A new tool to design executive compensation packages

Measure provides boards with recipe for determining pay duration

Frustration and anger over executives’ multi-million dollar paychecks in the wake of the financial crisis triggered a call for “say on pay” rules in the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The new regulations, approved by the Securities and Exchange Commission in January, require that shareholders have a vote on executive compensation, albeit non-binding.

However, for such regulations to be effective, researchers at Olin Business School at Washington University in St. Louis say companies need to understand how executive compensation should be designed.


Olin researchers Radhakrishnan Gopalan, PhD, assistant professor of finance; Todd Milbourn, PhD, the Hubert C. and Dorothy R. Moog Professor of Finance; and Anjan Thakor, PhD, the John E. Simon Professor of Finance, say companies have not had the proper tools for determining how to pay executives.

They have developed a formula that businesses can use to align the duration, or payout, of an executive’s compensation with the strategic needs of the company.

Designed to provide a framework for examining short- and long-term pay contracts, the new study offers an analysis that may help boards of directors set executive compensation in a more scientific manner as it relates to the time horizon of the pay package.

The paper, “The Optimal Duration of Executive Compensation: Theory and Evidence,” also is authored by Fenghua Song, PhD, a 2007 WUSTL graduate and current faculty member at Penn State University.

The researchers examined executive compensation packages for 1,500 S&P firms from 2006-08.

They found that industries with longer-duration projects, such as defense, utilities and coal, offer longer vesting schedules to their executives. They also determined that firms in the financial services industry have some of the longest vesting schedules in their contracts, which they found surprising given the criticism that short-termism in executive compensation at banks may have contributed to the financial crisis.

The average pay duration for all executives (including those below the level of the CEO) in the sample is around 0.91 years, while CEO pay contracts have a longer duration at about 1.06 years. Executives with longer-duration contracts receive higher compensation, but a lower bonus, on average.

“Our approach was to really ask, ‘can we develop a measure that allows us to in fact determine what the duration is,’ ” Thakor says. “Then you can label something short-term, label something medium-term and you can label something long-term.

“Once you’ve done that, then let’s step back and see if we can link the actual observed duration of an executive compensation contract to the attributes of the firm that uses such a compensation contract,” he says.

Other researchers have looked at the ratios of stock-versus-cash in CEO contracts and how those relate to short- or long-term decisions.

“Since our measure is just so much more precise, so much more specific to the contract that’s there, I think it’s the first one to be able to really do it well,” Milbourn says.

The new measure provides a board of directors a recipe for determining pay duration.

“You know the amount of salary, bonus, restricted stock and stock options and you have the vesting schedules,” Gopolan says. “Here is a formula that allows you to input those figures and come up with a specific duration number.”

The authors of the new research received the 2011 Olin Award May 4 at a ceremony in St. Louis. The annual juried competition for “faculty research with the greatest potential to advance business” bestows a $10,000 prize and was initiated by Richard J. Mahoney, former chair and CEO of Monsanto. Mahoney is a current executive-in-residence at Olin Business School.

A pdf of the paper is available at apps.olin.wustl.edu/faculty/milbourn/duration_ver_apr15.pdf.