Moshe Levy is a professor at the Hebrew University of Jerusalem, Jerusalem School of Business Administration. This post is based on a recent paper by Professor Levy. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here ).

It is well-known that CEOs are sometimes rewarded for luck. The classic example is that of oil company CEOs whose compensations increase with the price of oil (Bertrand and Mullainathan 2001). This has been show to hold for other factors that are both outside the control of the manager, and observable to the boards who grant compensation, yet rarely adjust it for these factors. My paper is an attempt to estimate the magnitude of the pay-for-luck component in option-based compensation. How much of the “pay-for-performance” compensation is actually paid for luck?

The answer to this question depends on the ratio between the manager’s talent, T, defined as her ability to increase the firm’s average return, and the inherent “noise” in the stock’s returns, as measured by the standard deviation of returns, σ R . We develop an analytical expression for the proportion of option-based compensation that constitutes pay-for-luck as a function of the ratio σ R ∕ T. We show that this proportion grows very quickly with σ R ∕ T. For the empirically estimated parameters the pay-for-luck component exceeds 90% of the compensation. This result is robust, and stems from the fundamental fact that chance plays a dominant role in determining firm performance.

The large pay-for-luck component implies that, perhaps in contrary to widespread belief, standard option-based compensation does not constitute a strong motivational force for the manager. Indeed, we show that an option’s motivational force is inversely related to its pay-for-luck component. Consider, for example, a manager with talent T=2%, i.e. a manager who can increase the firm’s average annual return by 2% if she exerts effort and manifests her talent. Alternatively, the manager can refrain from exerting effort to manifest her talent, in which case the firm’s average return will be the same as the industry average. By how much does the manager’s expected compensation increase as a result of her effort? We show that for standard non-indexed at-the-money options and realistic parameters the increase is only about 12% relative to the case of exerting no effort. This does not seem to constitute a very strong motivational force. It seems likely that other factors, such as ego, self-fulfillment, and the desire not to be perceived as lazy, are likely much more effective motivating forces. We find that indexing the option to the market (or industry, or both) and setting its strike price 50% higher than the granting-day price almost doubles the option’s motivational force.

Employee stock options may very well be a desirable component of executive compensation. This paper shows that the standard form of option compensation, with non-indexed at-the-money options, is very far from optimal, though, as its pay-for-luck component is in the ballpark of 90%, and its motivational power is rather low. Why are such options the standard practice? A possible answer is provided by the “skimming” view of Bebchuk and Fried (2009). Indexing the option, and setting the strike price much higher than the granting-day price almost doubles the option’s motivational power. It is thus hard to justify the current norm of granting options at-the-money and not indexing them to the industry or market returns.

The full paper is available for download here.