governance mechanism. Accepted by Journal of Business Finance and Accounting in January 2019.
Written by practicing attorneys whose expertise includes advising clients on the implementation and operation of equity-based incentive compensation programs, Public Company Stock Incentive Plans Line by Line is a comprehensive examination of an omnibus, equity-based incentive plan for a US public company. It explains the reasoning behind the various provisions in the plan document, noting where certain considerations must be made to ensure compliance with applicable tax and securities laws. The book covers such key topics as award types, tax concerns, securities law matters, plan administration, and considerations relating to the process of marketing a plan to shareholders. This publication also notes where industry trends are headed in light of the increased public focus on equity-based compensation programs. Public Company Stock Incentive Plans Line by Line is a valuable resource for legal consultants and advisers, as well as officers and directorsespecially members of the compensation committeesand human resources personnel of public companies that maintain or are considering building equity-based compensation plans.
Corporate Payout Policy synthesizes the academic research on payout policy and explains "how much, when, and how". That is (i) the overall value of payouts over the life of the enterprise, (ii) the time profile of a firm's payouts across periods, and (iii) the form of those payouts. The authors conclude that today's theory does a good job of explaining the general features of corporate payout policies, but some important gaps remain. So while our emphasis is to clarify "what we know" about payout policy, the authors also identify a number of interesting unresolved questions for future research. Corporate Payout Policy discusses potential influences on corporate payout policy including managerial use of payouts to signal future earnings to outside investors, individuals' behavioral biases that lead to sentiment-based demands for distributions, the desire of large block stockholders to maintain corporate control, and personal tax incentives to defer payouts. The authors highlight four important "carry-away" points: the literature's focus on whether repurchases will (or should) drive out dividends is misplaced because it implicitly assumes that a single payout vehicle is optimal; extant empirical evidence is strongly incompatible with the notion that the primary purpose of dividends is to signal managers' views of future earnings to outside investors; over-confidence on the part of managers is potentially a first-order determinant of payout policy because it induces them to over-retain resources to invest in dubious projects and so behavioral biases may, in fact, turn out to be more important than agency costs in explaining why investors pressure firms to accelerate payouts; the influence of controlling stockholders on payout policy --- particularly in non-U.S. firms, where controlling stockholders are common --- is a promising area for future research. Corporate Payout Policy is required reading for both researchers and practitioners interested in understanding this central topic in corporate finance and governance.