Based different firms adopt different pay practices, the

Based on the data collection of the median level of total executive compensation from 1936 to 2005, it is noticeable is that the level of CEO pay has increased and the structure of CEO compensation has changed dramatically since the 1970s. While the pay level refers to how much the CEO receives, the pay structure involves different components that make up the compensation. Although different firms adopt different pay practices, the compositions of CEO pay packages generally include salary, annual bonus, payouts from long term incentive plans, restricted option grants and restricted stock grants. In parallel with changes in the level of executive pay, the pay structure has been transformed from being dominated by salaries and annual bonuses with only moderate levels of equity prior to the 1970s, to having options surged and became the largest component of CEO pay towards late 1990s; from 2001 and 2014, performance-based stock has become the most popular form of equity compensation (Edmans A., Gabaix X. and Jenter D. 2017). However, because of the mix, it is hard to conclude how well the package as a whole achieves the objective of aligning the interests of CEOs and shareholders.One approach to ensure this is to grant stock and stock options (Hall and Liebman. 1998), the entitlement given to CEOs to purchase a set of shares at the pre-specified price, incentivising them to think of the long term performance of the firm and to invest in value-adding risky projects. The idea is that CEOs can either keep or sell the shares after exercising the options, and make profit from the difference between the sale and grant price. CEOs are usually unable to exercise new options until the vesting period, which is the period of time before shares in their stock option plan or benefits in a retirement plan unconditionally owned by them. However, a controversial claim has been raised, pointing out that the executives are rewarded with stock options benefit when the stock price rises but experience no reduction in real wealth if the stock price drops (Gomez-Mejia L., Berrone P. and Franco-Santos M. 2014). Consequently, CEOs may take imprudent risks without considering the potentially destructive long term consequences as their wealth will not be damaged in case stock price declines. The issue with this side effect, as claimed by Murphy (2009) in his paper, is that the so-called “excessive” or “imprudent” risks cannot be precisely defined, leaving limited evidence to prove that existing compensation structures are responsible for the risk taking crisis.The root cause of this concern with high equity incentives is not the amount of stocks or options that CEOs have, but their vesting horizon (Edmans A. 2014). Shorter vesting periods would allow CEOs to sell equity faster and to forfeit less equity when leaving the firm, leading to a greater possibility of short-termism as one of the managerial myopias. In the banking industry, this problem is accentuated as it deters desirable long term actions like investment in R&D or human capital because they are costly in the interim and only pay off in the long run, therefore not benefitting the CEO as he may have left his post. In addition, the fact that the compensation structure in financial sector consists of a low fixed salary and a variable component depending on performance may end up rewarding greatly for superior performance but no real penalties for failure, as CEOs would devote their efforts to rise the variable part of the scheme. Therefore, financial services firms should keep salaries below competitive market levels, making earning a zero bonus a significant penalty (Murphy K. 2009).Possible ProposalHaving identified the shortcomings of the current compensation schemes, it is therefore critical to propose a solution that minimises short-terminism, encourages investment decisions and discourages imprudent risk taking behaviour. There is no doubt that the compensation scheme should be designed to align the interests of shareholders with those of CEOs, but merely having a cap on pay or imposing a high tax on compensation pay is not enough.The current proposal is to link compensation to firm risk. As mentioned in one of the previous sections, simply aligning the interests of the CEOs and shareholders is not enough within highly levered firms like an investment bank in the financial sector, because shareholders prefer the executives to take excessive risks due to firm’s low equity level. Therefore, it is important to link these CEOs’ compensation to the firm’s risk so that creditors’ interests are also taken into account, and the firm can make obligatory payments to the creditors. One way to do so is through deferred compensation and pension, also known as inside debt, meaning to delay the CEO’s receipt of a certain amount of current-year salary and bonus, investing it with the firm at a fixed rate of return until or even after retirement. While inside debt has been supported by studies stating that bank CEOs with higher levels of inside debt compensation exposed their firms to less risk and therefore performed better during subprime financial crisis (Tung F. and Wang X. 2011), its shortcomings have been revealed. Wei and Yermack (2010) argued that inside debt is unsecured like bonds and other creditor loans in the event of default, forcing CEOs to lose the same percentage from their deferred compensation pool as the debt holders’ losses. To protect their future income stream, CEOs are discouraged to take excessive risks so that the possibility of going bankrupt and the “go for broke” incentives during financial distresses are reduced.The other problem with highly levered firms is that they can be “too big to fail”. In addition to shareholders focusing on their own interests of taking up perverse risky projects with limited downside but unlimited upside potential, deposit insurance and implicit bailouts can encourage imprudent risk taking behaviours as well. To prevent this from happening, it is proposed that the compensation of CEOs at highly levered firms should be structured to maximise both equity and debt values of the firm (Bolton P., Mehran H. and Shapiro J. 2010). This has been supported by Macey and O’Hara (2003) that the heightened duties to ensure the safety and soundness of these enterprises should not be exclusive to shareholders, but also to include directors, corporate officers and creditors.ConclusionIn conclusion, aligning the interests of CEOs and shareholders is a pre-condition for an optimal executive pay scheme and key to solve the Principal-Agent problem. Based on that, this essay has proposed a compensation scheme that reduces short-termism, prevents excessive risk taking but encourages CEOs to take up valuable risky projects that may benefit the firm in the long term. However, the optimality of the scheme seems to work only theoretically and the actual compensation schemes can be more complex. Firms are, therefore, advised to tailor their compensation pay schemes according to different activities and conditions so as to avoid possible managerial myopia. 

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