How to Design a Good Manager Compensation Scheme

FRANCESCA FRANCO AND OKTAY URCAN FIND THAT COMBINING EARNINGS WITH OTHER TARGETS LOWERS THE RISK OF CHEATING

Executive multi-metric compensation schemes that combine earnings with stock returns and other (non-earnings) targets foster executive multi-optimization efforts and mitigate manipulative earnings management incentives. This is the main finding of a new paper written by Francesca Franco of the Bocconi Department of Accounting and Oktay Urcan of the University of Illinois at Urbana-Champaign that has been recently featured on the CLS Blue Sky Blog on Corporate Governance, the blog on corporations and the capital markets of the prestigious Columbia Law School.
 
The paper examines how different approaches to designing performance-based schemes that grant equity to executives can affect their incentives. The different schemes usually blend earnings (e.g., EPS, net income, etc.) metrics with stock returns and other non-financial targets (e.g., sales growth and ROI) and take two typical functional forms.
 
In “summative” schemes, the final payout from the agreement is the weighted sum of the payouts gained on the various metrics within the formula. These schemes can still give executives the incentive to prioritize the achievement of a sub-set of the targets, typically the ones that are easier to manipulate or achieve. In “binding” schemes, on the other hand, no partial payout is granted unless specific binding metrics (often referred to as “circuit breakers”) hit or beat their threshold performance. In the case of systems that combine earnings with non-earnings binding metrics, the achievement of non-earnings strategic targets therefore acts as a pre-condition for the grant to vest on earnings metrics. Since the grant will be payable only if earnings targets and non-earnings binding conditions are met, these schemes are expected to reduce executive focus on earnings manipulation.
 
  

Professors Franco and Urcan investigate which performance-based executive compensation arrangements can help achieve better corporate results, using a large sample of executive performance equity grants paid to 6,947 executives in 841 S&P 1500 firms between 2006 and 2019. The authors find that earnings-based grants give executives the incentives to manipulate financial numbers, since meeting or exceeding the earnings targets triggers at least part of the expected payouts. However, schemes that condition the grant on the contemporaneous achievement of earnings and non-earnings targets mitigate executive earnings management and aggressive reporting incentives.
 
“Our results indicate that schemes that condition earnings-based grants to non-earnings binding targets provide executives with much lower incentives to misreport. This discovery carries significant implications on two fronts. First, it implies that binding schemes can potentially mitigate executive tendencies towards earnings management. Second, it suggests that the complexity introduced by these performance-based schemes stimulates multi-dimensional optimization. Executives are given the incentives to excel across diverse financial and non-financial domains.”
 
Francesca Franco, Oktay Urcan, “Multi-Metric Vesting Schemes in Executive Performance Equity Grants”, working paper.
 

by Andrea Costa