The problem with executive compensation plans

Yesterday, I wrote about the difference between arithmetic and compound return and why it is important for investors to understand this difference. Today I want to focus on the implications this relationship has for executive compensation and incentive plans.

Nowadays, CEOs and other top executives of listed companies have a bonus that is linked to the performance of the share price. The idea is to align interests between the executives and the shareholders who are, after all, the owners of the company. If the executives manage a company so that the share price is maximised in the long run, then that is in the best interest of the shareholders because they stand to make the most money as well.

And this is where I think compensation schemes that link executive compensation to the share price are making a mistake.

Don’t get me wrong, I am all for linking executive compensation to the performance of the share price and I am all for linking it to the performance of the share price over longer time periods of 3 to 5 years or even longer. Incentives work and incentives need to be aligned with the goals of different stakeholders. But if you think back to yesterday’s post, I showed there that the average stock in the S&P 500 had a higher annual return than the index itself, yet the long-term compound return was a little bit below the S&P 500. The reason for this was that the volatility of individual stocks is higher than the volatility of the market overall and this higher volatility acts as a drag on compound returns.

If you link executive compensation purely to the change in share prices between today and some day three or five years from now, you don’t care about the path the share price takes between today and the payoff date. And you care even less about the share price after the payoff date. The result is that executives can try to engage in something akin to a pump-and-dump scheme. They can push the share price artificially higher in order to maximise the share price at the payoff date just to let it collapse, once bonus time is over. If you think that doesn’t happen, read this). The result is artificially high share price volatility due to the incentive scheme for the executives and a lower compound return for shareholders.

Instead, in my view, the better executive incentive scheme would be to pay bonuses based on a combination of the share price return and the volatility of the share price (the Sharpe Ratio comes to mind). This way, executives would be compensated not just for maximising returns, but for maximising returns with as smooth a path over time as possible.

Some readers may argue that by providing rolling windows for share price targets the path of the share price should become smoother. After all, an executive might cash in big time this year and then get nothing next year when the share price tanks. That is true but remember that bonuses don’t come symmetrical. In a good year, executives get a larger bonus, and many incentive plans are structured in such a way that if certain share price thresholds are surpassed the bonus becomes much larger. Meanwhile, in a bad year, executives get a bonus of zero. Yes, they suffer from a declining share price as well, but there is a lower “beta” if you will to the downside than to the upside. And all these features of compensation plans create an incentive to artificially pump up the share price in some years and then let it drop a lot in others. It effectively creates incentives to create excess volatility in the share price to benefit the executive.