Home > Compensation > Managers` total wealth analysis: should companies follow it in connection with stock price?

Managers` total wealth analysis: should companies follow it in connection with stock price?

Is looking into the annual compensation enough to get an idea of how incentives are working? Shouldn`t companies look at stock related pay received in previous years, and assess if wealth invested in the company provides an adequate incentive? In fact, for larger companies, wealth invested in the company is usually is much bigger than annual compensation, so that a 50% movement in the stock price could engender a wealth effect as big as six times the annual manager`s compensation

These data were provided by Larcker and Tayan (1), who analysed the topic back in 2012. They gathered data, (available from the proxy statements) about annual compensation and stock and options held by managers. They found large differences in those ratios among companies, in what they think is a cumulative effect of shares and options granted through the years: at the end the incentives could be very different to those originally intended by the company.

Larcker and Tayan used “convexity” to compare pay structures; if the manager has mainly shares, an increase in stock prices has a predominantly linear relationship with his accumulated wealth, whereas when the manager has a bigger proportion of stock options, the relationship is more convex, that is the payoff curve is much steeper, (even more when options are partly out of the money). Steeper or more convex curves would be enhancing riskier attitudes by managers. Different firms, (regulated or not, service or industrial –with environmental externalities-, …) should have different curves and boards should be aware of the total cumulative wealth risk-taking incentives built through the years.

The authors also think about stock price volatility itself: a mix bent towards options would reward executives more if they decide to take riskier initiatives so that volatility increases, whereas a pool charged mainly with stocks does not produce this higher pay. At the end, companies need to know what they need in terms of innovation and risk taking, according to their cycle phase, their strengths and weaknesses, business mix, etc., and act accordingly in building their executives wealth mix through the years.

As a conclusion, Larcker and Tayan recommend companies to follow several facts:

  • Does risk appetite as defined by the board correspond to the current convexity of the payoff curve?
  • The way the stock price evolution affects convexity in time,
  • How should the mix of options and stock change to correct convexity to desired levels? How would allowing managers reduce their stock holdings or hedge their risk exposure affect convexity?
  • How does stock option vesting and conversion into stocks affect the mix?
  • Finally, boards should know the levels compensation would reach in case everything goes as planned or even better, in order to set correct incentives, and be able to explain them to investors, both before and after big rewards are granted.

(1) Does your CEO compensation plan provide the right incentives?, at http://www.mckinsey.com/insights/organization/does_your_ceo_compensation_plan_provide_the_right_incentives, by David F. Larcker and Brian Tayan, published at the McKinsey Quarterly journal in April 2012.

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