Indexing Executive Compensation Contracts
Speaker
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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