The Diminishing Returns of Incentive Pay in Executive Compensation Contracts

For the past thirty years, the conventional wisdom has been that executive compensation packages should include very large proportions of incentive pay. This incentive pay orthodoxy has become so firmly entrenched that the current debates about executive compensation simply take it as a given. We argue, however, that in light of evolving corporate governance mechanisms, the marginal net benefit of incentive-laden pay packages is both smaller than appreciated and getting smaller over time. As a result, the assumption that higher proportions of incentive pay are beneficial is no longer warranted. A number of corporate governance mechanisms have evolved to duplicate incentive pay's positive incentive effects, thereby reducing its marginal benefit. Most significantly, a newly robust CEO labor market has made incentive pay largely redundant in focusing CEO attention on stock prices. In addition, while the marginal benefit of incentive pay has been overstated, its costs are significant and often overlooked. As a result, we believe that the net overall effect of incentive pay on shareholder wealth is now either minimally positive or even negative. We also argue that, given the strength of the corporate governance mechanisms discussed in the Article, attempts to improve company performance by "fixing" incentive pay structures are unlikely to succeed. Nevertheless, the trend towards greater and greater incentive pay continues unabated. This resiliency, however, is not surprising even in a competitive market. In the past, the incentive pay orthodoxy was justified because corporate governance mechanisms were not as robust. Incentive-laden contracts therefore became a key marker for "good governance" in the compensation context. In addition to the stickiness of that status quo, incentive pay's staying power has been supported by the private interests of those who benefit from the conventional view of its efficacy. As a result of the incentive pay orthodoxy, executives receive greater pay, boards bear less responsibility for that pay, and compensation consultants and experts garner more attention. On the other hand, there is no constituency with a significant incentive to soberly assess the benefit of incentive pay that is not afflicted with informational disadvantages or collective action problems. INTRODUCTION I. QUESTIONS ABOUT THE PURPORTED BENEFITS OF INCENTIVE PAY A. Complementarity and its Limits 1. The New Managerial Labor Market a. The Labor Market as Ex Post Settling Up b. The Importance of Share Price in Both Incentive Pay and the Managerial Labor Market c. Comparing the Force of Disciplinary Measures d. Sensitivity to Underperformance e. Summary 2. Attempted Improvements to Incentive Pay Practices B. The Likelihood of Arriving at an Optimal Contract II. THE COSTS OF INCENTIVE PAY A. Raising Firms' Compensation Costs 1. Risk Premiums 2. Less Effective Accountability Mechanisms a. Reduced Transparency for Third Parties b. Reduced Salience to Third Parties 3. Bargaining Effects a. Reduced Board Responsibility for Large Payments b. Mental Accounting Difficulties c. Admission of Significant Unchecked Agency Costs and CEO Centrality B. Incentives for Excess 1. Option Awards and Excessive Risk 2. Increased Accounting Fraud III. EXPLAINING THE RESILIENCY OF INCENTIVE PAY A. Status Quo Bias, Herding, and Signaling B. Private Interests of Participants C. The Moral Pull of Incentive Pay CONCLUSION INTRODUCTION In the aftermath of the financial crisis, executive compensation has received an immense amount of attention. In January 2011, the Financial Crisis Inquiry Commission blamed the crisis, in part, on executive compensation. …