Lower Salaries and No Options? On the Optimal Structure of Executive Pay

Abstract

We calibrate the standard principal-agent model with constant relative risk aversion and lognormal stock prices to a sample of 598 U.S. CEOs. We show that this model predicts that most CEOs should not hold any stock options. Instead, CEOs should have lower base salaries and receive additional shares in their companies; many would be required to purchase additional stock in their companies. These contracts would reduce average compensation costs by 20% while providing the same incentives and the same utility to CEOs. We conclude that the standard principal-agent model typically used in the literature cannot rationalize observed contracts. Copyright 2007 by The American Finance Association.

Stock Options and Chief Executive Officer Compensation

“…First, in marked contrast to the conclusions by Meulbroek (2001), Hall and Murphy (2002) and Dittmann and Maug (2007) that do not solve the complete bi-level optimization problem between the principal and agent, we find that stock options are almost always an important part of the optimal CEO compensation contract. Second, consistent with Aseff and Santos (2005), restricting the compensation contract to fixed salary, at-the-money stock options, and restricted stock produces roughly the same expected payoff to owners as the optimal unrestricted second-best compensation contract.…”

“…Similarly, Dittmann and Maug (2007) conclude that stock options should almost never be part of the compensation contract for chief executive officers (CEOs). In contrast, Kadan and Swinkels (2006) develop and test an agency model where stock options dominate restricted stock when non-viability (or bankruptcy) risk is zero.…”

“…Finally, Dittmann and Maug (2007) consider an agency model with a number of realistic features and use the FOA to assess whether observed CEO compensation contracts are optimal. In particular, their analysis assumes that observed compensation contracts implement the optimal action and asks whether the principal can write a contract that induces the same action with less cost.…”

Executive Compensation: A Survey of Theory and Evidence

“…Murphy (2002), Jenter (2002), and Dittmann and Maug (2007) answer it by calibrating a standard agency model with constant relative risk aversion utility and lognormal …rm value 37 and …nd that the disadvantages of options dominate, suggesting that the optimal contract should use only stock and no options. Moreover, when Dittmann and Maug (2007) drop the restriction that the contract must be piecewise linear (i.e., consist of salary, stock, and options), they …nd that the optimal nonlinear contract is concave. Using a di¤erent model, Holmström and Milgrom (1987) predict linear contracts, which again suggests that incentives should be implemented purely with stock, and not non-linear instruments such as options.…”

“…However, incentives stem from the e¤ect of stock returns on the executive's utility, rather than his monetary wealth, which will di¤er if he is risk-averse (see Dittmann and Maug, 2007; and Section 2.1.2). Dittmann and Maug (2007) estimate a measure of utility-adjusted wealth-performance sensitivity based on assumptions on CEOs' relative risk aversion. In addition, an executive's actions may a¤ect the …rm's total value rather than its equity value.…”