Excess Pay = Excess Investor Trouble

Three professors have just released a study that finds that firms whose boards overpay executives also create abnormally low returns for investors "for periods up to five years after sorting on pay. For example, firms that pay their CEOs in the top ten percent of pay earn negative abnormal returns over the next five years of approximately -13%. The effect is stronger for CEOs who receive higher incentive pay relative to their peers." The results "are consistent with high-pay induced CEO overconfidence and investor overreaction towards firms with high paid CEOs."

For every dollar overpaid to a CEO, they found, investors lose $100. Indeed, "firms in the highest compensation decile earn significant negative excess returns. The performance worsens significantly over time. We find that the worst component of incentive pay for future performance is the value of options granted and long-term incentive payouts to executives. The proportions of these two components in total compensation are significantly negatively related to the excess return earned by the firm."

After Congress imposed heavier taxes on high cash payouts, CEOs and boards moved to stock options as a way to align the interests of executives with those of shareholders. While some of the results surely proved beneficial, some CEOs also got into the game of "managing earnings"through accounting tricks, or pursuing short-term strategies to boost earnings.