Executive long-term incentive plan grants: excessive compensation or motivational tool?

This research is a contribution to the huge amount of literature concerning executive compensation. Main goal is to empirically test the relationship between firm's economic costs of executive longterm incentive plan (LTIP) grants and firm performance, among Dutch stock market-listed companies for the period 2002-2007. Although a lot of research has been done on the subject of pay-for-performance, literature on the subject performance-based equity is -especially for the Netherlands - relatively scarce. Next to this gap in literture, this research is relevant for several other reasons. To start, executive compensation practices are increasingly criticized. In response, politicians are considering action against these compensation packages, for instance through tax measures. Secondly, evidence on the pay-performance relationship generally is quite weak. This would scientifically underpin mentioned criticism, since improving performance is te main justification of adopting performance-based compensation. Thirdly, the composition of executive compensation changed over time; variable components have become relatively more important. Moreover, concerning variable compensation, LTIPs gain a growing share. In 2007, LTIPs made up 40% of total executive compensation in the Netherlands (Hewitt, 2008). Theorically, two lines of research are generally pursued . On the one hand, the optimal contracting theory argues that agency problems are mitigated by executive compensation. The interests of utility-maximizing executives are aligned with those of shareholders through incentive-based compensation. One would expect, therefore, that variable compensation components as short - and long - term bonuses (STIs and LTIPs), are in the best interests of shareholders - provided that these bonuses are rightly implemented. On the other hand, managerial power model argues that executive compensation is, rather than a solution to the agency problem, a part of this problem itself. It is reasoned that power over directors enables executives to extract rents from shareholders, through influencing the design of their own compensation packages. This way, performance-based compensation might be used to camouflage rent extraction in times of high performance. Next, the basis on which executives LTIP grants are allocated could be of influence on the relationship between firm performance and fair value of future grants. Executive LTIP grants are regulary allocated on the basis of past performance and fair value of future grants. Executive LTIP grants are regularly allocated on the basis of past performance, a fixed number policy, of a fixed value policy. The former two reward executives for high performance with a higher value LTIP grants. The relationship between executive LTIP grants' fair value and firm performance is, therefore, investigated in two different ways. The first hypothesis expects that executive LTIP grants' fair value is of positive influence on future firm performance. The second hypothesis expects that firm performance is of positive influence on the fair value of the future executive LTIP grants. Both hypotheses are tested by using Granger causality tests. For each hypothesis, two tests are run; one including the explaining variable, and one excluding it. Hypothesis are assumed to be supported, if two conditions are met. One the one hand, model's explanatory power should increase if the explaining variable is included. On the other, the explaining variable should demonstrate a significant positive effect estimate. Time-lags are used within a range from one to five years, to control for the long-term aspect. In order to test the extend to which other factors determine the dependent variables' value, several control variables are included: firm size, excess cash flow, growth opportunities, business risk, leverage, a year-dummy, an index-dummy, and, finally a lagged value of dependent variable. Firm performance is measured by Tobin's Q, return on assets (ROA), and total shareholder return (TSR). To obtain data regarding the value of executive LTIP grants, a database provided by Hewitt Associates is used. This database contains compensation fata for Dutch stock market-listed companies. The period of analysis concerns 2002-2007. The value of executive LTIP grants is calculaated by using a Monte Carlo-simulation, taking performance criteria into account. It concerns the fair value of stock options, which indicates, rather than the provided incentives to executives (the face value), the economic costs to firms of executive LTIP grants. Empirical results supporting the first hypothesis are weak. To start, the first condition for Granger causality has not been met - all models on the subject of the first hypothesis lose some explanatory power if the fair value of lagged executive LTIPs is included. Moreover, individual effects only demonstrate a positive influence of executive LTIP grants on future firm performance to a fairly limited extent. The second hypothesis, in contrast, is generally supported by empirical results. Next to an increase in explanatory power of all models if lagged firm performance is included, individual LTIP grants. Based on these results, therefore, one may argue that executive LTIP grants among Dutch stock market-listed companies have between 2002 and 2007 rather functioned as an extension of compensation, than as motivational tool. Several suggestions are given to explain these results. To start, based on the