Performance-vested stock options and interest alignment
Introduction
In the wake of the corporate scandals that plagued the beginning of this decade, concerns have increasingly been raised regarding various aspects of corporate governance (DeFond et al., 2005). As an important component of corporate governance reforms, managerial compensation, especially equity compensation (stock and stock options), has come under scrutiny. This study empirically analyses the effectiveness of attaching performance targets to option vesting in aligning managerial interest and shareholder value.
The vesting of traditional stock options (hereafter, TSOs) is contingent simply upon the passage of time. Opponents of TSOs argue that the link between managers' pay and firm performance is inadequate (Gerakos et al., 2007), as managers are generously rewarded when the market as a whole rises even if they underperform the market average or their peers. Accordingly, activist shareholders have proposed that firms attach company-specific performance targets to equity compensation and condition option vesting on the achievement of performance targets. These proposals have been rapidly implemented.1
Although the claim is that compared with traditional stock option plans vesting performance targets provide better incentives, the implications of such reward mechanism on managerial behavior are the subject of debates (Bruce and Buck, 2005). Some theoretical studies show that performance-vested stock options (hereafter, PVSOs) provide managers greater incentives than their traditional counterparts to behave in line with the owners' best interest (Johnson and Tian, 2000, Kuang and Suijs, 2006). However, theoretical evidence also suggests that this compensation design may have undesirable consequences: because risk-averse managers with undiversified portfolios have an incentive to influence their own compensation in order to maximize their private interests (Bertrand and Mullainathan, 2001, Hall and Murphy, 2002), basing managers' remuneration or their promotion opportunities on performance targets induces managerial game-playing at the expense of shareholders (Healy, 1985, Gaver et al., 1995, Jensen, 2003, Camara and Henderson, 2005, Kuang, 2008). The consensus in the goal-setting literature is that ‘challenging’ targets, i.e., targets that are achievable by exerting high effort, are associated with improvements in firm performance (Merchant and Manzoni, 1989, Locke and Latham, 2002, Jensen et al., 2004). But the high achievability of performance targets calls into question whether they are vulnerable to managerial manipulation (Conyon and Murphy, 2000).
The debate on the incentive effects of PVSOs is also conducted among practitioners. In its Global Best Practice 2006 for “Corporate Performance Management”, PWC advocates that firms attach performance targets to stock option compensation. In contrast, some high profile corporations urge shareholders to reject the PVSOs, as they believe that attaching performance targets to stock options puts the company at a competitive disadvantage in the sense that the performance hurdles constrain the company's ability to recruit and retain top talent.2 Moreover, some executive compensation critics challenge the incentive effects of PVSOs. They allege that firms merely grant PVSOs in order to placate investors calling for compensation reforms, and that the symbolically adopted PVSOs with easily achievable performance targets provide no additional incentives (Gerakos et al., 2007).
This study empirically examines the incentive effects of attaching performance targets to option vesting by testing the relation between PVSO compensation and interest alignment between owners and managers, where the level of interest alignment is measured by pay-performance sensitivity (PPS) (Jensen and Murphy, 1990, Garen, 1994, Aggarwal and Samwick, 1999, Conyon et al., 2000b). We attempt to answer two research questions. First, is PVSO compensation associated with greater interest alignment between managers and shareholders? Second, what is the role of difficult-to-achieve vesting targets in this relationship? The study focuses on the UK because listed firms in the UK disclose more detailed information on managerial compensation compared to firms in the US, an advantage that facilitates our investigation.3 Based on a data set of 4238 observations from 1383 executive directors in the largest 244 UK non-financial firms from 1999 to 2004, we find that the use of PVSO schemes in managerial compensation contracts is associated with a higher level of pay-performance sensitivity, which suggests improved alignment of owner and manager interests through the use of PVSOs. In addition, we find that increased target difficulty influences pay-performance sensitivity by decreasing interest alignment.
The contribution of this paper to the compensation literature is fourfold. First, we are among the first to empirically investigate the incentive effects of PVSOs. Despite the popularity of PVSOs in contemporary compensation packages, the extent to which this incentive instrument is effective remains an open question. Second, our findings have implications for investors and regulatory bodies who advocate firm condition managerial equity compensation upon the achievement of real improvements in firm performance. Third, we make a methodological contribution in that we address the fact that some executives (firms) are more alike than others (i.e., within one firm (within one industry) in our sample), and thus observations are not completely independent in the full sample. Finally, our empirical work rests on a new and comprehensive database, which facilitates a detailed analysis on executive pay and board structure.4
The remainder of the paper is organized as follows. We describe the UK institutional background and develop the hypotheses in Section 2, followed by a description of our methods in Section 3. Sample selection procedure and data sources are presented in Section 4. We discuss the empirical findings in Section 5. Section 6 presents the results of sensitivity tests. The paper concludes with a summary and discussion in Section 7.
Section snippets
Institutional background and hypothesis development
Top managers in the UK receive two separate forms of compensation: a direct component and deferred rewards. The direct component consists of salary, annual bonus, pension, and other cash compensation. The deferred rewards generally comprise stock and stock options (e.g., PVSOs and TSOs).
UK managerial pay level and its association with firm performance are subjects that generate heated debates among government regulators, capital markets, and academia. One of the major concerns pertains to the
Methodology
This section quantifies the extent to which management pay is sensitive to corporate performance, and the effect of PVSOs on PPS. In an attempt to address some of the concerns with prior PPS modelling methodologies, we introduce multilevel modelling method.
Sample selection and data sources
Our initial sample consists of the 350 largest non-financial18 firms in the UK, based on market capitalization in 2004. The reason for focusing on large firms is threefold. First, large firms are of greatest concern to investors. Second, large firms are more likely to reward managers with PVSOs (Conyon et al., 2000a), and usually disclose
Empirical analysis
Fig. 1 depicts the time series of the composition of total executive pay in our sample. The cash-based component accounts for less than 35% of the average total compensation received by executive directors, with this percentage declining precipitously since 2002. Meanwhile, equity-based components of executive total wealth have increased. The observed pattern in managerial compensation structure coheres with prior findings that soaring managerial compensation since the 1980s is largely due to
Alternative explanation
Vesting targets impose additional risk on managers, and hence managers will ask for increased compensation, which suggests that firms that use PVSOs to compensate their executives grant more options relative to firms that use TSOs. This possibility may result in firms granting PVSOs to compensate their executives more intensively in equity (and in turn in total), which could then explain the higher pay-performance relationship associated with the use of PVSOs.
To test the validity of this
Conclusions
This paper investigates the incentive effects of performance-vested stock options in aligning shareholder and management interests. Option vesting conditions are expected to prevent managers from benefiting from effort-irrelevant factors, and our results are supportive of this conjecture. We find that the use of a PVSO plan in an executive compensation contract is associated with higher pay-for-performance sensitivity, suggesting the convergence of owner and management interests. Further, in a
Acknowledgements
We thank Laurence van Lent and Jeroen Suijs for their generous guidance and consistent encouragement. We are indebted to Chris Ittner, Robert Scapens, Jeltje van der Meer-Kooistra, Arjen van Witteloostuijn, Tom Groot, Henri Dekker, Marc Wouters, Marleen Willekens, Willem Buijink, Jan Bouwens, Ingolf Dittmann, and Philip Joos for their valuable comments. We are also grateful to Vivien Beattie (Joint Editor) and two anonymous referees. Special thanks to the participants of the PhD conference on
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