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The Ethical Dimension of Equity Incentives: A Behavioral Agency Examination of Executive Compensation and Pension Funding

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Abstract

We draw on the behavioral agency model to explore the ethical consequences of CEO equity incentives. We argue that CEOs are more concerned with funding pension plans when they have more to gain from their stock options yet will increasingly underfund employee pension funds as their current option wealth increases. Our findings reveal that both effects hold when the CEO has greater power (also occupying board chair) over firm decision making. Our study suggests that there is an ethical dimension to equity incentives, given they are intended to align CEO interests with shareholders, yet potentially incentivize CEO behaviors with adverse consequences for employees. Insights from our findings provide boards and regulators with behavioral levers to protect employee well-being in the context of pension funding.

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Notes

  1. Some research has considered the effects of incentive alignment on bondholders, concluding that incentive alignment mechanisms that link managerial incentives to that of shareholders can result in a transfer of wealth from bondholders to shareholders (DeFusco et al. 1990; Jensen and Meckling 1976).

  2. While the PBGC provides partial insurance against the loss of a pension due to employer insolvency, this pension insurance is statutorily limited to paying a maximum annual amount of $59,320/year and more crucially, is dependent upon the PBGC remaining solvent—which is far from certain according a government audit (GAO 2017).

  3. The underfunding decision occurs via the decision to contribute more (or not) to the pension fund when the value of pension assets declines below the value of pension liabilities. To limit moral hazard risks that could increase the PBGC’s liability for the pensions of bankrupt firms, employers have been required to hold 90% of the estimated future pension obligation in the pension fund. This has been phased up to 100% (between 2008 and 2012) in accordance with the Pension Protection Act. Below the required funding level (100% as of 2012), “catch-up” contributions to pension assets are required by law as described above (cf., Anantharaman and Lee 2014); over that threshold, additional contributions to pension assets are optional (Rauh 2009). Defined benefit pension funds of S&P 500 firms have gone from being fully funded in 2007 to underfunded on average by 19% of pension liabilities in 2015.

  4. We exclude “under-water” options because they have no cash value to lose given the stock price is below the exercise price. They do however have potential wealth value should the stock price rise sufficiently to create positive wealth in the future. We choose to focus on stock options given that their ubiquity in compensation packages, the high-powered incentives they create and the focus of prior behavioral agency research on stock options (Larraza-Kintana et al. 2007; Martin et al. 2013).

  5. There is a possibility that pension assets may be invested in managed funds or index funds which includes the focal firm. Given this is likely to be a very small proportion of those equity assets, this is not likely to result in confounding of our models.

  6. Semadeni et al. (2014) recommend reporting Sargan statistics and first stage F statistics when conducting 2SLS analyses.

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  1. Melbourne Business School, University of Melbourne, Carlton, VIC, 3053, Australia

    Geoffrey P. Martin

  2. Eli Broad College of Business, Michigan State University, East Lansing, MI, 48824-1122, USA

    Robert M. Wiseman

  3. Department of Management, WP Carey School of Business, Arizona State University, Tempe, AZ, USA

    Luis R. Gomez-Mejia

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Martin, G.P., Wiseman, R.M. & Gomez-Mejia, L.R. The Ethical Dimension of Equity Incentives: A Behavioral Agency Examination of Executive Compensation and Pension Funding. J Bus Ethics 166, 595–610 (2020). https://doi.org/10.1007/s10551-019-04134-7

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