Optimal Incentive Contracts for Loss‐Averse Managers: Stock Options versus Restricted Stock Grants

Abstract

This paper provides an explanation for the widespread use of stock option grants in executive compensation. It shows that the optimal incentive contract for loss-averse managers must contain a substantial portion of stock options even when it should consist exclusively of stock grants for "classical" risk-averse managers. The paper also provides an explanation for the drastic increase in the risk-adjusted level of CEO compensations over the past two decades and argues that more option-based compensation should be used in firms with higher cash flow volatility and in industries with a higher degree of heterogeneity among firms. Copyright 2006, The Eastern Finance Association.

CEO Cash and Stock‐Based Compensation Changes, Layoff Decisions, and Shareholder Value

“…To mitigate potential effects of secular trends in executive compensation (Kole and Lehn, 1999; Dodonova and Khoroshilov, 2006), we create a control sample of ExecuComp firms that do not announce layoffs over the period of our study. We match the control firms to layoff firms by industry (two‐digit Standard Industrial Classification code, SIC) and prior performance (90% to 110% of prior‐year return on assets, ROA) using a procedure similar to Barber and Lyon (1996).…”

Does Say on Pay Matter? Evidence from Say-on-Pay Proposals in the United States

“…For robustness, we include an indicator equal to 1 if the proposal passes, and we report the results in Panel B of Table 4. Further, utilizing more options allows managers to lever their payoffs once performance is turned around (see e.g., Dodonova and Khoroshilov, 2006;Brookman, Chang and Rennie, 2007). The passed indicator is not significant in any specification.…”

Does Say‐on‐Pay Matter? Evidence from Say‐on‐Pay Proposals in the United States

“…This change in compensation mix may help retain talent. Further, utilizing more options allows managers to lever their payoffs once performance is turned around (see e.g., Dodonova and Khoroshilov, ; Brookman, Chang and Rennie, ). To do so, boards move away from cash compensation and rely more heavily on incentive compensation.…”