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I remember an interesting theory about golden parachutes in Steven Landsburg's "The Armchair Economist". In a typical publicly traded company, the CEO is actual

I remember an interesting theory about golden parachutes in Steven Landsburg's "The Armchair Economist". In a typical publicly traded company, the CEO is actually much more heavily invested in the company than the shareholders. His salary, and probably the major part of his assets, are dependent on the performance of the company. On the other hand, the average share holder is well diversified. Therefore, a CEO will be incentivized to pursue a highly conservative strategy, while the shareholders may wish that he takes more risk. To offset this, the shareholders may make it known that a generous severance package, as well as generous benefits if the company does exceptionally well, are on the table, to simultaneously soften the blow if he takes a bad risk, and sweeten the deal if he takes a good risk. In other words, the point of executive compensation may not be to produce better results on average, but rather to increase the variance of the results.

rhino369 10y ago
And the original golden parachutes were created to incentivize a good acquisition. A CEO whose company gets acquired is often firing himself. So the whole idea was to give them a huge score if it happened. Otherwise CEOs might fight takeovers just to keep their jobs. And, if a lot of the CEO performance results is just luck, then bad luck can ruin them. If a company is on the brink of failure, nobody is going to take the job without a parachute. It could be their last job if they take the blame.
- st3v3r 10y ago
  So why not make the golden parachute "if we get acquired, you get this" instead of "if you get fired, you get this".
  - pdeuchler 10y ago
    Because CEOs didn't get there by not knowing how to negotiate and insulate yourself from risk
  - ohyes 10y ago
    What's to stop the board from firing him and then doing the acquisition to save the money that they would have had to pay him.
    - st3v3r 10y ago
      In theory? Not much. In reality? For one, that's a lot of work, especially to screw someone who did a decent job (presumably), who's compensation probably is a drop in the bucket compared to the stock price, and, let's be honest, has a chance to be on your board. The amount of incest in company boards is pretty high. So if you do it to them, there's a chance they'll do it to you.
  - rhino369 10y ago
    They did originally. I think even now most big CEO's don't have a really huge golden parachute. And at a certain point, it's just differed compensation. Instead of 2 million a year and zero parachute, they get 1.75 million a year and a million dollar chute. There is also another form of golden parachute, which the person is getting paid for getting on a sinking ship. Otherwise nobody is going to become the CEO of a failing company. They are basically getting paid for the hit to their reputation.
  - SeeDave 10y ago
    This exists, it's called a "Change in Control" arrangement.
fauigerzigerk 10y ago
But as an investor I don't care much if one particular company takes more or less risk. I just want to know how much it takes so I can adjust my portfolio accordingly.
Florin_Andrei 10y ago
> a generous severance package, as well as generous benefits if the company does exceptionally well, are on the table, to simultaneously soften the blow if he takes a bad risk So a pay gap of up to (and sometimes over) 1000x between CEOs and rank-and-filers, given all the saving and investing that the CEO could do just like any Average Joe, would not be enough to "soften" any "blows"? Huh.
- nkurz 10y ago
  The gigantic pay gap may be an injustice, but I think you are missing the subtlety of the theory. The worry is that the CEO will become too personally dependent on that 1000x salary to take "appropriate" risk. For example, assume that launching a new product line has a 50% chance of doubling the companies profit, a 25% chance of doing nothing, and a 25% chance of cutting the profit in half. For the shareholders, this is probably a good bet to take. Then assume the CEO will be replaced if profits drop. In the absence of a "golden parachute", a CEO might reason that a 25% chance of being fired and loosing their cushy job makes the plan not worth pursuing. The theory (OP wasn't necessarily endorsing it) is that a rich severance package can better align the interests of the parties. While I personally think "cronyism" is a better explanation for the current situation, the theory is better than others I have seen.
  - Florin_Andrei 10y ago
    > I think you are missing the subtlety of the theory There's nothing "subtle" about a plain racket. And there's nothing subtle anymore, either, about bringing in the Ayn Rand style of "debating" by putting people down. At 1000x pay gap, the CEO needs only work a few months to have nothing to worry about for the rest of his life. Anything on top of that, anything, is a luxury item. "Risk" of what? Having to manage with only 2 yachts instead of the customary 3? Right, that's a serious existential threat, gotta mitigate it. Shave a couple orders of magnitude off that pay gap, and then the argument might, just might, begin to make sense.
    - drakonandor 10y ago
roymurdock 10y ago
(1) The CEO is actually much more heavily invested in the company than the shareholders. His salary, and probably the major part of his assets, are dependent on the performance of the company. On the other hand, the average share holder is well diversified. (2) Therefore, a CEO will be incentivized to pursue a highly conservative strategy, while the shareholders may wish that he takes more risk. 1 is true (assuming heavy equity-based compensation), but 2 does not follow from 1. What does follow is that the CEO will do whatever he can to make short term gains for the company before he exits, even if it means kicking the can down the road for future managers and long-term shareholders to take a hit on at a later date. When the whole management team is on in this short-term focus, it is colloquially referred to IBGYBG (I'll be gone, you'll be gone). Shareholders are not a homogeneous group of investors. Some pension/mutual funds invest with the goal of exiting in 10 years. Some activist shareholders invest with the goal of pumping up the price, then cashing out within 3 months (see Carl Icahn and Apple). A sizeable (and growing) portion will be owned by index funds while some will be owned by hedge funds, etc. Then you also need to factor in employees, executives, etc. One (newer) way to make this group happy as a whole and solve the IBGYBG problem is through clawbacks - punishing ex-executives for the things that happened on their watch. Check out Wells Fargo to see how this is playing out in Congress and in court. The question the paper is trying to answer - what motivates CEOs to "exert effort" in able to return industry-beating results - seems like it has a simple answer to me: no CEO wants to fail at his/her job and be known as the one who presided over company X's slow decline into bankruptcy/irrelevance. Doesn't look so good on the resume when shopping around for your next C-suite role.
- drakonandor 10y ago
  There are rules (from the SEC as well as often the company board) which prevent executives from selling significant portions of their stakes quickly.
Zigurd 10y ago
That sounds very academic and theorized in a vacuum. If that were true you might expect contract terms to be explicit about this, and quarter-oriented management to be less commonplace.
amluto 10y ago
> Therefore, a CEO will be incentivized to pursue a highly conservative strategy I strongly disagree. A CEO is probably highly personally invested in the company, but that investment almost always has an unusual structure: it resembles a call option, not equity. If a CEO generates a large gain over the course of a few years, the CEO makes a lot of money. In contrast, if the CEO generates a large loss over the course of a few years, the CEO loses very little. This can give a CEO an incentive to make extremely risky decisions because the CEO doesn't personally suffer much more from a huge loss to the company than from a small loss to the company. This problem exists for investment managers. In a hedge fund that charges a performance fee on investment gains, managers have a perverse incentive to take large risks. It gets more pronounced if the fund is already down for the year: if, say, the fund has taken a 40% loss, it can look very attractive to the manager to bet all of the remaining assets on a coin flip. Heads, they get their bonus. Tails, they now have a 90% loss, but they weren't getting their bonus either way and they lose nothing. Edit: At least the coin flip is neutral on expectation. But the same issue exists for a bet with negative expected value: the manager gets some benefit if they get very lucky, so the manager has positive expected value even if the fund has very negative expected value from their decision.
- hammock 10y ago
  >This can give a CEO an incentive to make extremely risky decisions That's the intended effect. You missed the point. Read woopwoop's comment again.
  - postnihilism 10y ago
    I think you need to read both woopwoop and amluto's comments again. woopwoop is saying that the equity compensation given to CEOs is a disincentive for taking risks and that it needs to be offset by a promised severance package in order to increase the variance of outcomes. amluto is saying that this is a mischaracterization of the equity compensation for CEOs, which only exposes them to gains and not losses and thus they are already incentivized to pursue a risky strategy (e.g. golden parachutes are not required to create this incentive).
elihu 10y ago
The way I look at it, executive stock options aren't to reward behavior, they're to ensure loyalty. It's normal for any human being to feel more empathy for hard-working employees that they work with every day than shareholders who are more distant and who contribute in a passive way. Stock options give CEOs a large financial incentive to place the interests of stockholders above those of employees whenever those come into conflict (for instance, in decided whether to use profits to increase compensation or increase dividends). Anyways, that's my theory of why large executive stock bonuses might be a good for shareholders despite unintended consequences like decreased risk taking.
ontheinternets 10y ago
I think all these comments are on to the same well-documented idea: Principal-Agent problems https://en.wikipedia.org/wiki/Principal%E2%80%93agent_problem https://en.wikipedia.org/wiki/Principal%E2%80%93agent_proble...
Maarten88 10y ago
> To offset this, the shareholders may make it known that a generous severance package, as well as generous benefits if the company does exceptionally well, are on the table, to simultaneously soften the blow if he takes a bad risk, and sweeten the deal if he takes a good risk. This concept strikes me as grossly unfair towards the employees. Like the CEO, they are also not diversified. Their risks may be even bigger than that of the CEO: if the strategy fails, they may loose their job/income, and they make less to begin with. How are they rewarded for pursuing the more risky strategy?
- robryan 10y ago
  They will likely also have some level of stock based compensation. On the downside most tech employees can easily find a job elsewhere, whereas the CEO may take a reputation hit that makes it hard to get another position at a similar level. So it probably comes down to the regular employee not valuing downside protection enough to give up some base compensation or upside reward.
patrec 10y ago
> In other words, the point of executive compensation may not be to produce better results on average, but rather to increase the variance of the results. The hypothesis you relate isn't implausible, but I think you either got this part backwards, or, more likely, the way you state it is misleading. The strategy would be nuts if it were intended to produce worse expected outcome in terms of monetary return at the (additional) cost of increased variance.
greggman 10y ago
I'm curious if these incentives really work at all. For example it's common knowledge a real estate agent won't go for the most money per deal. They'll go for the quickest money per deal. No real incentive to spend extra time pursuing the most money. I get that's not a direct analogue for the CEO case but how do we know the getting 80 million for hard work and success is more motivation than 15 million for easy work and failure. It seems like if you want to motivate success you'd also need to disinsentivise failure . Not by making it so the CEO gains less if they fail but so they actually lose.if they fail. In otherwords their net worth has to go down for failure.

rhino369 10y ago

And the original golden parachutes were created to incentivize a good acquisition. A CEO whose company gets acquired is often firing himself. So the whole idea was to give them a huge score if it happened. Otherwise CEOs might fight takeovers just to keep their jobs. And, if a lot of the CEO performance results is just luck, then bad luck can ruin them. If a company is on the brink of failure, nobody is going to take the job without a parachute. It could be their last job if they take the blame.

st3v3r 10y ago
So why not make the golden parachute "if we get acquired, you get this" instead of "if you get fired, you get this".
- pdeuchler 10y ago
  Because CEOs didn't get there by not knowing how to negotiate and insulate yourself from risk
- ohyes 10y ago
  What's to stop the board from firing him and then doing the acquisition to save the money that they would have had to pay him.
  - st3v3r 10y ago
    In theory? Not much. In reality? For one, that's a lot of work, especially to screw someone who did a decent job (presumably), who's compensation probably is a drop in the bucket compared to the stock price, and, let's be honest, has a chance to be on your board. The amount of incest in company boards is pretty high. So if you do it to them, there's a chance they'll do it to you.
- rhino369 10y ago
  They did originally. I think even now most big CEO's don't have a really huge golden parachute. And at a certain point, it's just differed compensation. Instead of 2 million a year and zero parachute, they get 1.75 million a year and a million dollar chute. There is also another form of golden parachute, which the person is getting paid for getting on a sinking ship. Otherwise nobody is going to become the CEO of a failing company. They are basically getting paid for the hit to their reputation.
- SeeDave 10y ago
  This exists, it's called a "Change in Control" arrangement.

fauigerzigerk 10y ago

But as an investor I don't care much if one particular company takes more or less risk. I just want to know how much it takes so I can adjust my portfolio accordingly.

Florin_Andrei 10y ago

> a generous severance package, as well as generous benefits if the company does exceptionally well, are on the table, to simultaneously soften the blow if he takes a bad risk So a pay gap of up to (and sometimes over) 1000x between CEOs and rank-and-filers, given all the saving and investing that the CEO could do just like any Average Joe, would not be enough to "soften" any "blows"? Huh.

nkurz 10y ago
The gigantic pay gap may be an injustice, but I think you are missing the subtlety of the theory. The worry is that the CEO will become too personally dependent on that 1000x salary to take "appropriate" risk. For example, assume that launching a new product line has a 50% chance of doubling the companies profit, a 25% chance of doing nothing, and a 25% chance of cutting the profit in half. For the shareholders, this is probably a good bet to take. Then assume the CEO will be replaced if profits drop. In the absence of a "golden parachute", a CEO might reason that a 25% chance of being fired and loosing their cushy job makes the plan not worth pursuing. The theory (OP wasn't necessarily endorsing it) is that a rich severance package can better align the interests of the parties. While I personally think "cronyism" is a better explanation for the current situation, the theory is better than others I have seen.
- Florin_Andrei 10y ago
  > I think you are missing the subtlety of the theory There's nothing "subtle" about a plain racket. And there's nothing subtle anymore, either, about bringing in the Ayn Rand style of "debating" by putting people down. At 1000x pay gap, the CEO needs only work a few months to have nothing to worry about for the rest of his life. Anything on top of that, anything, is a luxury item. "Risk" of what? Having to manage with only 2 yachts instead of the customary 3? Right, that's a serious existential threat, gotta mitigate it. Shave a couple orders of magnitude off that pay gap, and then the argument might, just might, begin to make sense.
  - drakonandor 10y ago

roymurdock 10y ago

(1) The CEO is actually much more heavily invested in the company than the shareholders. His salary, and probably the major part of his assets, are dependent on the performance of the company. On the other hand, the average share holder is well diversified. (2) Therefore, a CEO will be incentivized to pursue a highly conservative strategy, while the shareholders may wish that he takes more risk. 1 is true (assuming heavy equity-based compensation), but 2 does not follow from 1. What does follow is that the CEO will do whatever he can to make short term gains for the company before he exits, even if it means kicking the can down the road for future managers and long-term shareholders to take a hit on at a later date. When the whole management team is on in this short-term focus, it is colloquially referred to IBGYBG (I'll be gone, you'll be gone). Shareholders are not a homogeneous group of investors. Some pension/mutual funds invest with the goal of exiting in 10 years. Some activist shareholders invest with the goal of pumping up the price, then cashing out within 3 months (see Carl Icahn and Apple). A sizeable (and growing) portion will be owned by index funds while some will be owned by hedge funds, etc. Then you also need to factor in employees, executives, etc. One (newer) way to make this group happy as a whole and solve the IBGYBG problem is through clawbacks - punishing ex-executives for the things that happened on their watch. Check out Wells Fargo to see how this is playing out in Congress and in court. The question the paper is trying to answer - what motivates CEOs to "exert effort" in able to return industry-beating results - seems like it has a simple answer to me: no CEO wants to fail at his/her job and be known as the one who presided over company X's slow decline into bankruptcy/irrelevance. Doesn't look so good on the resume when shopping around for your next C-suite role.

drakonandor 10y ago
There are rules (from the SEC as well as often the company board) which prevent executives from selling significant portions of their stakes quickly.

Zigurd 10y ago

That sounds very academic and theorized in a vacuum. If that were true you might expect contract terms to be explicit about this, and quarter-oriented management to be less commonplace.

amluto 10y ago

> Therefore, a CEO will be incentivized to pursue a highly conservative strategy I strongly disagree. A CEO is probably highly personally invested in the company, but that investment almost always has an unusual structure: it resembles a call option, not equity. If a CEO generates a large gain over the course of a few years, the CEO makes a lot of money. In contrast, if the CEO generates a large loss over the course of a few years, the CEO loses very little. This can give a CEO an incentive to make extremely risky decisions because the CEO doesn't personally suffer much more from a huge loss to the company than from a small loss to the company. This problem exists for investment managers. In a hedge fund that charges a performance fee on investment gains, managers have a perverse incentive to take large risks. It gets more pronounced if the fund is already down for the year: if, say, the fund has taken a 40% loss, it can look very attractive to the manager to bet all of the remaining assets on a coin flip. Heads, they get their bonus. Tails, they now have a 90% loss, but they weren't getting their bonus either way and they lose nothing. Edit: At least the coin flip is neutral on expectation. But the same issue exists for a bet with negative expected value: the manager gets some benefit if they get very lucky, so the manager has positive expected value even if the fund has very negative expected value from their decision.

hammock 10y ago
>This can give a CEO an incentive to make extremely risky decisions That's the intended effect. You missed the point. Read woopwoop's comment again.
- postnihilism 10y ago
  I think you need to read both woopwoop and amluto's comments again. woopwoop is saying that the equity compensation given to CEOs is a disincentive for taking risks and that it needs to be offset by a promised severance package in order to increase the variance of outcomes. amluto is saying that this is a mischaracterization of the equity compensation for CEOs, which only exposes them to gains and not losses and thus they are already incentivized to pursue a risky strategy (e.g. golden parachutes are not required to create this incentive).

elihu 10y ago

The way I look at it, executive stock options aren't to reward behavior, they're to ensure loyalty. It's normal for any human being to feel more empathy for hard-working employees that they work with every day than shareholders who are more distant and who contribute in a passive way. Stock options give CEOs a large financial incentive to place the interests of stockholders above those of employees whenever those come into conflict (for instance, in decided whether to use profits to increase compensation or increase dividends). Anyways, that's my theory of why large executive stock bonuses might be a good for shareholders despite unintended consequences like decreased risk taking.

ontheinternets 10y ago

I think all these comments are on to the same well-documented idea: Principal-Agent problems https://en.wikipedia.org/wiki/Principal%E2%80%93agent_problem https://en.wikipedia.org/wiki/Principal%E2%80%93agent_proble...

Maarten88 10y ago

> To offset this, the shareholders may make it known that a generous severance package, as well as generous benefits if the company does exceptionally well, are on the table, to simultaneously soften the blow if he takes a bad risk, and sweeten the deal if he takes a good risk. This concept strikes me as grossly unfair towards the employees. Like the CEO, they are also not diversified. Their risks may be even bigger than that of the CEO: if the strategy fails, they may loose their job/income, and they make less to begin with. How are they rewarded for pursuing the more risky strategy?

robryan 10y ago
They will likely also have some level of stock based compensation. On the downside most tech employees can easily find a job elsewhere, whereas the CEO may take a reputation hit that makes it hard to get another position at a similar level. So it probably comes down to the regular employee not valuing downside protection enough to give up some base compensation or upside reward.

patrec 10y ago

> In other words, the point of executive compensation may not be to produce better results on average, but rather to increase the variance of the results. The hypothesis you relate isn't implausible, but I think you either got this part backwards, or, more likely, the way you state it is misleading. The strategy would be nuts if it were intended to produce worse expected outcome in terms of monetary return at the (additional) cost of increased variance.

greggman 10y ago

I'm curious if these incentives really work at all. For example it's common knowledge a real estate agent won't go for the most money per deal. They'll go for the quickest money per deal. No real incentive to spend extra time pursuing the most money. I get that's not a direct analogue for the CEO case but how do we know the getting 80 million for hard work and success is more motivation than 15 million for easy work and failure. It seems like if you want to motivate success you'd also need to disinsentivise failure . Not by making it so the CEO gains less if they fail but so they actually lose.if they fail. In otherwords their net worth has to go down for failure.