Ideas for Leaders #536

Deferred Compensation Helps Retain CEOs

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Key Concept

Researchers exploited a U.S. accounting rule change to prove the power of deferred compensation. The rule change pushed many U.S. firms to significantly accelerate vesting of deferred compensation plans. Of the firms that chose to accelerate vesting, a large majority quickly lost their CEOs. During the same period, most firms that did not accelerate their vesting did not see any significant CEO departure.

Idea Summary

Theoretically, deferred compensation should keep executives from leaving the firm. One way to defer compensation is through unvested equity pay. After four or five years, the pay is vested. This deferred compensation plan punishes managers who leave early: they lose any unvested pay.

Whether such programs actually help retention has been unclear. Some studies show a correlation between unvested pay and executive retention; other studies do not. Even with those studies that show a correlation, it is difficult to make motivational assumptions given that other factors that might be influencing retention. For example, a company with limited investment opportunities might have deferred compensation plans with short vesting periods. When CEOs leave, are they leaving because they are fully vested, or because of their firm’s limited investment opportunities? Difficult to tell. Another example of the correlation ambiguity might be self-selection. In other words, CEOs who are more interested in a stable, long-term position with one company might choose a company that has longer vesting periods. Thus, the CEOs are not staying because they are not vested: they are staying because they prefer to stay, which is why the long vesting periods did not bother them in the first place.

One can see the difficulty in proving that longer vesting periods keep CEOs in the firm. However, an accounting change in the U.S. provided a unique opportunity to test this assumption.

In 2004, the Financial Accounting Standards Board implemented rule FAS 123-R, which required companies to expense the value of unvested equity, both for future options and, retroactively, for options that had been granted before the rule change but that were not yet fully vested.  

However, there was a loophole. Options that were fully vested by the rule’s compliance date did not have to expense unvested options. The compliance date was set as a firm’s first fiscal year starting after June 15, 2005. Almost randomly, some firms — those whose fiscal years started in June to December — were at a disadvantage because the rule went into effect for them in 2005. Firms with fiscal years starting in May or earlier did not have to comply with the new rule until 2006. Many of these firms took advantage of this de facto ‘grace’ period to accelerate the vesting of their equity options before the compliance date and thus avoid the new rule.

Researchers now had a unique situation in which a large group of firms were suddenly motivated to accelerate their vesting periods. Taking advantage of this opportunity, a research team from the University of Amsterdam and the Frankfurt School of Finance and Management identified 767 U.S. firms that significantly accelerated their vesting periods to exploit the new rule’s loophole. The acceleration was staggered based on the fiscal year of the firms.

The results were unequivocal. The researchers demonstrated that a 1% increase in the percentage of accelerated options due to FAS 123-R increased CEO turnover by an astounding 70%, and top executive turnover by 28%. At the same time, there was no mass migration of outside directors and other executives who receive less deferred compensation. Most importantly, the fact that the departure dates varied among the firms but coincided exactly with the FAS 123-R compliance date for each firm proves the link between the accelerated vesting and the turnover.

The researchers also showed that CEO departures had a negative impact on the firms’ stock prices, and eventually led to higher compensation for remaining executives. 

Business Application

The accounting rule change and its staggered compliance dates created an opportunity to test the potency of differed compensation. Intuitively, one might have thought that deferred compensation would encourage CEOs to stay longer with the firm. Given the overwhelming CEO departures in response to the accelerated vesting, the implications are clear: Companies can prevent the turnover of CEOs and key top managers by deferring a portion of their annual pay. The research further reinforces the notion that equity vesting provisions are a key lever in managerial incentives.

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Authors

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Source

Idea conceived

  • May 2015

Idea posted

  • August 2015

DOI number

10.13007/536

Subject

Real Time Analytics