A Layman’s Guide to Separating Causation from Correlation … and Noticing When Claims of Causality are Invalid

Imagine you’re the Minister for Education, deciding how large to make a school district. Larger school districts offer parents more school choice. You look at data from thousands of school districts and find that, in larger districts, child performance is better. You’re tempted to infer that district size increases child performance. But, as we know, correlation doesn’t imply causation. There are two alternative explanations:

  1. Reverse causality: child performance increases district size. When kids are doing better, a school district is allowed to expand.
  2. Omitted variables: neither district size nor child performance cause each other, but a third variable causes both. If parents care about education, they will both demand school choice (larger school districts) and also tutor their kids at home (increasing child performance).

The problem of separating causality from correlation occurs in virtually every question that we try to study with data.

  • Showing that adults with a degree earn higher salaries doesn’t mean that university is a worthwhile investment. It might be that high-ability kids go to university and their high ability would have led to them earning more anyway (ability is an omitted variable). Or, kids who expect high salaries in the future (e.g. due to being from well-connected families) are more willing to take on the debt to go to university today (reverse causality).
  • Showing that socially responsible firms perform better doesn’t mean that social responsibility pays off. It might be that, only once a firm is already performing well can it invest in social responsibility (reverse causality). Or, a forward-thinking management team (i) performs better, and (ii) gives thought to social issues (management quality is an omitted variable).
  • Showing that firms that cut investment subsequently perform badly doesn’t meant that cutting investment is bad. A McKinsey study makes the very strong causal claim to have found “finally, evidence that managing for the long-term pays off“. Their claim has been accepted as gospel by many, without recognising reverse causality – when a firm knows that its future prospects are poor, it should cut investment today. Presumably, this is what McKinsey advises its clients to do!
  • Showing that firms where a CEO has a high equity stake (owns a lot of shares) subsequently perform better doesn’t mean that equity incentives work. It might be that, when a CEO expects a firm to perform better in the future, she’s more willing to hold shares today.
  • Showing that a fad diet leads to weight loss doesn’t mean the diet caused weight loss. It might be that the desire to lose weight caused a person to choose the diet, and also to exercise more and it’s the latter that led to the weight loss (omitted variables).

The problem is even worse due to confirmation bias, as I explained in my recent TEDx talk, “From Post-Truth to Pro-Truth”. We jump to the conclusion that fits our view of the world.

  • Professors like me are all too eager to believe that our fascinating class is what got students that job.
  • We want to think that “nice guys finish first” – that responsible companies beat irresponsible ones.
  • Those whose view businesses as evil and self-serving will want to think that those who cut investment (to pay dividends or buy back stock) get their comeuppance later.
  • People like me who spend their lives studying on incentive compensation really want to believe that incentives actually matter, and that they’re not wasting their time.
  • Any proponent of a fad diet or slimming pill will claim they’re to thank for your six-pack abs.

We must be very, very careful about interpreting evidence as causal, when it only shows a correlation. Fortunately, there are now clever techniques to separate causality from correlation – (I) instruments, (II) natural experiments, and (III) regression discontinuity. This article aims to explain these techniques in simple language. But before starting, I must caution that these techniques are only valid in very rare cases. Some papers use one of the three “magic phrases” to try to claim that they have identified causality, and then back it up with as technical language as possible to give the aura of statistical sophistication and batter the reader into submission. Instead, as I’ll explain, you don’t need to be a statistical expert to see whether the authors are trying to pull the wool over your eyes. All you need is common sense. For each of these techniques, I have a “Reader Beware” section on what to look for. The intended audience for this post is practitioners, who might use academic research to guide policy or practice, so I will paint with a broad brush. For a more detailed academic treatment, please see Roberts and Whited (2012).

I begin by defining terms. We are interested in the causal effect of an independent variable (e.g. district size, degree) on a dependent variable (e.g. child performance, future income). A causal interpretation is only possible if the independent variable is exogenous (randomly assigned) – if university places were randomly given to some school leavers and not others, and those that went to university earned more, we could infer that the degree caused the higher salary. However, most variables are endogenous. They are not randomly assigned, but the product of something else – the dependent variable itself (expecting a high future income encourages you to get a degree today – reverse causality), or a third variable that also affects the dependent variable (high ability makes you more willing to get a degree – omitted variables).

I. Instruments

How do we solve the problem that the independent variable is endogenous? In a medical trial, you would randomly assign the independent variable (a new drug) by giving it to some patients (a treated group) and a placebo to others (a control group). But, we can’t do this in social sciences – we can’t force some firms to give their CEOs high equity stakes and others to give low equity stakes.

So, what we want is something as-good-as-random. This is an instrument – something that randomly shocks the independent variable, just like random assignment of a new drug. In the school district example, Hoxby (2000) used rivers as a shock to district size. In the U.S., school districts were formed in the 18th century, when crossing a river was difficult due to no cars and few bridges, and so districts very rarely crossed rivers. Hoxby found that school districts that were naturally smaller, due to rivers, exhibited worse performance. Since these districts were “randomly” assigned a small size, the results imply a causal effect from district size to child performance.

A valid instrument must be:

  1. Relevant. It must affect the independent variable of interest. Rivers are relevant, as they placed natural boundaries on district size.
  2. Exogenous. It must not affect the dependent variable except through the independent variable. Rivers are unlikely to affect a child’s performance other than through affecting district size. (Technically, this is referred to as “satisfying the exclusion restriction”; I will use “exogenous” for short).

To give an example of the ingenuity of some valid instruments:

  • Does a family firm perform better when it appoints a family CEOs rather than an external CEO, or worse due to nepotism? If family-run firms perform better, it could be due to reverse causality: if the firm is performing well, the owners will keep it within the family; if it’s not, they will need an outsider to fix it. Bennedsen, Nielsen, Perez-Gonzalez, and Wolfenzon (2007) use the gender of the CEO’s first-born child as an instrument. Gender is:
    1. Relevant: when the first child is male, family owners are more likely to pass on control to a family CEO than when the first child is female.
    2. Exogenous: it’s unlikely that the gender of a CEO’s first child will affect the performance of the family firm other than through affecting whether the next CEO is from within or outside the family.
  • Rather than studying whether firms actually have a family CEO, the authors predict whether firms will have a family CEO based on the gender of the first-born child. They found that firms with a higher probability of having a family CEO (due to having a male first child). Since whether a firm is predicted to have a family CEO is random – because the gender of the first child is random – this implies that family CEOs cause worse performance.
  • Does watching TV cause autism? If the correlation is positive, it may be that autistic kids watch TV more (reverse causality), or neglectful parents both abandon their kids to watch TV, and also cause autism (omitted variables). Waldman, Nicholson, Adilov, and Williams (2008) use rainfall as an instrument. Rainfall is:
    1. Relevant: rainfall causes kids to watch TV, since they can’t play sport outside.
    2. Exogenous: rainfall doesn’t cause autism other than through its impact on TV-watching (it doesn’t suddenly cause parents to be neglectful).
  • Rather than studying the actual number of hours of TV-watching, the authors predict TV-watching based on rainfall. They found that kids with higher predicted TV watching are more likely to be autistic. Since predicted TV-watching is random – because rainfall is random – this implies that watching TV causes autism.

Reader Beware

Often authors will claim causality by using the magic word “instruments” (or “instrumental variables”), when the instruments are actually invalid because they are not exogenous (it is relatively easy to find instruments that are relevant). A reader should ask the following questions:

  • Can the “instrument” affect the dependent variable other than through the independent variable? Let’s return to the earlier question of whether the CEO’s equity stake causes better future performance. We might use CEO age as an instrument for her equity stake, as older CEOs tend to have accumulated more shares. But, CEO age is not exogenous, since it might directly affect firm performance. Older CEOs might perform better as they are more experienced, or worse as they are entrenched.
  • What causes the instrument to vary to begin with, and could this factor also affect the dependent variable?  Even if CEO age did not directly affect firm performance (older CEOs are just as good as younger CEOs), whatever drives cross-sectional variation in age may do so. For example, trouble in the firm’s business model may lead to a firm retaining an old CEO, and also reduce firm performance.
  • Is the instrument a lagged variable? Some papers use last year’s independent variable as an instrument – in our setting, this would be the CEO’s equity stake last year. It’s relevant – last year’s equity stake will be linked to this year’s, since equity stakes tend to be stable over time. Surely it’s also exogenous – since it’s last year’s stake, it was already set in advance of this year? But, whatever causes this year’s stake to be endogenous also likely causes last year’s stake to be endogenous. Last year, the CEO could have forecast performance to be good this year, and so chosen to hold more shares.
  • Is the instrument a group average? Some papers use a group average as an instrument – in our setting, this would be the average equity stake among CEOs in the same industry as firm X. It’s relevant – if rival firms are giving their CEOs lots of equity, firm X must do so too, to remain competitive. Surely it’s also exogenous – the equity stake of other CEOs shouldn’t affect firm X’s performance? But, any endogeneity in firm X’s equity stake is simply soaked up at the industry level (see Section 2.3.4 of Gormley and Matsa (2014) for more detail). If the industry as a whole is performing well, firm X will perform well, and CEOs of other firms in the industry will gladly hold high equity stakes.
  • Are the authors up-front about their instruments? A tell-tale sign is when, in the introduction to a paper, authors say something like “we control for endogeneity using instruments and show that the results remain robust” without explaining what the instruments are until much later in the paper. Finding valid instruments is very difficult and it is the authors’ responsibility to explain what the instruments are and justify why they are relevant and exogenous. Not being up-front about what the instruments are suggests the authors may themselves not be sufficiently convinced about their validity, and so they bury them deep into the paper.

Even though some papers may claim to have statistically proven exogeneity, there is no valid test to do this. So, the best way to assess exogeneity is to use common sense – could the “instrument” (or whatever drives the instrument) affect the dependent variable other than through the independent variable? Note that no instrument will be completely exogenous and one can always spin stories to argue that it is not. For example, one could spin a story that rivers directly affect child performance, because when kids look out onto a river, they get inspired to be more creative. Ultimately, the reader must use common sense to see whether such stories are reasonable.

As an example of how authors might use complex technical language to overwhelm the reader into believing they have shown causality, consider the following extract:

“We reestimated our models using the xtabond2 procedure in STATA, which utilizes the generalized method of moments (GMM) model also known as system GMM. The xtabond2 procedure is designed for panels that may contain fixed effects and heteroscedastic and correlated errors within units, and employs first differencing, which instruments variables with suitable lags of their own first differences, to eliminate these issues and potential sources of omitted variable bias (please see Arellano & Bover, 1995; Blundell & Bond, 1998; Roodman, 2009). Furthermore, and importantly, xtabond2 also allows the ability to specify variables as endogenous to examine whether potential endogeneity is influencing findings.”

Sounds impressive, but when you strip back from the technical language, you see that the authors are using “lags” (i.e. last year’s variable – more precisely, the change in the variable from last year), which is generally invalid for the reasons discussed above. I use the above extract in no way to poke fun at this paper, but to stress that it’s common sense, not technical sophistication, that enables us to assess validity.

II. Natural Experiments

As discussed earlier, in social sciences, it is hard for the researcher to randomly assign treatments. A natural experiment is when firms are naturally (i.e., without the researcher having to do anything) divided into treated and control groups, for example if a law affects some firms but not others.

Bertrand and Mullainathan (2003) study whether takeover defenses worsen firm performance by entrenching CEOs and allowing them to coast. Their natural experiment is the adoption of state anti-takeover laws. Crucially, different states passed these laws in different years. Consider two plants located in New York, one of which belongs to a Delaware-incorporated firm and the other to a California-incorporated firm. In 1998, Delaware but not California passed anti-takeover laws. The Delaware-owned plant is affected by the law and part of the treated group; the California-owned plant is unaffected by the law and part of the control group.

Assume that, after 1998, we found that the Delaware-owned plant produced 2 (units of output) and the California-owned plant produced 7.  We might conclude that anti-takeover laws reduce output by 5. But, such a conclusion would be premature. Perhaps inefficient firms happen to incorporate in Delaware, and so the Delaware-owned plant was performing poorly even before 1998. Thus, it’s not the law that caused the Delaware-owned plant to perform poorly – it was performing poorly anyway. So, we must perform what’s known as a difference-in-differences analysis, which is best explained by the following (hypothetical) example:

Pre-1998 Post-1998 Difference
Delaware 8 2 -6
California 11 7 -4
Difference -3 -5 -2

Since the Delaware-owned plant is generally more efficient, it was already performing worse than the California plant pre-1998. The difference in their performance was -3 in the bottom row.  After 1998, the difference widened to -5. So, the difference-in-differences – the increase in the difference after 1998 – is -2, and so we can conclude that anti-takeover laws cause performance to fall by 2. Crucially, we use the pre-1998 difference in performance to control for the fact that Delaware-owned plants might be inherent different from California-owned plants.

We could also reach the same -2 conclusion by using the right-hand column, rather than the bottom row. The performance of the Delaware-owned plant fell from 8 to 2 after 1998 – a difference of -6. But, we can’t attribute this decline to the anti-takeover law, because many other events could have happened in 1998 that caused this fall – perhaps the economy went into recession in 1998. This is the role of the control group – the California-owned plant. We can use its difference in performance of -4 to measure the impact of other events that happened in 1998. The difference-in-differences is -2. So, we reach the same conclusion that anti-takeover laws cause performance to fall by 2.

Reader Beware

  • Are the treated and control groups trending in the same direction? The California-owned plant is only a valid control for other events that happened in 1998 if it is affected by the same events as the Delaware-owned plant. This is why Bertrand and Mullainathan use two plants located in New York – if the New York economy suffers a recession, it should have the same effect on both plants. If they had instead compared a plant incorporated and located in Delaware to a plant incorporated and located in California, the latter would not be a good control as Delaware may have suffered a recession in 1998 but not California. So, it is critical that the treated and control groups be trending in the same direction – the change in their performance post-1998 should have been the same if no law had been passed. This is known as the parallel trends assumption.
    • Note that we do not require the treated and control groups to be similar. In the above example, Delaware-owned plants are less efficient than California-owned plants. The level of their productivity is different pre-1998 -we only require the change or trend in their productivity around 1998 to have been the same had no law been passed. We can check this by checking the trends in performance of both plants for several years prior to 1998.
  • Was the natural experiment anticipatedIf the law change was anticipated, firms could respond in anticipation of the law. Then, a researcher might incorrectly conclude that the law had no effect – because the changes had already been made before the law got passed. Moreover, as Hennessy and Strebulaev (2016) show, anticipation may not only cause the measured effect to be weaker, but have the wrong sign.
  • Was the natural experiment exogenous? If firms could have lobbied for the law change, then it is no longer random whether a plant is treated or a control. Perhaps Delaware-incorporated firms knew that their future prospects were poor and lobbied legislators to pass anti-takeover laws in anticipation. As a result, we cannot conduct natural experiments using changes implemented by firms (as some papers do). For example, conducting a “difference-in-differences” between firms who chose to engage in stock splits and firms that do not, would not allow causal inference, since firms endogenously choose whether they are in the treated group (those who split their stock) and whether they are in the control group (those who don’t).

III. Regression Discontinuity

Here, randomness occurs due to the independent variable falling either just below or just above a cutoff in an unpredictable way. For example, Cunat, Gine, and Guadalupe (2012) study the effect of shareholder proposals to increase shareholder rights. Showing that firm performance improves after such proposals are passed does not imply that the proposals caused the improvement, because they are endogenous. Perhaps a large engaged blockholder made the proposals, and it could be the blockholder that improved firm performance. So, they compare proposals that narrowly pass (with 51% of the vote) to those that narrowly fail (with 49% of the vote). Whether the vote narrowly passes or narrowly fails is essentially random, and uncorrelated with other factors such as the presence of blockholders – if there were large blockholders, they would likely increase the vote from 49% to (say) 80%, not 51%. They compare the stock price reaction to the vote outcome, as well as changes in long-term performance, of firms where a shareholder proposal narrowly passes to firms where a shareholder proposal narrowly fails (similar to a difference-in-differences). Since the stock price and long-term performance improves significantly more for the former set of firms, they show that increased shareholder rights cause higher firm value and long-term performance.

For other examples of regression discontinuity that I have blogged about, see Flammer and Bansal (2017) on the effect of shareholder proposals to implement long-term incentives, and Malenko and Shen (2016) on the effect of proxy advisors on voting outcomes.

Reader Beware

  • Can firms perfectly manipulate the independent variable, i.e. choose whether they are above or below the threshold? Suppose directors have control over the votes of shares held in an employee benefit trust. Normally, they do not vote these shares, to avoid investor concerns about them distorting vote outcomes. However, in extreme conditions, they may. For close votes, control of these votes allow firms to essentially choose whether the vote is 51% or 49%. They might allow the proposal to pass if it is performing well (since it is not afraid about greater shareholder power), and cause it to fail if it performing poorly. Then, whether the proposal passes or fails is endogenous – it depends on firm performance.
    • Note that if firms can only partially (not perfectly) manipulate the vote, regression discontinuity is still valid as there is still some randomness as to whether the vote narrowly passes or narrowly fails.
  • Are firms comparable on other dimensions above and below the threshold? Firms above the threshold are treated and firms below are controls. The treated and control firms should be comparable on all other dimensions. Comparability might be violated if (hypothetically) firms with higher-quality management were able to predict when the vote is going to be close and persuade “swing” shareholders to vote against the proposal. Thus, management quality might jump when you move from above to below the threshold.

IV. An Alternative Technique: Common Sense

Finding valid instruments, natural experiments, and discontinuities is difficult. So, an alternative approach to get closer towards causality is to use common sense. For example, if your effect is indeed causal, it should be stronger in certain circumstances. If a higher CEO equity stake caused superior firm performance, through providing the CEO with better incentives, the effect should be stronger where CEOs have greatest freedom to slack – in firms with little ownership by institutional investors, poor governance, and low product market competition. This is what von Lilienfeld-Toal and Ruenzi (2014) show, as blogged about here.

Brav, Jiang, Partnoy, and Thomas (2008) show that, after hedge fund activists acquire a large stake in a firm and announce an intention to influence control, performance improves. There could be reverse causality if the hedge fund predicted the improvements and acquired the large stake in anticipation. As blogged about here, the authors support causality by showing that the improvements are stronger when the hedge fund employs hostile tactics, and remain significant even when the hedge fund already had a large stake prior to announcing its activist intent.

Note that common sense does not show causality as cleanly as the first three methods; it can only suggest causality. (In the first example, perhaps the measures of governance are inaccurate). But, it should be added to the toolkit. Just as a discerning reader should use common sense to avoid being impressed by complex, but invalid, statistical techniques, he/she should also be open to common sense approaches to suggesting causality, even if they cannot prove it. Researchers using this approach must be careful not to make strong causal claims.

CEOs Cut Investment To Sell Their Own Shares At High Prices

One of the most fundamental concerns with corporations is that they focus on short-term profit rather than investing for the long-term. This is a particular concern in the 21st century, where innovation is particularly critical for competitive success. Moreover, allegations of short-termism have serious social repercussions. Long-term investments, such as reducing carbon emissions, developing blockbuster drugs, or training workers, typically benefit stakeholders as well as shareholders, but short-term profit only goes to shareholders. The concerns that corporations exploit stakeholders to pander to shareholders has led to a substantial loss of trust in business and threatens its social license to operate.

But Where’s The Evidence?

However, actually finding evidence that short-termism even exists is extremely difficult. My prior post discussed several pieces of evidence to the contrary. Indeed, my 2007 “job market paper” (that you take on the academic job market in the final year of your PhD) was a theoretical model of how large shareholders can alleviate short-termism. In the first few minutes of most seminars, I’d get the question “What evidence is there that short-termism is even a problem in the first place?” I had to admit that there was little hard evidence – the best was a 2006 survey of executives where 78% admitted to sacrificing long-term value to meeting earnings targets, but this is only what executives claimed that they did, rather than what they actually did.

“No evidence of short-termism”, however, is not the same as “evidence of no short-termism”. There simply wasn’t evidence either way, since it’s hard to measure a CEO’s short-term concerns. One measure might be the amount of shares that she sells in the short-term. If the CEO sells a ton of shares in Q3 2017, then she wants the stock price to be particularly high in Q3 2017. Thus, she might cut investment in Q3 2017. But, a correlation between CEO equity sales and investment cuts would not imply causation. The problem is that CEO equity sales are endogenous – they are a deliberate choice of the CEO, and so this choice may be driven by other factors that also drive investment. For example, if prospects are looking bleak in Q3 2017, this might cause the CEO to rationally scale back investment, and separately to sell her shares.

Documenting Short-Termism: A New Approach

In a recent paper, Vivian Fang, Katharina Lewellen, and I* initiated a new approach. Rather than studying the shares that the CEO actually sells, we study the amount of shares that are scheduled to vest. For example, if a CEO was given a chunk of shares in Q3 2012, with a 5-year vesting period, they first become saleable in Q3 2017. CEOs typically sell a large portion of their shares when they vest, to diversify their portfolio (we verify this in the data). Thus, if the CEO knows that her shares will be vesting in Q3 2017, and so she’s likely to sell a large portion, she has incentives to cut Q3 2017 investment. Importantly, the driver of Q3 2017 vesting equity is the decision to grant the CEO shares back in Q3 2012. That was five years ago, and so is likely exogenous to (not driven by) Q3 2017 investment opportunities. Thus, any correlation between Q3 vesting equity and Q3 investment cuts is likely to be causal.

We include both shares and options in our measure of vesting equity and estimate this amount at the quarterly level. This is because the highest frequency with which investment is reported is also at the quarterly level. We regressed the change in investment (measured five different ways) on vesting equity and many control variables that may also drive investment cuts (e.g. investment opportunities or financing constraints).

CEOs Cut Investment When Their Equity Vests

We find a significant negative correlation between vesting equity and the growth rate in investment – using all five investment measures. Moreover, these results are robust to:

  • Removing equity grants where vesting depends on hitting certain performance targets, rather than reaching the end of a pre-specified time period (e.g. 5 years)
  • Considering only vesting stock or only vesting options
  • Including or excluding controls
  • Regressing the change in investment not on the amount of vesting equity, but the amount of equity sales that can be predicted by vesting equity

Alternative Explanations

So, the link between vesting equity and investment cuts appears to be robust. This is consistent with the idea that the CEO inefficiently cuts good investment projects to boost short-term earnings and thus the short-term stock price (the myopia hypothesis). But, as I explained in a recent TEDx talk, finding that the data is consistent with a hypothesis does not mean that the data supports the hypothesis – because it could also be consistent with alternative hypotheses.

The main concern is the efficiency hypothesis. Perhaps the CEO cuts bad investment projects, and so the cut in investment is efficient. Let’s say cutting investment is hard. It takes effort to identify wasteful projects and shut them down, and doing so may make the CEO unpopular  CEOs may instead prefer to coast and enjoy the quiet life. But, when the CEO is about to sell her shares, she overcomes her inertia and is willing to take tough decisions. If true, then short-term pressures are motivating, rather than distracting – a bit like how an impending essay deadline forces students to stop procrastinating.

We tested the efficiency hypothesis in two ways. First, if equity vesting causes the CEO to get her act together, you’d expect her to improve efficiency not just by cutting investment, but also by cutting other expenses or increasing sales growth. But, we find no evidence of this. Second, we show that that CEOs cut investment less when the cuts are more costly to them (the CEO is younger, so she suffers more from the long-term consequences of scrapping an efficient investment; or the firm is younger or smaller, suggesting that the investment is more valuable). These tests suggest that the investment cut is indeed likely to be inefficient.

How Does the CEO Benefit?

One complication is that Q3 earnings aren’t announced until the start of Q4. So, how does a CEO who sells equity in Q3 benefit from the earnings increase that results from the investment cut? We show that vesting equity increases the likelihood that the CEO issues positive earnings guidance in the same quarter. Doing so boosts the stock price by 2.5%, thus indeed allowing her to cash out at a high price. Indeed, we find that the CEO’s equity sales are concentrated in a small window immediately following the guidance event. So, the full picture appears to be – the CEO knows that her equity is vesting in Q3, so she cuts investment in Q3 and also issues positive earnings guidance in Q3, boosting the stock price and allowing her to sell her shares upon vesting.

If the CEO boosts earnings-per-share by 5c, how much should positive earnings guidance should she give? Probably around 4-5c – then, she will benefit as much as possible from the earnings increase – but not more than that else she will subsequently undeperform expectations. (The same reason explains why the CEO can’t issue positive guidance without the investment cut – both go hand-in-hand). Indeed, we find that, when more equity vests, the firm is particularly likely to beat the analyst forecast by a narrow margin (0-1 cent) but not a wide margin, consistent with the CEO communicating nearly all of the earnings increase ahead of time.

What Does It Mean For CEO Pay Design?

Executive pay is a highly controversial topic. Most people agree that it should be reformed, but the reforms typically focus on the level of pay. As I wrote earlier (see myth #5), the level of average CEO pay in the US is only 0.05% of firm value. Instead, these results suggest that the horizon of pay is more important – it affects the CEO’s incentives to invest, with potentially substantial implications for the company’s long-run success and the value it creates to other stakeholders. Cutting pay in half will win more headlines than extending the vesting horizon from (say) 3 to 7 years, but the latter is likely much more impactful. Indeed, the paper was referenced in the UK government’s Green Paper on Corporate Governance to justify the proposal to extend vesting periods. Here I describe a redesign of executive pay based in part on the results of this paper (since implemented by some companies), and here I summarize a paper by other scholars showing positive causal effects of long-term equity compensation.

* I apologize for covering one of my own papers. In this blog I typically cover other people’s papers. But, I needed to write about this paper anyway to fulfill the “dissemination” terms of my European Research Council grant, so decided to share it here.

House of Commons Report on Corporate Governance

Today the House of Commons Select Committee on Business, Energy, and Industrial Strategy (BEIS) published its report on corporate governance, after extensive consultation of oral and written testimony from a wide range of stakeholders. I applaud the Select Committee for such an extensive, thorough job with an issue of national importance, and am personally grateful to them for publishing my initial and supplementary written testimonies as well as inviting me to testify orally in Parliament. I endorse the vast majority of the recommendations and believe that they will help “make Britain a country that works for everyone”, in Prime Minister May’s words. This post aims to summarize the 81 page report into a few simple bullet points, and link them to the evidence.

Executive Pay

  • LTIPs (bonuses based on hitting financial targets) to be scrapped from 2018; no existing LTIPs to be renewed.
  • Instead, give executives equity that they are required to hold for the long term (at least 5 years). The equity must not vest (= become saleable) all in one go
    • See here for the arguments for replacing LTIPs with equity, and here for evidence that CEOs cut investment when their equity vests
    • These ideas are also advocated by The Purposeful Company, a leading consortium of leading executives, investors, consultants, and academics (full report here, short summary here)
    • LTIPs are almost ubiquitous, but used because “we’ve always done it that way” rather than because they are effective. Given this common usage, the proposal is a radical one – but a highly desirable one – and I greatly applaud the Committee for its boldness
  • Where bonuses are used, they should be on wider performance criteria (e.g. qualitative factors) and must be stretching
  • Shareholders’ “say-on-pay” vote will remain advisory, rather than being changed to binding (as initially mooted).
    • However, if an advisory vote has < 75% support, there should be a binding vote the next year and the Remuneration Committee (RemCo) chair should be encouraged to resign
  • Firms should not be forced to put workers on RemCos, but worker representation to be on a comply-or-explain basis
  • Firms, public sector, and large third-sector organisations to publish pay ratios between the CEO and senior management, and the CEO and all UK employees. The ratio must be on a consistent basis each year
    • The actual advocacy of pay ratios was lukewarm, with little justification given. See my Harvard Business Review article for the potential unintended consequences of such disclosure (including for workers themselves).

Directors’ Duties and Reporting

  • More specific and accurate reporting on directors’ duties to other stakeholders, including long-term consequences of decisions
  • Reporting to contain fewer boiler-plate statements. Companies to be more imaginative and agile in communicating directly with stakeholders
  • The report recognises that UK corporate governance is very well regarded internationally. Thus, it strongly supports maintaining
    • The unitary board, where all directors share the same responsibilities
    • The statement of directors’ duties in Section 172 of the Companies Act (that directors “promote the success of the company for the benefit of its members” (i.e. shareholders) while having regard for other stakeholders)
    • “Comply or explain” guidelines (firms do not need to comply with certain guidelines, permitting flexibility – but if they do not, they must explain why not)
  • I particularly applaud the report’s caution against overreacting to the scandals at BHS and Sports Direct. These scandals are tragic, but do not mean that all companies should have to suffer.
    • The Report writes (paragraph 24): “Corporate governance in the UK is still strong and remains an asset to the country’s reputation for doing business. We are conscious that a small number of highly damaging examples of corporate governance failure should not lead to a hasty and disproportionate response. We do not believe that there is a case for a radical overhaul of corporate governance in the UK”

Expanded Role for the Financial Reporting Council (FRC)

  • FRC to introduce a new tiering system (Red, Yellow, Green) for corporate governance
  • FRC to engage and hold directors to account
    • If engagement unsuccessful, report failings to shareholders
    • If still no response, take legal action
  • FRC to be renamed and resourced, to match this expanded role

Private Companies

  • New governance Code for the largest private companies to be developed
    • Compliance to be examined by an expanded FRC, funded by a small levy on businesses

Shareholder Engagement

  • Paragraphs 13-16 recognise the importance of blockholders (large shareholders) and the dangers of the ownerless corporation
    • However, this point is not subsequently picked up. Encouraging large shareholders to form, and helping shareholders to engage with companies, could further help the Government’s mission. See Chapter 4 of The Purposeful Company Policy Report.
  • Investor Forum to facilitate better engagement between boards and shareholders, particularly if rated Yellow or Red by new FRC tiering system
  • Shareholders encouraged to engage more in pay

Stakeholder Representation

  • Companies to be encouraged to consider a Stakeholder Advisory panel, to consult stakeholders other than shareholders
  • Annual Report to contain a section on how firms engage with shareholders
  • Workers on boards should not be mandated, but report highlights that there is nothing in the law to prevent it. Would like it to become the norm by opening up new director positions to all.
    • Worker directors will not be a delegate of the workforce as a whole but act in their own capacity, and have the same rights and responsibilities as other directors

Board Diversity

  • 2020 target for half of new appointments to senior and executive management to be women. Companies should explain why they have failed to meet the target and the steps taken to address it
  • Every existing FRC reference to gender diversity should also add a reference to ethnic diversity

Other

  • Firms to report on their people policy in the Annual Report, i.e. approach to investing in people and how they ensure that their pay and working conditions are reasonable
  • Investors to disclose voting records; FRC to name those who don’t vote
  • Firms to provide full information on advisors engaged in transactions

A Note on the Use of Evidence

  • The Report writes “The TUC states that “There is clear academic evidence that high wage disparities within companies harm productivity and company performance“.” This statement is actually false. The TUC (potentially inadvertently) quoted an unpublished 2010 paper by which found that high pay ratios are negatively correlated with firm performance. However, the final version of the paper was published in 2013 (i.e. 4 years ago). After going through peer review, it found the opposite result. In the authors’ own words, “We find that employees do not perceive higher pay ratios as an inequitable outcome. We do not find a negative relation between relative pay and employee productivity. We find that firm value and operating performance both increase with relative pay.”
    • This highlights the potential issue of “confirmation bias”. You can always find some academic paper to support any viewpoint (some studies support vaccination, others oppose it). So, just having “evidence” to support a viewpoint means little – what matters is the quality of evidence. One cannot just hand-pick an unpublished draft that shows what you would like it to show, particularly when the published version shows the opposite.
    • Claiming to be unaware of the published paper is not an acceptable defense. It is incumbent upon a witness, who chooses to quote an unpublished paper, to check whether it has since been published. Confirmation bias is not only misinterpreting evidence once you have received it, but the failure to search for new evidence. One cannot just stop at finding a half-finished paper because it shows what one would like it to show, and not bother to see if there is a finished version
    • I highlighted in my supplementary testimony that the result was overturned (and the US evidence was independently confirmed using UK data in a paper forthcoming in a top journal). Thus, while the bulk of the Report is balanced and well evidenced, it is surprising that it contains a statement known to be wrong. The Oxford Dictionaries word of 2016 is “post-truth”, which has led to a widespread, and very welcome, acknowledgment of the importance of correcting untruths. Thus, when such corrections are made, they should not be ignored.
    • As stated in my supplementary testimony, “The goal of the above is absolutely not to discredit the TUC, which is an organisation I respect, and whose goal of encouraging ethical treatment of workers I very much share. [Indeed, I expect that we both share strong support for the Committee’s recommendation for firms to disclose their people policy.] This is simply intended to be one example of how important it is to be critical with evidence.”
    • Moreover, that the paper finds that pay ratios are positively correlated with future performance is far from the final word. Academic evidence is only one input into a decision. My concern is only that, when evidence is quoted, it should be quoted accurately.
    • I will discuss best practices for the use of evidence in my upcoming TEDx talk, “From Post-Truth to Pro-Truth”, on 12 May in London. See here for details of the event and excellent other speakers.

Simplicity, Transparency, and Sustainability: A New Model For CEO Pay

How did BP CEO Bob Dudley get paid £14m in 2015, despite the stock price falling by over 15%? Because of a complex, opaque pay scheme known as a Long-Term Incentive Plan (“LTIP”).

A LTIP pays the executive according to multiple performance measures – for example, stock price, profitability, and sales growth – at the end of an evaluation period (say 3 years). For each measure, there’s a lower threshold (say a stock price of £4) that the executive must beat for the LTIP to pay off. The value of the LTIP rises with further increases above £4, before maxing out at a higher threshold (say £8).

LTIP

The philosophy behind LTIPs is sound – to link pay to performance. But, it does so in a needlessly complicated way, that allows for gaming and fudging.

Let’s start with gaming. Despite the name, evidence shows that “long-term” incentive plans lead to short-termism as the end of the evaluation period approaches. If the stock price is just below £4, the CEO may cut R&D, to boost earnings and get the short-term stock price over the hurdle. The CEO might also gamble. If the gamble fails, the stock price falls to £3, but the LTIP wouldn’t have paid off anyway, so the downside is limited. If the gamble succeeds, the stock price rises to £5, and the CEO cashes in. Effectively, the LTIP gives a one-way bet. And the problems aren’t limited to the bottom end. If the stock price is just above £8, there is no further upside. Rather than innovating, the executive may coast and be excessively conservative.

These thresholds are crazy. Society loses if firm performance is disastrous (£3) rather than bad (£4). And society gains if firm performance is great (£9) rather than good (£8). But, for the LTIP, there’s no difference between disastrous and bad, or between great and good.

Turning to fudging, there is a huge amount of ambiguity on how to design the LTIP:

  1. What performance metrics should be used? Should there be non-financial measures, e.g. treatment of workers? But if so, any measure will be incomplete, and encourage focus only on the measure being rewarded. For example, measuring worker pay won’t capture working conditions.
  2. How do we weight the measures? Should it be 52% on the stock price, 27% on profitability, and 21% on sales growth? Dudley received £14m, despite the stock price fall, due to heavy weighting on the safety and profit targets. Even worse, the weightings sometimes change after the fact, to overweight the dimension that the executive performs best on.
  3. How do we choose the thresholds? There’s no clear reason for £4, £8 or any number. In practice, the lower threshold is often easy to hit, leading to perceptions of unfairness – why should executives get a bonus for average performance, when ordinary workers don’t? Moreover, the thresholds are sometimes lowered if there’s a bad external shock (in BP’s case, an oil price decline) – but not increased upon good luck – again leading to a one-way bet.

What’s the solution? Cut LTIPs and other bonuses, and move towards paying the CEO in cash and shares (with a long holding period). This satisfies three principles:

  1. Simplicity. It’s simple. You don’t need to choose particular measures, weightings, or thresholds, and so the CEO doesn’t divert attention to gaming the system. It’s simpler than the alternative of giving executives cash and making them buy shares (even though it reaches the same outcome) as CEOs can game when they buy the shares (e.g. by releasing bad news to depress the stock price just before buying)
  2. Transparency. While it’s very difficult to value an LTIP, the value of stock is unambiguous. We know how much the CEO gets paid, and under what circumstances – according to the long-term stock price.
  3. Sustainability. It leads to sustainable performance. There’s significant evidence that, while the short-term stock price can be manipulated, the long-run stock price captures stakeholder value as well as shareholder value. Indeed, granting long-term equity has a positive causal effect on future profitability, innovation, and CSR (in particular, employee well-being)

A very important advantage of shares is that they can be given to all employees as well. This will help address fairness concerns. If the firm succeeds, why should only executives benefit? Employees contributed to the firm’s success as well. If they are given shares, they will benefit too. CEOs can’t gain without employees gaining also. But, if CEOs get LTIPs and workers get shares, the LTIP might pay off even if the stock price falls, leading to concerns of “one rule for them, another rule for us”. Indeed, evidence shows that broad-based equity plans improve performance, perhaps due to a team mentality.

Giving shares to all employees will allow them all to – quite literally – share in the firm’s success that they all helped create.

Frequently Asked Questions

Q1: Is this just a hypothetical idea? Will it be implemented in practice?
A1: The idea of de-emphasising LTIPs and increasing long-vesting equity was also:

Q2: Won’t this lead to CEOs focusing entirely on shareholders and ignoring other stakeholders?
A2: No. There’s indeed a trade-off between shareholders and stakeholders in the short-term, but not the long-term. CEOs can cut wages to increase shareholder value at the expense of workers, but in the long-term this erodes shareholder value, as workers leave.  See the “Sustainability” point above, and p26-33 of The Purposeful Company Interim Report for a summary of the evidence that purposeful behaviour – serving customers, employees, the environment, and society – boosts the long-term stock price.

Q3: Doesn’t even the long-term stock price depend on factors outside the CEO’s control, e.g. stock market upswings, leading to “windfalls”?
A3: This is true. But, if the CEO is given a straight cash salary (as some advocate), she will likely invest most of it in the stock market (indeed, as the government encourages the public to do). It’s much better if she invests it in her own firm, whose value is mostly (although not entirely) under her control, than other firms, whose value is almost entirely out of her control. Stakeholder trust is improved if the executive is invested, quite literally, in her firm’s success. Note that the CEO would also suffer losses from stock market downturns outside her control, sharing the losses alongside ordinary people who have invested for retirement.

Q4: Shouldn’t we use non-financial measures of performance (e.g. employee satisfaction) rather than a purely financial one?
A4: Any measure of performance will be incomplete and lead to the CEO ignoring factors not captured in the measure – just as teachers evaluated according to students’ test scores will “teach to the test” and not focus on instilling a love of learning. See the concerns under “Turning to fudging” above. The stock price is not a “purely financial” measure, as it is affected by very many non-financial dimensions (see A2 above).

Q5: Won’t this just lead to greed? CEOs just work hard only because it makes them rich – shouldn’t you want a CEO to be intrinsically motivated?
A5: We absolutely don’t want CEOs who work just to make themselves money. We want CEOs who are intrinsically passionate about making products that transform customers’ lives for the better, that provide employees with a healthy and enriching place to work, and preserve the environment for future generations. Profits are a by-product of purposeful behaviour, not the end goal. As stated in my TEDx talk, The Social Responsibility of Business, this long-term congruence gives “managers the freedom to simply engage in responsible behaviour, without a calculation, without expecting anything in return. To do things for intrinsic, not instrumental value. Because even though financial rewards are not the motivation for responsibility, they typically follow anyway.”

It’s not unfair to reward CEOs who act purposefully and improve the long-term stock price as a result. Similarly, we should punish CEOs who don’t act purposefully and reduce the long-term stock price as a result. Indeed, due to a CEO’s equity holdings, a 10% fall in the stock price leads to a pre-tax pay cut of £1.5m – a significant punishment.

As a thought experiment, if your future longevity and long-term health were not affected by how much you exercised, ate, drank, and smoked today, would your behaviour change?

Q6: Isn’t an advantage of LTIPs that it’s clear what the CEO should do to get paid – e.g. hit the target? The long-term stock price is so far off, the CEO doesn’t know how to hit it, so it has little motivating effect?
A6: There’s indeed no unambiguous way to boost the long-term stock price. And that’s precisely the point. It’s clear how to hit short-term targets, which is why they encourage manipulation (e.g. cutting R&D). It’s very hard to improve the long-term stock price in instrumental ways. Instead, the CEO does so by focusing intrinsically on serving investors, employees, customers, suppliers, and society. Doing so improves the stock price as a by-product.

Q7: Doesn’t the removal of performance thresholds make pay even less sensitive to performance? Even if the CEO fails, she still keeps her shares.
A7: While the number of CEO shares doesn’t depend on performance, their value does, and this dependence can be substantial (see A5). Creating an extra sudden drop if the CEO misses a threshold simply gives short-term incentives to hit the threshold. Moreover, since there is less risk of forfeiture, the CEO should be willing to accept fewer shares.

Q8: Isn’t there evidence that CEOs excessively discount future payouts, so a long-term incentive has little effect?
A8: This “evidence” is principally interviews of CEOs, where they claim they would discount future payouts. It’s not surprising they would say this, as some would prefer short-term rewards. The actual evidence is that long-term incentives have a positive causal effect on future profitability, innovation, and CSR.

The above argument confuses the value attached by the CEO to these payouts with their incentive effect. I agree that an undiversified CEO may value £1m of stock, with a 5-year vesting period, at less than £1m, and so she migh onlly be willing to give up £900,000 of guaranteed salary to receive this £1m. Similar to the cost of a risk management system, this £100,000 difference is worth paying to ensure correct decisions. Average FTSE 100 firm size is £8bn, so if short-term incentives cause myopic actions that reduce firm value by 5%, this is worth £400m.

However, this does not mean the incentive effect falls. Assume that, by taking long-term actions, the CEO adds 5% to the 5-year equity return. The “baseline” value of the equity could be +20% or -20% due to factors outside her control – equity is indeed risky. But, long-term actions increase the future value of equity by 5%, regardless of market conditions. If there is a downturn, long-term actions boost the stock return from -20% to -15%. If there is an upturn, they boost it from +20% to +25%. Either way, long-horizon equity provides effort incentives.

Why has CEO pay risen so much faster than worker pay?

Arguably the most convincing “smoking gun” evidence that CEO pay is excessive is how it’s risen much faster than median worker pay. In the U.S., CEO pay was $10 million, 350 times that of the average worker in 2013, compared to 40 times in 1980. This seems to debunk any argument that CEOs deserve their high pay because of their talent. CEOs in 2013 were not suddenly any more talented (compared to the average worker) than in 1980, so why is the multiple nearly 9 times higher? Instead, the argument is that the CEO has the board in his pocket, and so dictates an outrageous level of pay to the board.

One of the most influential finance papers written this millennium answers this question. It’s by Professors Xavier Gabaix and Augustin Landier*, then at NYU Stern, now at Harvard and Toulouse respectively. It was published in the 2008 Quarterly Journal of Economics; while I typically write about new papers, this paper is extremely relevant to the current debate on pay ratios yet seems to be largely absent from it. The one advantage of writing about an older paper is that we can see that it’s stood the test of time – it has 1,400 Google scholar citations (one measure of impact), and was cited as a major reason for Xavier winning the Fischer Black award for the person under 40 who has contributed most to finance (similar to the Fields Medal in maths).

Their argument is as follows. High pay is justified, not because CEOs have become more talented, but because talent has become more important. It’s helpful to start with an analogy from football (soccer). Most people would agree that Wayne Rooney is not more talented than Pele. Yet, Rooney gets paid far more than Pele ever did, even adjusting for inflation. This high pay is clearly not due to Rooney having Sir Alex Ferguson (who signed him) in his pocket. Instead, it’s because talent has become more important. Football is now a multi-billion dollar industry, due to TV advertising and a global marketplace, unlike in Pele’s time. Even if Rooney is only a tiny bit better than the next-best striker (and, most ordinary people couldn’t tell the difference in a training session), these tiny differences in talent can have a huge effect on Man United’s profits. If Rooney’s goals get Man United into the Champions League, that’s worth many millions. So, it’s worth it paying top dollar for top talent.

Now, let’s translate this from the football pitch to the boardroom. Just as the football industry has got much bigger, so have firms. Firms also now compete in a global marketplace, and technology changes so rapidly that the inability to change with the times can render firms virtually extinct (compare Blackberry with Apple). Thus, just like in football, it’s worth paying top dollar for top talent. Average firm size in the Fortune 500 is $20 billion. Thus, even if a CEO is only a tiny bit more talented than the next best alternative, and contributes only 1% more to firm value, that’s $200 million. Suddenly, his $10 million salary doesn’t seem so outrageous. Moreover, the Gabaix-Landier hypothesis isn’t just an abstract theory; you can test it. Unlike many models that are qualitative, they make quantitative predictions for how much pay should rise when firm size rises. They show that the increase in pay between 1980 and 2003 can be fully explained by the rise in firm size over that time. An update studying 2004-11 shows that subsequent changes were also linked to firm size – in 2007-9, firm size fell by 17%, and CEO pay by 28%.

But, why doesn’t this argument apply to employees? Because the CEO typically has a multiplicative effect on firm value. Their actions are scalable. For example, if the CEO implements a new production technology, or improves corporate culture, this can be rolled out firm-wide, and thus has a larger effect in a larger firm. 1% is $20 million in a $2 billion firm, but $200 million in a $20 billion firm. In contrast, most employees have an additive effect on firm value. Their actions are less scalable. An engineer who has the capacity to service 10 machines creates $50,000 of value regardless of whether the firm has 100 or 1,000 machines. In short, CEOs and employees compete in totally different markets, one which scales with firm size and the other which scales less so. “Fair” CEO pay is determined by comparing a CEO to other CEOs, just like a manager decides how much to pay an international footballer by comparing to another international footballer, not a reserve-team player at the same club (due to notions of “fairness”), or even to the CEO of Man United, as they compete in different markets.

Of course, this all assumes that CEOs actually create value in the first place. We can see Rooney score goals, and how the Man United team is weaker when he’s injured. He’s one of only two strikers. But, the CEO is one of thousands of employees; surely he has only a tiny impact on firm value? But, this can be studied as well. I already wrote here and here how the CEO’s contract has significant effects on firm value, suggesting that the CEO matters. Various papers (e.g. here, here, and here) have shown that CEO departures and deaths have a significantly negative effect on firm value and performance, and that the effect is stronger for well-paid CEOs, suggesting that pay is indeed reward for talent. You might be skeptical, because correlation doesn’t imply causation. Perhaps the firm was going to do badly anyway, and that’s why the CEO left (he deserted a sinking ship) or died (due to the stress). So, another paper looks at the effect of CEO family deaths, which are likely not caused by expectations of firm performance. If the CEO’s spouse, parents, children, or siblings die, this distracts the CEO. If the CEO didn’t matter (since there are so many other executives), this bereavement would be unimportant. But, they show that it has significant negative effects on profitability. The exception is that, if the CEO’s mother-in-law dies, profits go up (although the effect is statistically insignificant).

In short, looking at pay ratios is misleading, as CEOs and workers compete in different markets. What matters is welfare rather than equality. However, constraining CEO pay can drive top talent to other countries (or to private firms, or to other professions such as hedge funds), reducing firm performance and hurting everyone. Welfare is best achieved not by bringing the CEO down, but hiring a talented CEO who can bring everyone else up (and good CEOs do, as shown here). Good CEOs increase the size of the pie; they will naturally capture a large slice of the increase, due to the scalability of their talent, but other employees and society still get a larger slice than if the CEO were not hired, or not incentivized. Bad CEOs shrink the pie for everyone; this increases equality, but only by making everyone equally poor.

* Full disclosure: I have coauthored one paper with Xavier and Augustin (which provides evidence that CEOs have a multiplicative effect on firm value), and have written several more papers with Xavier. However, the impact that the paper has had illustrates the esteem the paper is held in by the academic profession more generally.

Long-Term Executive Incentives Improve Innovation and Corporate Responsibility

Executive compensation is fixed and needs reform. But, most of the calls for reform focus on the wrong dimensions. They focus on the level of pay, or the ratio of executive pay to median worker pay – even though the evidence suggests that low ratios are linked to lower future performance. As I have argued in the Wall Street Journal and World Economic Forum, the most important dimension is the horizon of pay – whether it depends on the short-term or long-term.

We certainly want executives to act in the interest of society, and for a more equal society. But, the way to increase equality is not to bring CEOs down, but to induce them to bring others up. Treating stakeholders (workers, customers, suppliers, the environment) well is costly in the short-term, but the evidence shows that it pays off in the long-term. So the best way to encourage purposeful behavior is not to scrap equity incentives (thus decoupling pay from performance), but extend the horizon to the long-term.

The trouble is that it’s hard to find causal evidence of the effects of long-term compensation. This is because long-term compensation is not randomly assigned. If long-term compensation were correlated with superior long-term performance, it could be that incentives caused good performance – or that executives who knew that long-term prospects were good were willing to accept long-term incentives to begin with. An excellent paper shows that total stock ownership is associated with superior future performance, and the relationship is likely causal, but they do not look specifically at vested stock ownership, not restricted stock ownership which the CEO is forced to hold for the long-term.

An insightful new paper by Professors Caroline Flammer (Boston University’s Questrom School of Business) and Pratima Bansal (University of Western Ontario’s Ivey School of Business) addresses this causality issue. It studies shareholder proposals that not only are on executive compensation, but specifically advocate the use long-term incentives (rather than advocating, say, cutting pay) – restricted stock, restricted options, or long-term incentive plans. However, simply looking at all proposals wouldn’t get round the causality issue. It could be that shareholder proposals arise due to a large engaged blockholder, and it could be the blockholder – not long-term compensation – that improve future performance. So, Caroline and Tima use a “Regression Discontinuity Design”. They compare proposals that narrowly pass (with 51% of the vote) to those that narrowly fail (with 49% of the vote). Whether you narrowly pass or narrowly fail is essentially random, and uncorrelated with other factors such as the presence of blockholders – if there were large blockholders, they would likely increase the vote from 49% to (say) 80%, not 51%.

They find that proposals to increase long-term compensation improve long-term operating performance, regardless of whether you measure it using return on assets, net profit margin, or sales growth. Interestingly, operating performance decreases slightly in the short-run, highlighting the fact that long-term orientation requires short-run sacrifices. But, the long-run benefits outweigh the short-term costs – firm value rises overall.

What’s the mechanism by which this happens? Skeptics might think that long-term CEOs might fire their workers – this is costly in the short-term (due to severance pay) but saves wages in the long-term. This is not the case. There are two channels, both of which are beneficial to society – so the rise in firm value is also socially optimal:

  • Innovation improves. Firms increase R&D. Moreover, they are not simply spending money blindly – this higher R&D expenditure leads to
    • More patents
    • Higher-quality patents (measured by citations per patent)
    • More innovative patents (measured by the distance from firms’ existing patents)
  • Corporate responsibility improves. Firms’ CSR ratings improve significantly, as measured by KLD ratings of a firm’s stewardship of four stakeholder groups: employees, the environment, customers, and society at large. The effects are strongest for employees; one of my own papers shows that employee satisfaction in turn improves firm value

The goal of any pay reform should be to act in the long-term interests of society.  Leading compensation expert Kevin Murphy forcefully argues that politicians’ desire to cut the level of pay is not driven by social considerations (given there is no evidence that cutting pay levels improve behavior), but jealousy and envy, or the desire to appear tough. Ironically, despite emphasizing the importance of thinking long-term, politicians’ proposals to regulate the level of pay are incredibly short-term. There will be an immediate gain in public approval from appearing tough, but the long-term benefits of instead making compensation more long-term are much more important.

As an aside, Caroline previously used Regression Discontinuity in an excellent paper, published in Management Science, which shows that CSR proposals (again, those that pass by a small margin) significantly increase shareholder value and profits. This is a powerful result, since many naysayers argue that CSR is at the expense of shareholder value. Instead, businesses and society are in partnership with each other, not in conflict. As I argued in my TEDx talk, “to reach the land of profit, follow the road of purpose”.

 

Why the MSCI Study Does NOT Show That Equity Incentives Backfire

MSCI have released an impactful study entitled “Are CEOs Paid for Performance? Evaluating the Effectiveness of Equity Incentives”, purporting to show that equity incentives lead to poor long-term performance. In simple language, they just don’t work. This study has been highly influential and seized upon by the Wall Street Journal, CNN, and Fortune as “smoking gun” evidence that incentives backfire. It’s also central to UK MP Chris Philp’s proposal for pay reform that was recently presented in Parliament.

I applaud MSCI for taking an evidence-based approach to CEO pay. Rather than proposing reform, they first start by looking at the evidence. In addition, the paper (in many parts) is written objectively and modestly, just describing the results without making any policy proposals; it is others who have since over-extrapolated from it. However, it does not actually show what it purports to show. Given the importance of CEO pay to society, and given the impact that this report has had on leading thinking, I thought it would be useful to clarify what they actually find.

The “punchline” graph, quoted in Philps’ report, is given below, which shows a (weakly) negative link between CEO pay and long-term shareholder returns:
msci

The authors argue that it shows that “Companies that awarded their CEOs higher equity incentives had below-median returns”. This conclusion is unwarranted, for the following reasons:

  1. They study Total Summary Pay, not Equity Incentives

As can be seen in the above graph, the y-axis is “Total Summary Pay”. This includes newly-granted stock and options, but also many other components, such as salaries and bonuses. Thus, it is very inaccurate to describe the results as being about “equity incentives”. Equity incentives are certainly one component of pay, but there are many other components as well. Higher summary pay does not mean higher equity incentives. Similarly, you would never say that, because “Total Shareholder Return” (TSR) was low, dividends must be low. Dividends are an important element of TSR, but not the only element (capital gains are also important).

  1. Even the Equity Incentives they do capture miss almost all the action

Total Summary Pay does include newly-granted stock and options. But, as I wrote previously in “Eight Common Myths About CEO Pay“, the vast majority of a CEO’s incentives come from previously-granted stock and options. As shown by Jensen and Murphy (1990),  the most-cited study on CEO incentives in history, incentives from previously-granted equity are several orders of magnitude higher than new equity grants. (As a simple example, Steve Jobs was famously paid $1 a year at Apple, and so no new equity in some years. Does this mean he didn’t care about performance?  Clearly not, because he had hundreds of millions of previously-granted equity.)

Willis Towers Watson, the leading compensation consultant, give a separate critique of the MSCI incentive measure in their article “The media and the MSCI study: A textbook case of missing the boat?

  1. They miss out many important control variables

The headline result, in the above graph, does not control for firm size. This is a serious omission since it is well-known that small firms pay less, and small stocks typically outperform. (See my earlier post, “Size Matters, If You Control Your Junk“). They do control in a robustness test, but this should be in their main specification.

Moreover, even the robustness test omits obvious controls, such as risk. It’s well established that riskier firms pay more, and also deliver lower stock returns, which could be driving the results.

  1. The results do not show a causal effect of CEO pay

Even if there were a strong negative link between CEO pay (or incentives) and future stock returns, they do not show a causal relationship. To be fair, MSCI don’t make causal inferences, but media outlets do, e.g. the Wall Street Journal state the MSCI study asks if “high CEO pay helps drive better results”. It could be that future stock returns cause current pay. A firm that has bleak future prospects will have to pay a CEO more to attract her in the first place.

So, what does a correctly-done study show? As I wrote in “Higher Stock Returns When CEOs Own More Shares“, von Lilienfeld-Toal and Ruenzi show in an excellent Journal of Finance paper that firms with higher CEO stock ownership – considering all ownership, not just newly-granted shares – outperform low-ownership firms by 4-10% per year over the long-run.

Is this study also subject to the correlation/causation critique? Perhaps CEOs who know that their firm will do well in the future will be more willing to accept stock (rather than cash) in the first place. So, to suggest that the effect is causal – high equity causes the CEO to take better decisions – the authors show that the effect is stronger in settings in which the CEO has greater discretion. These are firms in which:

  • Sales growth is high, which gives the manager resources (e.g. free cash) that she could waste, as well as power (the board is less likely to interfere if the CEO has delivered high sales growth)
  • Low institutional ownership and weak external governance – when investors are not monitoring the CEO, she has greater discretion
  • Weak product market competition. If the product market is competitive, the CEO has to maximize value (even if she had weak equity incentives) to stay in business; if there’s little competition, she can slack off
  • The CEO is the founder, also correlated with power

Pay certainly should be reformed. I have argued for such reform vigorously in the Wall Street Journal and World Economic Forum.  But, just like a doctor needs to make an accurate diagnosis before prescribing the remedy, before proposing any reform, we need to start with the facts – what are the areas in most serious need of remedy, and what are the ones that are working well? This is the role of academic research. To be published in the Journal of Finance, von Lilienfeld-Toal and Ruenzi had to present their paper at many academic conferences and seminars, and undergo stringent peer review. While peer review is far from perfect, this reduces the risk that incentives are mismeasured, or the study makes claims that it does not actually show. The above link shows that their paper was first posted in 2009 and took 5 years to be published, while they refined it to ensure the findings are solid.

MSCI should absolutely be credited for their evidence-based approach, and I again reiterate that many of the causal claims are made by the media, rather than them. However, one statement does cause concern: they write that “While we have not completed a full statistical evaluation of this relationship, we believe the findings are sufficiently compelling to serve as a basis for further review and discussion regarding this widely debated aspect of corporate governance.

Thus, even they recognize that their findings are half-baked. But, you would never report the results of a medical study (e.g. a clinical trial on a drug), until it was complete. Doing so would be completely irresponsible. Unfortunately, it is also irresponsible in an economic context, where it may lead to laws being passed or decisions being taken based on inaccurate evidence (see the recent Brexit referendum). While academic studies are released in “working paper” form, before eventual publication, this is typically after presenting it and sending to peers first – the authors have taken it as far as they can and are now soliciting outside suggestions. Here, the authors know that they have not taken it as far as they can and the evidence is incomplete, yet MSCI has been taking out full-page adverts in newspapers and magazines parading this study. CEO pay is such an important for society that we must ensure that any evidence we use to suggest policy reform is solid, rather than half-baked.

How Virtually Every Pay Regulation Has Backfired

Few topics make the public as angry as CEO pay. In the UK, the average FTSE 100 CEO earned £5.4m in 2015, 148 times the median worker. For US S&P 500 CEOs, these figures are even more extreme: $12.4m and 335 times.

This pressures politicians to do something about CEO pay. Indeed, regulating pay might nowadays be an even better way of winning the public’s approval than tax cuts and spending increases. In the US, both Donald Trump and Hillary Clinton have been unusually united in blasting the high levels of CEO pay. The UK’s new Prime Minister, Theresa May, has proposed putting workers on boards, making say-on-pay votes binding rather than advisory, and forcing firms to disclose the ratio of CEO pay to median worker pay.

But, let’s take a step back. First, it’s not actually clear that CEO pay is a problem to begin with. In an earlier post, I explained that many accusations are based on myths, which simply don’t hold up when you look at the evidence. Second, even if it were, regulation may not be the best way to fix it.

In an excellent article, “The Politics of Pay“, Kevin J. Murphy of the University of Southern California (one of the world’s leading experts in executive pay) argues that the entire history of U.S. compensation legislation is littered with unintended consequences. Simply put, 80 years of evidence shows that regulating pay doesn’t work.

How can politicians keep getting it so wrong? Because their motivation for regulating isn’t to increase social welfare or curb inequality, but to appear tough. When a pay scandal breaks out- even if it’s a single isolated incident – the public demands that politicians do something. For a politician, taking a bad action is better than taking no action. Here are three examples:

1. Golden Parachutes

In 1982, William Agee, the CEO of Bendix, was given a $4.1 million golden parachute after his firm was taken over. The public was outraged, and demanded that Congress do something about it. It responded in 1984 by imposing severe tax penalties on golden parachutes that exceeded 3x salary. Sounds reasonable – surely taxes would deter such excessive payments? But in fact, it encouraged them.

  • Companies Introduced Golden Parachutes. Back in 1982, golden parachutes were fairly rare. But, the new law alerted CEOs to this attractive clause. So, many CEOs who previously hadn’t heard of golden parachutes now demanded them.  By 1987, 41% of the largest 1,000 firms had golden parachutes, which rose to 70% by 1999.
    • Murphy shows that this problem isn’t specific to golden parachutes. Most laws forcing disclosure of perks led to CEOs receiving more perks, as they now saw what their peers were getting and demanded to get the same.
  • Companies Increased Golden Parachutes. The “3x salary” cap implicitly suggested that a golden parachute is OK as long as it doesn’t exceed 3x salary. So firms who had modest golden parachutes prior to 1982 suddenly increased them to 3x salary. By 1991, 47.5% of golden parachutes were at this level; by 1999, this was 71%.
  • Companies Introduced Tax Gross-Ups. Some in-demand CEOs got the company to pay the tax themselves. And, even though these tax gross-ups were introduced in response to taxes on golden parachutes, they subsequently spread to company cars, club memberships, and corporate jets. Congress unleashed a monster.

2. The Clinton $1 million cap

In his 1992 election campaign, Bill Clinton (foreshadowing his wife 14 years later) lambasted CEO pay as being excessive. A year after his election, Congress changed the tax code to prevent companies enjoying tax deductions on salaries exceeding $1 million – unless they were performance-based. This again backfired:

  • Companies Increased Salaries to $1m. The new code implicitly suggested that a high salary is OK as long as it doesn’t exceed $1m. Sound familiar? Clinton could have learned from history and seen what had happened with golden parachutes. But, his incentives were not to create social value; instead to appear tough.
  • Companies Paid Bonuses For Mediocre Performance. Let’s say a firm needs to pay a CEO $1.5 million to attract her, because she’s uniquely qualified. How can it do so without suffering tax penalties? It pays her $1 million, and reclassifies the other $0.5 million as a bonuses with a easy-to-meet target, so it’s effectively guaranteed. This defeats the whole point of bonuses – they should only be given for good performance.
  • Stock Options Increased. Since stock options are performance-based, their use started to significantly increase. Murphy points out other tax and accounting rules that also led to the explosion of stock options. So, if people complain about excessive stock options, it’s regulators they should be complaining about.

3. The EU Banker Bonus Cap

The problem isn’t confined to the US. A separate Murphy article, “Regulating Banking Bonuses in the European Union: A Case Study in Unintended Consequences“, addresses the European Union’s cap limiting banker bonuses to two times salary. There are several problems:

  • Increased Salaries. To remain competitive (with non-EU banks), a fall in bonuses must be accompanied by an increase in base salaries. Thus, if the bank fails and the banker gets no bonus, he gets a higher salary (for non-performance) than he would have before.
  • Increased Bankruptcy Risk. The advantage of bonuses is that banks can cut them when times are hard, and so remain solvent. You can’t cut salaries. This increases the risk that banks go bankrupt – ironic since the main driver for regulation was the financial crisis.
  • Reduced Incentives. The reduction in bonuses decouples the banker’s pay-for-performance. This reduces his incentive to manage risk as, even if the bank performs poorly, he still receives a high salary. It also reduces his incentive to create value by innovating, as he captures less of the upside. Just following the status quo is enough to be well-compensated.

Perhaps you might think – there’s nothing wrong with regulation, but it’s sneaky firms responding to regulation (e.g. by reclassifying salaries as bonuses). This argument is false on two grounds. First, responding to regulation may not be devious. It may well be that the firm truly needs to pay $1.5m to attract the CEO, and so get around the regulation legally. This is little different to a restaurant getting around liquor license laws by allowing diners to bring their own alcohol. Second, even if the response is devious, it’s how firms and CEOs actually behave. You might say – in an ideal world, CEOs shouldn’t demand perks when they find out about their peers’ perks. But, we don’t live in the ideal world, we live in the real world. A textbook solution only works in textbooks; any real-world solution should take into account how people behave in the real world.

So, what is the solution? To do nothing? Far from it. But, to leave the decisions to major shareholders, who have the incentive to get these decisions right. High CEO pay comes straight out of shareholder returns, and if the contract causes the CEO to take bad decisions – or demoralizes employees – shareholders suffer the consequences. And, things are being done. 11 countries have passed say-on-pay legislation since 2002; Correa and Lel (2016) show that it reduces pay and increases pay-performance sensitivity. Interestingly, advisory votes are more effective than binding votes – in contrast to politicians’ desire to take the toughest possible action. We have also seen innovation in other dimensions of pay – lengthening vesting horizons (to encourage the CEO to think long-term) and paying with debt rather than just equity (to dissuade excessive risk-taking).

Moreover, when pay is inefficient, it is often a symptom of a more underlying governance problem, brought on by conflicted boards and dispersed shareholders. Addressing pay via regulation will solve the symptoms; encouraging independent boards and large shareholders will solve the problem. That will improve not only pay, but other governance issues.

The bottom line is that, to the extent pay is a problem, it should be shareholders, not politicians, who fix it. Leaving it to shareholders is like a doctor choosing self-cure rather than amputating a limb. The amputation is the most dramatic action, but may not be the most effective. The goal of policy shouldn’t be to write headlines, but to create long-term value for society.

Eight Common Myths About CEO Pay

Few business topics capture the public’s interest – and ire – as CEO pay. Indeed, a major reason why executives carried little weight in the Brexit referendum was the belief that they are overpaid crooks.

But, does perception actually match reality? The public’s view is largely shaped by what the media reports. And, the media has the incentive to report the most egregious cases – of CEOs being paid millions despite poor performance – because they make for good stories.  There might be thousands of cases where pay is fair, which never get reported.  This is similar to how views on immigration (another topic misunderstood in the referendum) may be skewed by newspapers only reporting stories of benefit-scrounging immigrants, when there may be millions of others who work hard and pay taxes.

Note that I’m not saying that CEO pay is perfect and should be untouched. I’ve argued on multiple occasions, e.g. in the Wall Street Journal and World Economic Forum, that pay should be reformed.  But, just like a doctor needs to make an accurate diagnosis before prescribing the remedy, before proposing any reform, we need to start with the facts – what are the areas in most serious need of remedy, and what are the ones that are working well? We want to avoid amputating a limb that’s actually healthy. And the facts highlight that many myths about CEO pay are simply untrue.

  1. CEO wealth is not sensitive to performance

This myth is based on the view that salaries and bonuses are relatively insensitive to performance. But, changes in salaries and bonuses are only a very small part of the CEO’s overall incentives. The biggest component is her stock and option holdings. Some studies take into account stock and options granted this year, but we must also take into account all stock and options granted in all previous years.  What matters is wealth-performance sensitivity, not pay-performance sensitivity – i.e. the sensitivity of the CEO’s entire wealth to performance.

As a simple example, Steve Jobs was famously paid $1 a year at Apple, regardless of performance.   Does this mean he didn’t care about performance?  Clearly not, because he had hundreds of millions of his own wealth invested in the company’s stock.  Taking this into account, the median S&P 500 CEO loses $480,000 when the stock price falls by just 1%. Moving to the UK, data from PwC shows that this figure is £85,000 for the median FTSE 100 CEO. It’s smaller, but still substantial, and if anything the comparison might suggest that UK CEOs need more equity compensation, not less as many politicians claim.

Sir Vince Cable, the former UK Secretary of State for Business, Innovation, and Skills, has frequently quoted studies claiming that CEOs are not punished for poor performance. But, these studies simply do not measure incentives properly. They only study salaries and bonuses and ignore the CEO’s shareholdings.

  1. CEOs are overpaid because shareholders are powerless

The myth is that pay is designed by directors who are in the CEO’s pocket, and rubber-stamp egregious packages.  Shareholders are too small for directors to listen to them.

So, what happens when shareholders can run the show? Evidence shows that, when private equity firms and hedge funds take large stakes in firms, they’re not afraid to make major changes. They improve operating performance, increase innovation, and even fire the CEO in many cases. But they very rarely cut the CEO’s pay. While large investors see many things to fix in a firm, the level of pay doesn’t seem to be one.

  1. High equity incentives causes poor performance

The myth is based on a well-cited recent study by MSCI which finds that CEOs paid below the median underperform those who pay above the median.  Quite apart from correlation not implying causality, the study does not measure equity incentives properly. I describe these issues in further detail here.

  1. Incentive pay doesn’t work

There are many studies that show that incentives don’t work for many jobs.  This is because performance measures only capture one dimension of performance. For example, paying teachers for test results may encourage them to teach-to-the-test. But, none of these studies are on CEOs. For CEOs, there is an all-encompassing performance measure – the stock price. In the long-run (an important caveat), the stock price all CEO actions, including employee satisfaction,  customer satisfactionenvironmental stewardship, and patent citations.

Indeed, a comprehensive study finds that CEOs with high stock ownership outperform those with low share ownership by 4-10% per year. Moreover, further tests suggest that it’s share ownership that causes outperformance, rather than CEOs who predict that their stock will outperform being more willing to accept shares in the first place.

  1. The level of pay is the most important dimension

Virtually all the debate on CEO pay concerns the level of pay – for example, calls to regulate or disclose the level of CEO pay relative to the level of employee pay.  But, this level has very little effect on firm value. Average CEO pay in the US is $10 million, compared to average firm size of $20 billion. That’s only 0.05% of firm value. Far more important is the horizon of pay – e.g. whether equity vests in the long-run or short-run. For example, high employee satisfaction improves firm value by 2-3%/year, but takes 4-5 years to fully show up in the stock price. Extending the vesting horizon from 3 years to 6 years will encourage CEOs to invest in employee satisfaction.  It is better to focus on reforms that create 2-3% of firm value, not 0.05%.  (And, employees benefit more from the former also).

Indeed, this excellent study shows that lengthening the horizon of equity incentives has a positive causal effect on both firm value and operating performance. The channel is that it leads CEOs to increase both innovation and stakeholder relations. This makes total sense – such investments take a long time to pay off, so only far-sighted CEOs will undertake them. Thus, if we want companies to be more innovative and purposeful, lengthening horizons is much more effective than cutting pay. Rather than bringing CEOs down (by reducing their pay), we want to encourage them to build others up (by increasing their horizon).

  1. High pay inequality causes poor performance

Even if pay levels have little direct effect, perhaps they have an important indirect effect through affecting morale? But a recent study finds that firms with higher within-firm pay inequality exhibit higher operating performance and higher long-run shareholder returns.  While the authors are careful not to claim causality, their correlation clearly does not support concerns that “high pay disparities inside a company … have a negative impact on a company’s overall performance”

  1. Binding say on pay is better than advisory say-on-pay

UK Prime Minister Theresa May advocates moving from advisory say-on-pay to binding say-on-pay. It just sounds tougher. But, a careful study of 11 countries that has found that advisory say-on-pay has proven more effective than binding say-on-pay in both decreasing the level of pay and increasing its sensitivity to performance.

  1. Putting employees on boards improves performance

Theresa May also suggests putting worker representatives on director boards.  But, this has been tried in Germany.  Companies with greater representation on employees on the board have significantly lower value.

There are clearly many dimensions of the pay debate for which facts don’t apply.  For example, whether should be driven by efficiency or equality is a subjective topic about which reasonable people can disagree.  And, even given a set of facts, reasonable people can disagree on how to interpret them.  But, we should at least start the discussion with facts, rather than myths and hunches.  Companies cannot launch a new drug without providing evidence that it’s safe and effective.  In contrast, politicians and policymakers feel they can make calls for reform without even attempting it to back it up with evidence.  Just as evidence-based medicine has led to vastly superior medical decisions, evidence-based policy can ensure that any reforms we do make benefit society as a whole.

Higher Stock Returns When CEOs Own More Shares

Executive compensation is a controversial topic. US CEOs earn 373 times the average worker, and so it takes them less than a day to earn the same as an average worker does in a whole year. But, despite attracting most attention and ire, the level of pay is actually not so important for firm value. Average pay in a top-500 firm is $13.5 million – huge in anyone’s eyes. But, the average size of a top-500 firm is $10 billion, so the salary is only 0.135%. That’s not to say that the level of pay doesn’t matter – a firm can’t be blasé about $13.5 million (else you could justify every wasteful expenditure saying that it’s small compared to firm value) – but other dimensions of pay may be more important.

In particular, much more important than the level of pay is the sensitivity of pay – how it varies with performance. But, this dimension is also controversial, in particular the use of bonuses. Bonuses are often awarded for “on-target” performance (whereas many rank-and-file employees simply get their salary for “on-target” performance; the performance targets can be too easy; and the CEO can game the system, focusing on one target to the exclusion of others. For example, a bonus based on sales or earnings growth may cause the CEO to ignore corporate culture. In addition, while an even higher bonus is paid for good (rather than on-target) performance, the bonus is sometimes barely reduced for poor performance – it’s an asymmetric “heads I win, tails I don’t lose” scenario.

Equity compensation – giving the CEO shares – solves many of these issues. In the long-run, the stock price captures all the channels through which the CEO can improve firm value – if he pollutes the environment, invests in his workers, engages in a restructuring, all of these actions eventually affect firm value. (Of course, the key words are “in the long-run”, so the stock should come with a long vesting period). There is no ambiguity as to which measure to reward (sales growth or earnings growth?) or what target to set (2% or 5%?), nor asymmetry – the value of the CEO’s shares rises with good performance and falls with bad performance.

But, where’s the evidence? In an excellent paper in the 2014 Journal of Finance, Ulf von Lilienfeld-Toal and Stefan Ruenzi find that a strategy of buying shares in which the CEO has a high level of stock ownership, and shorting shares in which he has low ownership, earns 4-10%/year (depending on the definition of “high” and “low”). This result suggests not only that CEO incentives “matter”, but also that the market doesn’t recognize that they matter. Even though CEO ownership is public information, the market doesn’t take it into account (perhaps because, like the media, it’s focused on the level of pay) – and so investors can earn superior returns by trading on it.

Of course, correlation doesn’t imply causation. The positive relationship could be because CEOs have inside information on firm value, and are more willing to accept stock (rather than cash) when they expect future stock returns to be high. So, to suggest that the effect is causal – high equity causes the CEO to take better decisions – they show that the effect is stronger in settings in which the CEO has greater discretion. These are firms in which:

  • Sales growth is high, which gives the manager resources (e.g. free cash) that he could waste, as well as power (the board is less likely to interfere if the CEO has delivered high sales growth)
  • Low institutional ownership and weak external governance – when investors are not monitoring the CEO, he has greater discretion
  • Weak product market competition. If the product market is competitive, the CEO has to maximize value (even if he had weak equity incentives) to stay in business; if there’s little competition, he can slack off
  • The CEO is the founder, also correlated with power

Like any paper, there are a few unanswered questions. The authors only include stock that the CEO voluntarily holds (i.e. has vested but the CEO has not sold). They don’t include unvested stock, nor options. Both unvested stock and options also provide the CEO with incentives to maximize value, so I would be interested to know whether the results hold when including these dimensions also (and any investor wishing to use this as a trading strategy might want to back-test the strategy including all incentives – vested stock, unvested stock, and options). Regardless, the paper makes a very important contribution highlighting the dimensions of CEO compensation that investors, the media, and the public should focus on – the sensitivity rather than level of pay, and suggesting that equity ownership may have a causal effect on firm performance rather than simply reflecting the CEO’s private information.