Reforming executive compensation: Simplicity, transparency and committing to the long-term

Summary

In "Reforming executive compensation: Simplicity, Transparency and Committing to the Long-term," Bhagat and Romano present a comprehensive proposal aimed at restructuring executive incentive plans, primarily targeting firms that receive government financial assistance and are considered systemically risky, though they advocate for its broader adoption across all companies. The authors contend that prevailing executive compensation practices foster short-termism and excessive risk-taking, which can destabilize financial institutions and necessitate public bailouts. The methodology centers on a specific recommendation: executive incentive compensation should exclusively comprise restricted stock and restricted stock options. A critical aspect of this proposal is that these equity-based incentives would be "restricted," meaning executives could not sell the shares or exercise the options for a period of at least two to four years after their resignation or last day in office. To address immediate concerns such as tax obligations, liquidity needs, and potential premature executive turnover, the authors suggest allowing a modest portion of compensation to be paid out currently. The paper's findings highlight that this reformed compensation structure would provide superior incentives for executives to manage firms with a focus on investors' longer-term interests. By delaying the ability to cash out equity, the proposal aims to diminish executives' motivation to manipulate public statements, manage earnings, or accept undue levels of risk solely for short-term stock price appreciation. This approach is intended to reduce managerial incentives for unwarranted risk-taking, thereby decreasing the likelihood of public resources being expended in bailouts of "too big to fail" financial firms.