How limiting CEO pay can be more effective, less costly

April 15, 2015

CEOs make a lot of money from incentive pay tied to stock performance. Although such schemes help align executives’ interests with shareholders, they are not necessarily the best schemes as compared to schemes that rely on trust between board and executives.

“Ironically, the necessary trust is easier to establish when the alternative of using stock-based pay is less powerful. Our research found that government-imposed limits on contingent compensation make stock-based pay a worse alternative, facilitating superior trust-based incentives,” says Ben Hermalin, an economist in the Haas Economic Analysis and Policy Group, UC Berkeley’s Haas School of Business,

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The paper, “When Less is More: The Benefits of Limits on Executive Pay,” forthcoming in the Review of Financial Studies, is co-authored by Prof. Hermalin and Peter Cebon, senior research fellow, Melbourne Business School, University of Melbourne.

Abstract

We derive conditions under which limits on executive compensation can enhance efficiency and benefit shareholders (but not executives). Having their hands tied in the future allows a board of directors to credibly enter into relational contracts with executives that are more efficient than performance-contingent contracts. This has implications for the ideal composition of the board. The analysis also offers insights into the political economy of executive-compensation reform.

The full study is published online:  http://rfs.oxfordjournals.org/content/early/2015/01/31/rfs.hhu140.full.pdf+html


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