Indexing Executive Compensation Contracts

Speaker

Ingolf Dittmann

Professor of Corporate Governance and Managerial Accounting

Erasmus School of Economics (ESE), Erasmus University Rotterdam

Abstract

We introduce indexed contracts into the standard model of executive compensation.
We calibrate the model to a sample of US CEOs and analyze two settings, one
that assumes efficient contracting and another one where shareholders can use indexed
contracts to recapture rents from CEOs. The main finding is that the benefits from
indexing are typically small: Average gains are 3% of compensation costs in our baseline
case and zero for the median firm in many plausible scenarios. The main reason is
that for about 80% of the CEOs in our sample, indexing destroys incentives because it
reduces option deltas and the likelihood of bad outcomes, and much of the incentives
of observed contracts come from the desire to avoid these bad outcomes. Finally, if the
benchmark is the stock market index, which is associated with a market risk premium,
the benefits from indexing decline further. The incentive effect and the risk-premium
effect together annihilate most of the potential benefits from improved risk-sharing
through indexation. If we assume that CEOs extract rents, then indexing contracts
is an inadequate instrument to recapture these rents, because the higher volatility of
non-indexed securities is an efficient way to provide incentives.

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