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Six Challenges in Designing Equity-Based Pay

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  • Brian J. Hall
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    Abstract

    This paper analyzes why the primary goal of the equity-pay explosion--creating long-run ownership incentives for top executives--has often been difficult to achieve in practice. More generally, I describe six challenges in the design of equity-based pay plans and discuss potential solutions. The six challenges involve: 1. mismatched time horizons; 2. gaming; 3. the value-cost wedge'; 4. the leverage-fragility tradeoff; 5. aligning risk-taking incentives; and 6. avoiding excessive compensation. The paper also discussed the merits of stock versus options and concludes that restricted stock is often a superior form of compensation.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9887.

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    Date of creation: Aug 2003
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    Publication status: published as Brian J. Hall, 2003. "Six Challenges In Designing Equity-Based Pay," Journal of Applied Corporate Finance, Morgan Stanley, vol. 15(3), pages 21-33.
    Handle: RePEc:nbr:nberwo:9887

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    1. Lisa Meulbroek, 2001. "The Efficiency of Equity-Linked Compensation: Understanding the Full Cost of Awarding Executive Stock Options," Financial Management, Financial Management Association, Financial Management Association, vol. 30(2), Summer.
    2. Johnson, Shane A. & Tian, Yisong S., 2000. "Indexed executive stock options," Journal of Financial Economics, Elsevier, Elsevier, vol. 57(1), pages 35-64, July.
    3. Brian J. Hall & Jeffrey B. Liebman, 1998. "Are CEOs Really Paid Like Bureaucrats?," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 113(3), pages 653-691, August.
    4. Kevin J. Murphy & Brian J. Hall, 2000. "Optimal Exercise Prices for Executive Stock Options," American Economic Review, American Economic Association, American Economic Association, vol. 90(2), pages 209-214, May.
    5. Loderer, Claudio & Martin, Kenneth, 1997. "Executive stock ownership and performance Tracking faint traces," Journal of Financial Economics, Elsevier, Elsevier, vol. 45(2), pages 223-255, August.
    6. Paul A. Gompers & Andrew Metrick, . "Institutional Investors and Equity Prices," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 20-99, Wharton School Rodney L. White Center for Financial Research.
    7. Jennifer Carpenter, 1999. "Does Option Compensation Increase Managerial Risk Appetite?," New York University, Leonard N. Stern School Finance Department Working Paper Seires, New York University, Leonard N. Stern School of Business- 99-076, New York University, Leonard N. Stern School of Business-.
    8. Jensen, Michael C & Murphy, Kevin J, 1990. "Performance Pay and Top-Management Incentives," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 98(2), pages 225-64, April.
    9. Bushman, Robert M. & Smith, Abbie J., 2001. "Financial accounting information and corporate governance," Journal of Accounting and Economics, Elsevier, Elsevier, vol. 32(1-3), pages 237-333, December.
    10. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
    11. Lucian Arye Bebchuk & Jesse M. Fried & David I. Walker, 2002. "Managerial Power and Rent Extraction in the Design of Executive Compensation," NBER Working Papers 9068, National Bureau of Economic Research, Inc.
    12. Brian J. Hall & Jeffrey B. Liebman, 2000. "The Taxation of Executive Compensation," NBER Chapters, National Bureau of Economic Research, Inc, in: Tax Policy and the Economy, Volume 14, pages 1-44 National Bureau of Economic Research, Inc.
    13. Cotter, James F. & Zenner, Marc, 1994. "How managerial wealth affects the tender offer process," Journal of Financial Economics, Elsevier, Elsevier, vol. 35(1), pages 63-97, February.
    14. Carpenter, Jennifer N & Remmers, Barbara, 2001. "Executive Stock Option Exercises and Inside Information," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 74(4), pages 513-34, October.
    15. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    16. Robert Gibbons & Kevin J. Murphy, 1990. "Relative performance evaluation for chief executive officers," Industrial and Labor Relations Review, ILR Review, Cornell University, ILR School, vol. 43(3), pages 30-51, February.
    17. Esty, Benjamin C., 1997. "Organizational form and risk taking in the savings and loan industry," Journal of Financial Economics, Elsevier, Elsevier, vol. 44(1), pages 25-55, April.
    18. Core, John E. & Larcker, David F., 2002. "Performance consequences of mandatory increases in executive stock ownership," Journal of Financial Economics, Elsevier, Elsevier, vol. 64(3), pages 317-340, June.
    19. Morck, Randall & Shleifer, Andrei & Vishny, Robert W., 1988. "Management ownership and market valuation : An empirical analysis," Journal of Financial Economics, Elsevier, Elsevier, vol. 20(1-2), pages 293-315, January.
    20. Lambert, Richard A. & Lanen, William N. & Larcker, David F., 1989. "Executive Stock Option Plans and Corporate Dividend Policy," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 24(04), pages 409-425, December.
    21. Esty, Benjamin C., 1998. "The impact of contingent liability on commercial bank risk taking," Journal of Financial Economics, Elsevier, Elsevier, vol. 47(2), pages 189-218, February.
    22. Lewellen, Wilbur & Loderer, Claudio & Rosenfeld, Ahron, 1985. "Merger decisions and executive stock ownership in acquiring firms," Journal of Accounting and Economics, Elsevier, Elsevier, vol. 7(1-3), pages 209-231, April.
    23. Mehran, Hamid, 1995. "Executive compensation structure, ownership, and firm performance," Journal of Financial Economics, Elsevier, Elsevier, vol. 38(2), pages 163-184, June.
    24. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, Elsevier, vol. 3(4), pages 305-360, October.
    25. Rajesh Aggarwal & Andrew A. Samwick, 1998. "The Other Side of the Tradeoff: The Impact of Risk on Executive Compensation," NBER Working Papers 6634, National Bureau of Economic Research, Inc.
    26. Brian J. Hall, 1999. "The Design Of Multi-Year Stock Option Plans," Journal of Applied Corporate Finance, Morgan Stanley, Morgan Stanley, vol. 12(2), pages 97-106.
    27. Brian J. Hall & Thomas A. Knox, 2002. "Managing Option Fragility," NBER Working Papers 9059, National Bureau of Economic Research, Inc.
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    Cited by:
    1. Bizjak, John M. & Lemmon, Michael L. & Naveen, Lalitha, 2008. "Does the use of peer groups contribute to higher pay and less efficient compensation?," Journal of Financial Economics, Elsevier, Elsevier, vol. 90(2), pages 152-168, November.
    2. Paul André & Samer Khalil & Michel Magnan, 2012. "The adoption of deferred share unit plans for outside directors: economic and social determinants," Journal of Management and Governance, Springer, Springer, vol. 16(1), pages 81-105, February.
    3. Bruno S. Frey & Margit Osterloh, 2004. "Yes, Managers Should Be Paid Like Bureaucrats," CREMA Working Paper Series, Center for Research in Economics, Management and the Arts (CREMA) 2005-03, Center for Research in Economics, Management and the Arts (CREMA).
    4. Bulan, Laarni & Sanyal, Paroma & Yan, Zhipeng, 2010. "A few bad apples: An analysis of CEO performance pay and firm productivity," Journal of Economics and Business, Elsevier, Elsevier, vol. 62(4), pages 273-306, July.
    5. Loureiro, Gilberto & Makhija, Anil K. & Zhang, Dan, 2011. "Why Do Some CEOs Work for a One-Dollary Salary?," Working Paper Series, Ohio State University, Charles A. Dice Center for Research in Financial Economics 2011-7, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
    6. Igor Filatotchev & Gregory Jackson & Chizu Nakajima, 2013. "Corporate governance and national institutions: A review and emerging research agenda," Asia Pacific Journal of Management, Springer, Springer, vol. 30(4), pages 965-986, December.

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