Wednesday, October 14, 2009

Better incentives for CEOs, and mutual fund managers, too

It is believed that the best way to provide proper incentives to CEOs is to compensate them with option on the stock of the firm they are leading. Options are highly sensitive to the stock's performance, and they are oriented towards the future. Can this be beaten?

Alex Edmans, Xavier Gabaix, Tomasz Sadzik and Yuliy Sannikov claim it is possible with "Dynamic Incentive Accounts." These are essentially escrow accounts that are rebalanced to make sure the equity share is high (and increasing) so as to track firm perfomance also after the CEO has left. Their advantage is that they can be set to follow firm performance further in the future than options can, they cannot be sold like options and they can also track relative poor performance, something options cannot do once they are out of the money (below the exercise price). I am sold. And it should also apply to fund managers. That would work much better than the now oft-criticized bonus system.

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