Floyd Norris of The New York Times wrote an interesting piece about executive compensation the other day (see Maybe It’s Time to Restructure Executive Stock Options). In the article he summarized findings from a recent academic study about variable compensation (e.g., stock options) and risky behavior. The study finds that executives whose compensation relies more heavily on stock options are more prone to take greater, and more often than not, unwarranted, risks. I believe that this finding, in and of itself, is fairly interesting. The article then goes on to discuss implications for restructuring stock option plans to incentivize the kinds of behavior that shareholders want to see from management. Namely, shareholders should be incentivizing long-term performance instead of short-term performance.

I have blogged on several occasions about the difficulty of incentivizing managers to maximize long-term, versus near-term, performance (see here and here). In my opinion this is one of the most difficult problems we face with respect to executive compensation.

In this article, Norris (and the study’s authors) suggests two potential fixes:

1. Grant in-the-money options – The idea behind this alternative is that if managers hold options that are in the money, they already have "skin in the game" and will therefore have an incentive not take inappropriate risks. This is because if the stock price goes down, managers actually stand to lose something.

2. Grant restricted shares instead of options – Likewise, the thinking here goes that if managers hold actual shares, if those shares go down, they are destroying the value of their shares and reducing their own compensation.

There is one not-so-subtle assumption associated with these alternatives. Specifically, these are viable alternatives only to the extent that managers think about, and treat, stock options granted at current market prices differently than restricted shares or in-the-money stock options. Otherwise stated, they must think of options granted at current market prices as found money – money that they didn’t expect to receive that more or less falls into their lap if their bets pay off. By contrast, managers must think (and act) as if restricted shares or in-the-money options were already theirs (which in a way they are). If managers do not think about (and treat in practice) these types of variable compensation mechanisms differently, we should expect no observable change in risk behavior.

I have to say up front that I am generally a fan of restricted shares over stock options. I’m not necessarily opposed to granting in-the-money options either. However, neither of these solutions, in principle, solves the long-term vs. short-term agency problem.

The key lies in how such compensation programs are implemented and the specifics of the restrictions attached to the shares. In general, the longer the term managers must hold their shares/options, the better aligned their interests will be with shareholders. In addition, irrespective of the alternative chosen, we again must be careful not to lavish top brass with too many shares, …or options that are too far in-the-money.

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