Radhakrishnan Gopalan, Todd Milbourn, Fenghua Song, and Anjan V. Thakor
Duration of Executive Compensation
Journal of Finance | Volume 69, Issue 6 (Dec 2014), 2777-2817

We address the issue of how to measure the extent to which a particular executive compensation package is long-term in nature. One of the long-standing criticisms in the press and among politicians and regulators is that executive compensation contracts sub-optimally reward short-term performance and therefore induce myopic managerial behavior. Such rewards allegedly encourage executives to boost short-term performance at the expense of long-term value. The importance of this issue has been heightened by the fact that the apparent "short-termism" of the compensation of the CEOs of financial service firms is viewed by many as a contributing factor to the recent financial crisis. In this paper, we propose a new measure, named CEO Pay Duration, which allows us to actually quantify the extent of short-termism in executive pay. We hope our measure can help a variety of audiences. For example, boards of directors can use it to align the duration of the CEO's compensation with the strategic needs of the company. Bank regulators can use it to determine whether bank executive compensation is indeed "too short-term" in nature. Compensation consultants can use it to improve their benchmarking of executive compensation.

The measure

Our measure of executive pay duration characterizes the mix of both short-term and long-term pay. The measure is a close cousin of the duration measure commonly used in fixed income securities. We compute pay duration as the weighted average of the vesting periods of the different components of executive compensation, with the weight for each component being equal to the fraction of that component in the executive's total compensation. We calculate this measure using detailed data on the vesting schedules of restricted stock and stock options of all named executives of S&P 1500 firms during the years 2006-09.

The Questions

With this measure in hand, we empirically address the following questions:

Vesting Periods

We find that the vesting periods for both restricted stock and stock options cluster around the three to five year period, with a large proportion of the grants vesting in a fractional (or graded) manner during the vesting period. There is, however, significant cross-sectional variation in the vesting schedules and pay duration across firms. For example, executive pay duration tends to be correlated with both project and asset duration: industries with longer-duration projects, such as Defense and Utilities, offer longer-duration pay to their executives. We also find that firms in the Finance-Trading industry have above-median CEO pay duration (they rank 11th among the Fama-French 48 industries). This is somewhat surprising in light of the recent and heavy criticism that short-termism in executive compensation at banks may have contributed to the 2007-09 financial crisis. Moreover, the average pay duration increased during our sample period, especially for executives in the manufacturing and utilities industries. The average pay duration for all executives (including those below the CEO) in our sample is around 1.22 years, while CEO pay has a slightly longer duration at about 1.44 years. Executives with longer-duration contracts receive higher total compensation, but lower bonus, on average.

Empirical Findings

We find that executive pay duration is longer in firms with higher market-to-book ratio, for firms with more long-term assets, and in more R&D-intensive firms. Consistent with standard principal-agent theory, we also find that riskier firms offer shorter-duration pay contracts. We also find that firms with better recent stock performance offer longer-duration pay contracts to their executives. This may be because better returns indicate more able CEOs, and Boards of such firms may find it optimal to lengthen their compensation vesting schedules to retain the executive. Our analysis reveals an ambiguous relationship between corporate governance and executive pay duration. Some governance proxies suggest that better-governed firms use shorter pay duration, whereas other proxies suggest the opposite. Pay duration is shorter for executives in firms with a higher proportion of nonexecutive director shareholdings, for executives with higher ownership in their own firms, and in firms with less anti-takeover provisions. However, we find that it is actually longer in firms with a larger fraction of independent directors on the board.

Pay Durations

Next, we explore how pay duration is related to the incentives of the manager to manipulate short-term performance. We use the level of abnormal accruals as our main proxy for managerial manipulation of short-term performance. The use of accruals, which is part of earnings not reflected in current cash flows, accommodates a temporary shift of the firm's reported earnings between the future and the present. Firms with high abnormal accruals will have high current-period earnings and low future earnings and vice versa. We find that firms that offer shorter-duration pay contracts to their CEOs have higher abnormal accruals in the current period. This negative association is stronger for earnings-enhancing positive accruals, and is robust to controlling for known determinants of abnormal accruals. We also find that the negative association between CEO pay duration and abnormal accruals is stronger among small firms, young firms, and firms with less liquid stock.