Defined-benefit pension plans and deferred compensation are often sizable and important components of CEO pay packages. In recent years, though, they have prompted controversy among investors, policymakers, and academics. On the one hand, CEO pension and deferred compensation are unsecured and typically underfunded obligations, and, like debt (they are often known as inside debt) exposing managers to the same default risks and insolvency treatment as outside do debtholders, and can help strengthen the alignment of executive and debtholder incentives. Consistent with this view, prior studies find that firms that pay CEOs a higher level of debt-like compensation incur lower cost of debt financing. In addition, debt-like compensation has been found to have other benefits such as providing managers with incentives to avoid excessive risk-taking, short-termism, and even illegal misconduct like accounting manipulation.
On the other hand, some commentators and scholars argue that generous pension plans are an opaque way for corporate executives to receive excessive compensation. They say that paying CEOs an excessively high level of inside debt could be a convenient form of stealth compensation that unduly favors the CEO and expropriates value from equity investors. These discussions suggest that paying CEOs a higher level of debt-like compensation could intensify manager-shareholder conflict.
In a new study, we contribute to this debate by examining the trade-off between costs and benefits of this debt-like compensation from shareholders’ perspective. Specifically, we test whether shareholders require a lower or higher cost of capital when investing in firms that pay CEOs a greater amount of pension and deferred compensation, relative to equity-based compensation. If shareholders believe the benefits of this debt-like compensation outweigh the costs, then we expect more shareholders to invest in these firms and for these firms to have a lower cost of equity financing. In contrast, if shareholders believe the costs outweigh the benefits, then shareholders are less willing to invest in these firms and more likely require a higher risk premium due to greater risk of managerial rent extraction.
Using a sample of U.S. firms, we find an overall negative relation between CEO inside debt and the firm’s cost of equity, where CEO inside debt is measured with the ratio of CEO debt-like compensation amount to CEO equity-based compensation amount,. This finding indicates that, from a shareholder’s perspective, the benefits of paying CEO debt-like compensation is greater than the costs. We find similar results when using seasoned equity-offering (SEO) underpricing as an alternate cost of equity measure. These findings suggest that shareholders value the beneficial role of CEO debt-like compensation in constraining excessive managerial risk-taking and fraudulent behavior.
Interestingly, the negative effect of CEO debt-like compensation seems nonlinear. Specifically, we find that when a firm pays the CEO an excessively high level of debt-like compensation, then the cost of equity capital actually rises. It implies that when a firm starts to award CEOs exorbitant pension and deferred compensation, then stock investors are averse to this practice. It can partially explain why investors have started to take aim at some executives’ overly-generous pensions and why some firms (e.g., Barclays and Standard Chartered Bank) have recently slashed CEO pensions.[1] Furthermore, the nonlinear relation, which suggests a negative slope when debt-like compensation is low and a positive slope when it is excessively high, suggests an optimal level of inside debt compensation that minimizes cost of capital. In an untabulated test, we find that the cost of equity capital is minimized roughly when the firm grants managers a mix of inside-debt and equity-based compensation so that the ratio equals the firm’s debt-to-equity leverage ratio. This finding is consistent with Jensen and Meckling’s (1976) conjecture and has important implications for equity investors, policymakers, and boards’ compensation committees.
We also conduct several supplemental tests. First, the implementation and enforcement of Internal Revenue Code (IRC) Section 409A Final Regulations in 2009 discouraged CEOs from making early withdrawals form pensions and should effectively strengthen the incentives provided by debt-like compensation. We find that during the post-Section 409A period, firms that have increased inside-debt compensation have relatively lower costs of equity. Second, if an executive pension plan is funded through a rabbi trust or has a lump sum option, then the executive’s risk of losing pension is significantly neutralized, resulting in a weaker inside-debt incentive effect. Consistent with this conjecture, we find that the effect of debt-like compensation on the cost of equity is less pronounced in firms with prefunded executive pension plans and in firms that provide executives with the lump-sum option. Third, to show that debt-like compensation helps reduce fraud, we provide evidence that the negative effect of debt-like compensation on cost of equity is stronger in firms with insufficient regulatory oversight (e.g., firms that are located far from SEC offices and thus less likely to attract attention from SEC enforcement teams.).
Overall, our findings support the view of some industry practitioners (e.g., William Dudley) that paying debt-like compensation to executives would ultimately benefit shareholders, if the level of the inside-debt compensation is not excessively high.
ENDNOTE
[1] Please refer to recent articles such as “Your Boss Doesn’t Need a Ferrari Allowance” (https://www.bloombergquint.com/view/investors-challenge-ceo-pension-perks), “Barclays to Cut Chief Executive Jes Staley’s Pension Allowance” (https://www.ft.com/content/14081c2a-113c-11ea-a7e6-62bf4f9e548a), and “Standard Chartered Slashes CEO Pension After Shareholder Row” (https://www.bloomberg.com/news/articles/2019-11-08/standard-chartered-slices-ceo-pension-after-shareholder-row#).
This post comes to us from professors Carl Hsin-han Shen at Macquarie University of Australia and Hao Zhang at Rochester Institute of Technology. It is based on their recent paper, “What’s good for you is good for me: The effect of CEO inside debt on the cost of equity,” available at here.