Ironing out the kinks in executive compensation: Linking incentive pay to average stock prices

Traditional stock option grant is the most common form of incentive pay in executive compensation. Applying a principal-agent analysis, we find this common practice suboptimal and firms are better off linking incentive pay to average stock prices. Among other benefits, averaging reduces volatility by about 42%, making the incentive pay more attractive to risk-averse executives. Holding the cost of the option grant to the firm constant, Asian stock options are more cost effective than traditional stock options and provide stronger incentives to increase stock price. More importantly, the improvement is achieved with little impact on the option grant's risk incentives (after adjusting for option cost). Finally, averaging also improves the value and incentive effects of indexed stock options. (C) 2012 Elsevier B.V. All rights reserved.