Rethinking Restricted Equity: A Path to Successful Executive Compensation

by Sanjai Bhagat
Misaligned executive incentive compensation policies have featured prominently in the media and senior policymaking circles in discussions focusing on the recent Wells Fargo scandal, the implosion of the big banks in 2008, and the demise of Enron, Qwest, and WorldCom circa 2000.
Why have executive compensation reforms been ineffective? How can boards structure a more effective executive compensation policy?
There is an answer
Incentive compensation of senior corporate executives should consist only of restricted equity (i.e., restricted stock and restricted stock options). That is, restricted in the sense that the individual cannot sell the shares or exercise the options for one to three years after their last day in office.
Many compensation contracts currently require the forfeiture of restricted shares when an executive leaves the firm, but boards may want to consider using restricted shares that are not forfeited when the executive departs and only vest after the executive leaves the company and over the course of a few years.
How to Think About Executive Compensation
There are three criteria boards can consider using to evaluate executive compensation reform policies: simplicity, transparency, and a focus on creating and sustaining long-term shareholder value.
A simple and transparent incentive compensation structure is desirable for at least three reasons. First, the corporate sector is particularly fast-moving, making it difficult to predict what risks may emerge as products and markets develop. In addition, how executives respond to regulatory and contractual incentives can alter risk in unanticipated ways that can evolve in complicated ways. Therefore, the more complicated and opaque the incentive package, the more difficult it will be to determine how individuals will respond and what risks will be incurred.
Second, as shareholders are now required to vote on CEO compensation packages, a simple incentive structure is easier for them to understand and evaluate, reducing the need to rely on third-party vendors of proxy voting advice, the value of which has been the subject of considerable controversy.
Third, simplicity and transparency in incentive compensation packages mitigate public skepticism toward high levels of executive pay in conjunction with poor performance, particularly when a firm’s failure effects the financial health of the public.
Finally, focusing on creating and sustaining long-term shareholder value would channel management’s attention to the longer-term profitability of an investment strategy. Business and legal scholars posit that managers should act in the best interest of long-term shareholders. What better way to do this than tie management incentive compensation to long-term share price?
Reward Executives Beyond Employment
Under a restricted equity plan, a CEO would have more powerful incentives not to invest in projects that are high-risk but unprofitable in the long-term. If an investment project resulted in an unexpected positive cash flow in a certain year prior to his or her retirement or resignation, the company’s share price would go up, the CEO’s net worth would go up on paper, but the CEO would not be able to liquidate his or her stockholdings.
The CEO would have to make an assessment of the likelihood of the large negative cash flow outcome during the years he or she continued to be employed at the company, plus one to three additional years. A CEO would then—presumably—be less likely to authorize or encourage the high-risk projects that generate positive cash flows in the early years, and large, negative cash flows in later years.
The long-term feature of this compensation package would curb optimistic estimates of a project’s long-term profitability by using high-powered financial incentives to prod an executive to attend to, and hence estimate more assiduously, all of a project’s cash flows, rather than solely those in the near term. If a company does not engage in the long-term, unprofitable investment project, then this would, of course, also serve the interests of the long-term shareholders.
Under this restricted equity compensation plan, all incentive compensation would be driven by total shareholder return instead of being directly related to accounting-based measures of performance such as return on capital, return on equity, or earnings per share. Accounting-based measures of performance tend to mostly focus on short-term performance. This view is consistent with the results of a recent survey of Fortune 500 directors conducted by the Rock Center for Corporate Governance at Stanford University where 51 percent of Fortune 500 director respondents said they consider total shareholder return to be the best measure of company performance compared to accounting based measures.
While the specific time horizon is ultimately the compensation committee’s decision, ideally, that time frame would extend one to three years after the executive’s departure. The rationale for this extended time frame is to maintain incentives for an executive in an “end-game” situation, i.e., an individual making decisions when he or she is reaching retirement. At the shorter end of this suggested time horizon, management’s discretionary authority to manage earnings under current U.S. accounting conventions unravels within a one- to two-year period, while at the longer end we think three years is a reasonable period in which at least the intermediate-term results of executives’ decisions will be realized.
The median tenure for S&P 500 CEOs is between five and seven years according to several studies cited in the book noted below. In the private company setting, it is common for top executives to wait six to ten years before receiving a substantial portion of their compensation for work performed earlier. For instance, the general partners of private equity partnerships typically receive their compensation towards the end of the life of the partnership, usually seven to ten years.
The widespread use of a deferred compensation structure in a real-world setting, where manager-owner conflicts of interest are thought to be better managed, suggests that this proposal could substantially improve managers’ incentives. This is despite well-known differences between the private equity and public company operating environments.
A further benefit of using a one- to three-year post-departure vesting period is that, because a CEO would be exposed to the impact of decisions made by his or her successor, the executive will focus more attentively on succession planning.
The Caveats
There are three important concerns with this compensation plan structure. First, if executives are required to hold restricted shares and options, they would most likely be under-diversified. Second, if executives are required to hold restricted shares and options post-retirement, they may be concerned with lack of liquidity. Third, this kind of a compensation plan could lead to early managerial departures as executives seek to convert illiquid shares and options into more liquid assets after the one- to three-year waiting period.
The deliberate under-diversification brought about by being subject to a restricted equity plan would lower the risk-adjusted expected return for the executive. One means of bringing an executive’s risk-adjusted expected return up to the previous level would be to increase the expected return by granting additional restricted shares and options to the executive. Thus, the amount of equity awarded under the restricted equity plan will be higher than that awarded under a short-term incentive plan.
Concerns regarding lack of liquidity and early departure are also valid. To address these concerns, managers should be allowed to annually liquidate 5 percent to 10 percent of their awarded incentive restricted shares and options. The requirement that they must retain the majority of the shares for several years after retirement or departure will provide sufficient incentive to advance long-term shareholder interests.
Unlike most other executive compensation reform proposals, this restricted equity plan does not place a ceiling on executive compensation. This compensation structure only limits the annual cash payouts an executive can realize. The present value of all salary and stock compensation can be higher than senior managers have historically received as the amount of restricted stock and restricted stock options that can be awarded to a manager is essentially unlimited. In practice, however, the award amounts should and need to be anchored to the current practices in the particular company. Of course, the higher value would only be realized were they to invest in projects that lead to value creation that persists in the long-term, in which case we have a win for long-term investors and a win for managers. Also, a focus on creating and sustaining long-term shareholder value would minimize the likelihood of a bailout which would be a win for taxpayers.
One Size Does Not Fit All
Compensation committees may want to consider adopting a restricted equity plan as the preferred mechanism for aligning management’s incentives to long-term shareholder wealth creation and to mitigate the taking of excessive risk. In implementing the proposal, corporate boards should be the principal decision-makers regarding:
  1. The mix of restricted stock and restricted stock options a manager is awarded.
  2. The amount of restricted stock and restricted stock options the manager is awarded.
  3. The maximum percentage of holdings the manager can liquidate annually.
  4. Number of years post retirement/resignation for the stock and options to vest.
However, one size does not fit all. Corporate boards need to use their understanding of the unique circumstances of their companies’ opportunities and challenges to amend the above restricted equity plan to serve as their executive incentive compensation plan, ensuring that the resulting plan is focused on serving the interests of long-term shareholders.

Dr. Sanjai Bhagat is and FEI member and the author of Financial Crisis, Corporate Governance, and Bank Capital (Cambridge University Press, 2017). Dr. Bhagat serves as an independent director, and has advised U.S. federal agencies and Fortune 500 companies on corporate governance and finance.