Stock options became a dirty word after the 2008 crash, blamed for encouraging CEOs to place too many risky bets. But in an economic recovery, a bigger threat might be playing it too safe. A new model for CEO pay from the McCombs School of Business finds that options have their place — along with restricted stock and severance pay — but the proper mix changes with the economic times.
A core principle of CEO pay incentives is to align them with a company’s goals. In the boom years before the crash, a common goal was explosive growth. Stock options rewarded executives for taking big risks, because they could exercise their options only when the stock rose above a target price. In the aftermath, federal regulators gave less favorable tax treatment to options and banned them for firms that got bailouts under the Troubled Asset Relief Program (TARP).
But it might be short-sighted to scrap options altogether, says Associate Accounting Professor Volker Laux. A recovery might be just the time when CEOs need a push to seek out risky innovations. “The problem is that [a CEO] might be too cautious and conservative,” says Laux, “and too concerned that if something goes wrong, they’re fired.”
Laux wondered how a firm could tailor its compensation package to inspire just the right amount of risk for the times. The answer: Juggling three chief types of incentives, each with distinct uses:
- Stock options, to goad a CEO to swing for the bleachers;
- Restricted stock, which a CEO can still cash in, even if he or she makes only base hits. For TARP companies, restricted stock was the only type of incentive still allowed;
- Severance pay, which takes some sting out of getting fired — especially during a bust, when another executive job might be hard to find.
To study different mixes of incentives, Laux turned to contract theory, a branch of game theory that studies how economic players agree on contracts with one another. In his model, the players were a board of directors and a CEO. The board could promote three different behaviors: motivate the CEO to seek innovations, discourage too much investment in risky projects, and on the flip side, discourage too little. Which combinations of incentives would best achieve those goals?
Running the equations in his model, Laux found that no contract could promote all those goals at once. During a boom, a CEO might need enticement to avoid too many daredevil investments. But the CEO needed none to avoid making too few. In a bust, by contrast, the CEO might need incentives to take bigger chances.
“You don’t have just one incentive problem,” says Laux. “Incentive problems are different in different environments.” In his research, Laux developed three different types of packages for three types of environments:
- In a boom, a CEO’s package should include options to encourage the quest for profitable innovations, Laux says. But it should dampen the urge for runaway risk-taking by including restricted stock.
- After a crash, though, a CEO is more inclined to stick with the status quo, for fear of getting fired if innovations don’t pay off. In that situation, Laux says, inducements need to be bold. Options are helpful, but so is severance pay to cushion the consequences of failure.
- Today’s environment of moderate growth is different from both extremes, Laux finds. Severance pay isn’t needed; a terminated CEO can more easily find a different job. Restricted stock is also unnecessary since the lukewarm economy is enough to discourage gambling.
The best incentive for today’s times, he concludes, is the much-maligned stock option. “You’re neither too concerned about excessive risk-taking nor about excessive conservatism,” Laux says.