The Hidden Nature of Executive Retirement Pay

Since the financial crisis, federal regulators have been searching for ways to rein in excessive risktaking in the financial sector. Many scholars and regulators have argued that executive retirement benefits can serve this risk-curbing function. Because top managers might not receive their promised retirement payouts if their firm goes bankrupt, the theory goes, generous retirement benefits encourage them to manage their firms more carefully. This view—sometimes called the “inside debt” hypothesis—assumes that, through retirement benefits, managers continue to be exposed to the firm’s credit risk after they retire. But no previous work has tested that assumption empirically. In our new Article, The Hidden Nature of Executive Retirement Pay, forthcoming in the Virginia Law Review, we provide the first systematic empirical study of the actual, risk-related features of managers’ retirement benefits.

Supporters of the inside debt theory argue that managers’ retirement payouts provide incentives against excessive risktaking because retirement pay is unsecured debt in bankruptcy. As such, an executive with a material amount of inside debt will refrain from taking excessive risk because she risks losing that retirement pay in bankruptcy. A number of recent publications in leading finance journals have supported this theory, and bank regulators have even suggested that inside debt could be used to mitigate risktaking at banks.

On the other hand, others have argued that large retirement payouts instead merely reflect managers’ influence over their own compensation. Because retirement pay is subject to less disclosure than other forms of compensation, these commenters argue, it is easier to hide from shareholders. Thus, large retirement packages simply reflect directors’ efforts to camouflage payouts provided to executives.

The view that retirement pay serves as inside debt depends critically on the assumption that retirement benefits put executives in a similar contractual position as the company’s creditors. Yet no previous work has tested that assumption.

Using retirement pay data for thousands of executives, we show that retirement payouts at many companies do little to curb managers’ incentives to take risk. First, the value of a large proportion of executive retirement pay is linked to company stock prices. Indeed, our data suggest that the retirement benefits of more than one out of three executives are invested entirely in the company’s stock. These benefits, which have previously been thought to provide executives with debt-like payouts, are instead functionally equivalent to stock-based pay.

Second, the evidence shows that many executives receive the bulk of their retirement payments immediately after leaving the firm. More than 20% of executives receive all of their payments in the year that they depart, and the median executive receives the entirety of her retirement pay within three years. Such pay is thus unlikely to align the interests of executives and long-term creditors. And we show that, on average, executives receive these payments more quickly as firm risk increases, further insulating them from losses to which long-term creditors are exposed.

These findings have important implications for policymakers and commentators who are concerned about the impact of retirement pay on executive incentives. Without understanding the contractual structure of compensation, our Article shows, lawmakers and researchers cannot know whether retirement pay aligns the interests of public company executives with those of creditors. As such, we argue that disclosure rules should be amended to give investors the complete picture on retirement pay. Additionally, neither regulators nor commentators should assume that retirement benefits suppress top managers’ appetite for risk, and future scholarship examining whether retirement pay reflects managerial influence or incentive alignment would benefit by distinguishing these payments on the basis of their contractual structure.

The full article, which is forthcoming in the Virginia Law Review, is available here.