The False Promise of Risk-Reducing Incentive Pay: Evidence from Executive Pensions and Deferred Compensation

By Alces, Kelli A.; Galle, Brian D. | Journal of Corporation Law, October 1, 2012 | Go to article overview

The False Promise of Risk-Reducing Incentive Pay: Evidence from Executive Pensions and Deferred Compensation


Alces, Kelli A., Galle, Brian D., Journal of Corporation Law


I. INTRODUCTION

Incentive-based pay for corporate executives has been at the center of many recent controversies. Although "pay for performance" is supposed to help shareholders control managers by aligning the financial interests of the two sides, some blame it for the sky- rocketing total pay taken home by top executives.1 In the wake of the 2008-2009 financial crisis, government regulators and legal scholars blame incentive compensation for causing, or at least not preventing, the climate of excessive risk taking that led to the meltdown.2 As a result, scholars and regulators are working on designing optimal incentive compensation schemes that properly set executive incentives to maximize profits to the extent possible while also constraining excessive risk seeking.3

We disagree with these approaches, and in this Article, argue that packing compensation with yet more incentives is unlikely to solve the problems of incentivebased pay. The scholarly proposals have grown more complex as various baskets of securities and mixes of salary, bonuses, and pensions combine to form grand compensation schemes under which, it is hoped, rational managers will have almost no choice but to manage the firm with the optimal degree of risk. The corporate managers of the executive compensation literature are like machines whose incentives can be finely adjusted in a number of directions with measured changes to the sources of their compensation. We argue here that this cannot be so, and that there is a limit to the amount of information a corporate executive can process when making a decision on behalf of the firm.

In particular, we are skeptical of recent proposals favoring the use of "inside debt," or corporate debt held by the debtor firm's insiders,4 as a solution not only to the traditional agency problems between creditors and managers, but also to the dangers of unrestrained risk in the financial sector. Inside debt in the form of executive pensions or deferred cash has become an important part of the mix of mechanisms used to compensate corporate managers.5 Recent commentators argue that pensions align managerial self-interest with the interests of creditors, thereby encouraging conservative investment decisions and lowering the cost of debt.6 Similarly, because excessive risk taking by financial firms bears much of the responsibility for the recent financial crisis, some scholars suggest that the managers of financial firms be compensated with debt securities.7 The arguments supporting this compensation scheme derive from the same reasoning supporting the use of inside debt in other firms-that it will temper risk seeking and align managerial self-interest with the interests of those who bear the downside risk of firm failures.8

We argue, in contrast, that compensation with inside debt is often inefficient, and at times not even effective at influencing managerial behavior in the direction stakeholders prefer. We argue that inside debt unnecessarily complicates managers' incentive structures and can therefore have perverse incentive effects or none at all. We present evidence from the behavioral economics literature that individuals are incapable of constantly balancing financial consequences of their decisions, particularly as those financial outcomes become more complex and depend on more variables. Highly complex pay structures can lead managers to take mental "shortcuts" that reduce the quality of all their decisions.9

Complex compensation schemes also require constant recalibration, making them less effective and less reliable methods of incentivizing managers. Legacy costs and cross-monitoring costs contribute to this problem. The use of inside debt to pay executives imposes legacy costs because inside debt payments are difficult to reverse or terminate. Pension and deferred salary obligations can remain even after the firm's debt has been repaid or its financial position or capital structure changes. …

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