1236
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Myths in management
Say you will – that’ll do
I ended Chapter 5 with some exposures of top management
remuneration. While the question of how to reward CEOs
and other top executives is an ongoing area of discussion and
research, one thing that pretty much everyone seems to agree on
is that, of course, executive compensation should be closely tied
to the performance of the rm.*
However, it is not easy to measure “the performance of the
rm”. Performance in terms of what? And performance over
what period? Therefore, a decade or two ago, the use of so-called
“long-term incentive plans” came about; simply put, top execu-
tives receive rewards (in the form of stock or cash) on specic
dates dependent on whether specic performance goals are met.
Such incentive plans are thought to much more precisely link
rewards to managerial performance, encouraging executives to
direct their attention to long-term protability rather than short-
term gains.
The stock market (that is, investors and analysts) loves them.
Ample studies in nancial economics show that when rms
announce the adoption of long-term incentive plans (for
example, through press releases or proxy statements), their stock
price immediately shoots up. Managers may not always like them
– getting rewarded (or not) based on very specic targets at very
specic points in time can spoil the fun a bit – but it was also
hard to resist them; not adopting one of those thingies made
you look “illegitimate”. Hence, the top managers of many rms
decided to adopt them after all.
Professors James Westphal from the University of Michigan and
Ed Zajac of Northwestern University decided to study the stock-
market effects of these long-term incentive plans once again, but
they did something more. First, as expected, examining 408 large
US companies, they too found that adopting rms’ share prices
* Although I have to admit that I might be an exception to this rule . . .
I sometimes cannot suppress the thought that giving top managers a xed salary
might not be a superior solution.
Business Exposed124
went up immediately when they announced that they were
going to install such an incentive plan.
Then Jim and Ed also examined whether it mattered how
you worded the announcement statement. Specically, they
measured whether the rm’s justication for adopting the
incentive plan explained that it did so to tie CEO compensation
more closely to shareholder wealth (that is, “all the right reasons”
for investors; for instance, global aluminum producer Alcoa did
this), instead of a more general description, for instance some
sort of HR reason (“this plan enhances our ability to attract
talent”; AT&T) or no explanation at all. And they found that
upon announcement, the stock price of the rms “who used all
the right words” went up by 2.4 percent, while the stock price
of the other rms announcing the same plan (but using some
other type of explanation) only increased by half of that (1.2
percent). That is, some rms gained benets twice from the same
thing, by only choosing their words a bit more carefully! That’s
easy money.
Then, though, it got really interesting. Next, Jim and Ed examined
what happened to the stock price of the rms that announced
that they were going to adopt a long-term incentive plan but,
subsequently, did not actually do it . . . (a whopping 52 percent
of rms did this!).
This is what they found: rst, they found that the stock price
of those rms went up on announcement of the plan just like
it did for the others (and why not, the stock market could not
yet know they were not actually going to implement it!). Then
Jim and Ed measured what happened to the stock price the week
following the announcement (when they still had not actually
implemented the scheme). Nothing; the stock price was still up.
Then they measured what had happened after a month; the stock
price was still up . . . Then they measured the outcome after a full
year; the stock price was still up. . . !
Stock prices went up after announcing the incentive plan. Stock
prices did not go down even when the rm subsequently did not
actually implement the scheme! Speak about easy money!!
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