For the typical citizen of the United States, there is nothing more inexplicable and infuriating about corporate America than the high level of executive compensation, particularly that received by the leaders of corporations, the chief executive officers, or CEOs. In many cases, the response is visceral— “It can’t be that a CEO deserves four hundred times as much as I make. No one is worth that much!” Merely because the outrage over executive compensation is visceral, it is not necessarily mistaken. One might more charitably characterize the damning of high executive pay as an intuitive one. But these assessments, whether visceral or intuitive, whether entirely mistaken or exactly on target, are not built on solid economic understanding. While the economics of executive compensation is complex, any ultimate judgment about the level and structure of executive compensation should be based on an informed understanding. This book provides that understanding for the educated layperson.
Incentives lie at the heart of the executive-compensation system that dominates corporate America and which increasingly finds favor throughout the world. In the main, corporations act to establish compensation systems that provide their executives with behavior-guiding incentives. However, some executives find their own, often perverse, incentives in the established pay systems. That is, they find their compensation program rife with incentives that they can exploit for personal gain at the expense of the firm and society.
Two main ways of controlling behavior are through monitoring and command, on the one hand, and providing incentives on the other. Monitoring and commanding an individual who is supposed to lead an organization has proven to have severe limitations; although, we will see that effective monitoring can play an important role. This leaves incentives as the chief way to establish a framework within which a corporate leader can direct the firm toward increasing profits, building firm value, and benefiting society. Reflecting this line of thought, corporations build executive-pay schemes around incentive compensation, which they deliver mainly in the form of pay related to the value of the firm’s shares. The two principal vehicles for providing share-based pay are restricted stock and executive stock options (ESOs).
Perhaps surprisingly, firms provide these incentives mainly to induce CEOs to increase the risk level of the firm beyond what they would otherwise choose. The incentive compensation should encourage the CEO to increase