CEO retirement benefits: The determinants of CEO pension and deferred compensation Gemma Lee College of International Studies Kyung Hee University Phone: 82-31-201-2213 gemma.lee@khu.edu Hongfei Tang Stillman School of Business Seton Hall University Phone: 1-973- 761-9428 hongfei.tang@shu.edu Current Draft: September 21, 2013 Abstract Although inside debt, such as executive pension and deferred compensation, constitutes a significant portion of CEO compensation packages, its determinants and vesting exercise have not been widely examined in the executive compensation literature. Using a large sample of S&P 1,500 firms from 2006 to 2008, we examine the main determinants of annual inside debt compensation and the relative strength of inside debt-to-equity holdings. We find that powerful CEOs, as measured by a larger board, CEO/chair duality, and a higher degree of anti-takeover provisions (ATPs), are more likely to obtain a large amount of annual inside debt compensation. In addition, as the probability of bankruptcy increases, CEO compensation exhibits a higher balance of inside debt compared to equity incentives, such as stock and stock option holdings. This finding is further supported by evidence that powerful CEOs are likely to withdraw their deferred compensation before retirement. However, the withdrawal occurs when the ratios of inside debt-to-equity balances of CEOs are large enough to incent the action and when the probability of bankruptcy is insignificant. Thus, the overall evidence suggests that inside debt serves as an important alignment role with debt holders despite the existence of CEOs rent extracting incentives. JEL classification: G30; G32; G33; G34; Keywords: Executive compensation; CEO pay; Managerial incentives; Pension; Deferred compensation; Deferred compensation withdrawal We acknowledge helpful comments from John Core, Gady Jacoby, Jen Itzkowitz, John McConnell, Veronika Pool, Laura Starks, Eleanor Xu and workshop participants at Seton Hall University and George Washington University. Special thanks go to David Yermack for his valuable comments and suggestions.
I. Introduction Broadly, in the case of publicly traded firms, executive compensation packages consist of a base salary, short-term performance bonuses, stock participation plans, pensions, and deferred compensation. To date, studies on executive compensation have concentrated on two of these components, cash and equity-based instruments. They overlook, however, the additional insights that research on pension and deferred compensation plans can reveal. 1 As the cash and equity components continue in the public policy spotlight, the incentive to move a significant portion of compensation into the less noticeable categories of pension and deferred compensation plans can increase. For example, Retired Bank of America Corp. Chief Executive Kenneth Lewis left with about $83 million in pension and insurance benefits, stock and other compensation, according to a securities filing Friday... Mr. Lewis, who retired Dec. 31, got 2009 compensation of $4.2 million. That came largely from an increase in the value of his pension benefits. Mr. Lewis agreed last fall to give up his 2009 base salary and any chance at a bonus at the request of Treasury Department pay czar Kenneth Feinberg, who made the request based on concerns about the amount of benefits Mr. Lewis could collect upon retirement. According to the filing, the 62-year-old Mr. Lewis is eligible for about $57 million in pension benefits, about $11 million in deferred compensation and an additional $4.6 million in vested and unvested stock. He also left BofA with a life-insurance policy valued at $10.3 million, but those benefits won't be paid out until he and his wife die. 2 From the perspective of a firm, the payment structure of pension and deferred compensation plans is similar to debt contracts, with the liability equaling the present value of the payments promised to its employees. Therefore, these contracts are often referred to as inside debt, a term attributed to Jensen and Meckling (1976). Several prior studies provide insights into the implications of pension plans in CEO 1 This is partially attributed to data availability. Information about pension and deferred compensation has not been available in the ExecuComp database until 2006. We explain recent disclosure rule changes in detail in Section II. 2 Retirement benefits for BofA s Lewis: $83 Million, Dan Fitzpatrick, Wall Street Journal, Feb 27, 2010. Pg. B3. 1
compensation packages. However, given that SEC disclosure requirements on pension and deferred compensation were not fully established until 2006, previous inside debt studies are limited to relatively small, hand-collected samples. 3 Since December 15, 2006, the amended SEC disclosure rules require companies to report the present value of accumulated pension benefits and the aggregate balance of nonqualified deferred compensation for each top executive and each plan. 4 These new requirements enable us to examine the determinants of the annual inside debt compensation, the relative strength of inside debt and equity compensation balances, and its vesting exercise for 2,242 CEO-year observations drawn from S&P 1,500 firms from 2006 through 2008. To the best of our knowledge, this is the first study to examine the determinants of executive annual inside debt compensation by including both pension and deferred compensation plans. Concurrent studies by Anantharaman, Fang, and Gong (2010) and Cassell, Huang, Sanchez, and Stuart (2011) utilize the same data source as ours, thus include both components of inside debt. However, their focus is very different from our study (e.g., the relationship between a CEO s inside debt to equity holding balance and the cost of debt, the number of debt covenants, and the firm s risky policy choices). In addition, this is the first study to document a CEO s inside debt vesting exercise and examine the determinants of deferred compensation withdrawal. To uncover new insights into firm behavior and executive compensation, we test the following two hypotheses: the rent extracting hypothesis and the incentive alignment hypothesis. Significant differences should be noted between the executive plans that are our focus and the tax-qualified pension and 401(k) plans available to non-executive employees. The executive plans are often negotiated, broader in scope, and richer in remuneration than the typical tax-qualified plan, raising the issue of whether executive plans reflect an arm s length bargaining power. Moreover, unlike bonus and stock based compensation, the payment formula for executive pension plans is often not directly tied to performance metrics, but is based largely on years of service and pre-retirement salary. This observation leads to the 3 See Sundaram and Yermack (2007), Gerakos (2010a, 2010b), Kalyta (2009a, 2009b), and Wei and Yermack (2011). 4 For details, see http://www.fasb.org/pdf/fas123r.pdf and http://www.sec.gov/rules/final/2006/33-8732a.pdf. 2
rent extracting hypothesis, which predicts that entrenched CEOs use their power to obtain a higher level of pay through executive pension and deferred compensation plans. Because the value of stock-based compensation is intended to be tied to the equity value of the firm, we observe notable increases in the use of stock-based compensation for executive pay in the 1990s as a means to align incentives of managers with the interests of shareholders. Recently, however, widespread concerns have emerged that increased stock-based compensation leads to excessive risktaking incentives. For this reason, it is suggested that executive compensation should be tied to total firm value, rather than only to the value of the common shares, in order to expose CEOs to a broader fraction of the possible fallout from risks taken. In particular, inside debt compensation is usually an unsecured and unfunded obligation of the firm, yielding an equal claim with other debt creditors in bankruptcy. The seminal study by Sundaram and Yermack (2007) examines factors affecting a CEO s inside debt-to-equity balance ratio. However, their sample includes only a CEO s pension balance for 237 large U.S. firms drawn from a Fortune 500 ranking companies in 2002, leaving out deferred compensation. As we observe from Panel A of Table I, we find that the value of deferred compensation is as significant as that of pensions. Moreover, as we show in section VII, pension and deferred compensation plans are nearperfect substitutes, suggesting that any analysis of inside debt that omits deferred compensation is incomplete. Therefore, using a large and general sample by including both components of inside debt in our paper, we re-examine this issue by proposing the incentive alignment hypothesis that inside debt performs an important alignment role by maintaining a CEO s higher inside debt-to-equity balance ratio when the risk of bankruptcy emerges. Previewing our empirical results, we first find that the evidence from annual inside debt compensation supports the rent extracting hypothesis. In particular our results reveal that CEO entrenchment, as measured by a larger board, CEO/chair duality, and a higher degree of anti-takeover provisions (ATPs), is associated with a higher value of a CEO s annual inside debt compensation. Consistent with the incentive alignment hypothesis, we also find that a higher probability of bankruptcy is positively associated with a CEO s inside debt-to-equity holdings ratio. 3
We further investigate the vesting exercise of a CEO s inside debt. Given that vesting requirements of deferred compensation are more flexible than those of pension plans, we observe that approximately 10% of the CEOs in our sample withdrew their deferred compensation before retirement. Our results indicate that CEO entrenchment measures are significantly and positively associated with the probability and amount of deferred compensation withdrawal. We also find that CEOs who withdraw their deferred compensation have a higher balance of inside debt as well as inside debt-to-equity balance ratios before and after the withdrawal. In addition, bankruptcy probabilities are negatively associated with the probability of withdrawal and the amount of deferred compensation withdrawn. Thus, the overall evidence suggests that inside debt holding serves as an important alignment role with debt holders despite the existence of a CEO s rent extracting incentives through annual inside debt compensation. These results are robust to potential sample selection bias arising from firms that offer inside debt compensation and firm- and manager-specific heterogeneities that affect CEO compensation. The rest of this paper is organized as follows. Section II describes CEO pension and deferred compensation characteristics. Section III details data sources and sample characteristics. Sections IV, V, and VI examine the determinants of the annual inside debt compensation of CEOs, their inside debt-toequity balance ratios, and their deferred compensation withdrawal decisions, respectively. Section VII explores the robustness of our results and VIII provides the summary and conclusion. II. CEO pension and deferred compensation Most salaried employees in the U.S. are covered by pension plans that provide them with payments upon retirement. The general U.S. pension plans are designed to be qualified for favorable tax treatments in the sense that employees income tax payments are deferred until retirement when they start receiving payouts from the pension plan. While the invested pension funds grow tax-free, neither the firm nor its employees pay taxes on the investment s value appreciation, while the firm receives a current deduction for contributing funds to a qualified pension plan. Thus, the plans provide a tax benefit to employees at no cost to the firm. A deferred compensation plan, which is another form of executive 4
compensation that is largely independent of the performance, appears analogous to a familiar 401(k) plan used by many salaried employees. Under the 401(k) plan, a fraction of the employee s salary is placed in a tax-deferred account, with the company usually making a contribution. 5 To attract and retain effective CEOs, firms have the incentive to provide them with non-tax qualified pension and deferred compensation, especially executives adversely affected by limits imposed by the Internal Revenue Service (IRS) on qualified pension and 401(k) plans. 6 The amount of the executive pension plans, also known as supplemental executive retirement plans (SERPs), represents what would be payable under the pension plan if the plan were not subject to IRS limits on the annual compensation recognized for the calculation of the pension plan benefits. In addition, firms typically offer their executives additional deferred compensation with a guaranteed rate of return, which is often higher than the market rate outside the tax-advantaged 401(k) plan. These guaranteed, above-market, and tax-deferred rates of return are powerful incentives for CEOs. There are significant differences between non-tax qualified plans available to executives and taxqualified plans available to non-executive employees. For one thing, the executive pension and deferred compensation plans are likely to shift part of an executive s tax burden onto the firm. Unlike the taxqualified pension and 401(k) plan, the investment income generated from the executive non-qualified plans is immediately subject to taxation, for which the company must pay. If the pension and the deferred compensation had been distributed as a salary instead, the executives would have to bear the tax burden on any income or capital gains subsequently generated. Given that the tax rates on long-term capital gains currently paid by most individuals are lower than the marginal corporate tax rates paid by firms, the shift is likely to be inefficient. As another point, the executive plans are likely to shift the risk of poor investment performance from the executives to the company. A tax-qualified pension plan available to non-executive employees is 5 Like a regular tax qualified pension plan, neither the firm nor the employee pays taxes on the earned income and capital gains until the employee withdraws the funds. 6 The IRS set the tax-qualified pension plan limit at $230,000 of annual employee compensation in 2008. Under the 401(k) plan, employees covered by such a plan cannot defer more than $15,500 of their compensation. 5
usually a defined contribution plan, in which the firm commits to contribute a specified amount each year. The amount available to an employee upon retirement depends on the performance of the plan s investment. Thus, the risk of poor investment performance falls entirely on the employee. In contrast, an executive pension plan is typically a defined benefit plan, which guarantees fixed payments to the executive for life. As a result, the executive pension plan is likely to shift the risk of investment performance entirely to the firm and its shareholders, while the executive is guaranteed a specified stream of payments regardless of investment performance as long as the firm remains solvent. As for a deferred compensation plan, companies usually offer higher rates of return than the market rate on the executive deferred account. Therefore, executives under the plan are likely to earn higher rates of return than those available in the market, whereas employees covered by a 401(k) plan earn returns equal to similar pre-tax returns outside the plan. Although a company may offer executives no higher than the market rate, the effective interest rate earned by executives is higher than it appears because of the substantial tax benefit. Therefore, as long as the effective after-tax rate is higher than the market rate, executives earn substantial gains at the cost of the firm, a benefit not provided to non-executive employees. III. Data and sample This section details our sample selection procedure and describes the sample characteristics. The initial information on executive compensation is obtained from the summary compensation dataset from the Standard & Poor s ExecuComp database for S&P 1,500 companies from 2006 to 2008. We begin from 2006 because it is the earliest year that ExecuComp reports executive pension and deferred compensation information. Next, we merge the detailed pension and deferred compensation information from the pension dataset and deferred compensation dataset. However, the pension data do not specify whether the reported pension plan is tax-qualified, and therefore whether that pension plan is available for a majority of employees or only for certain executives. As a result, we carefully read each proxy statement and classify each pension plan as either being tax-qualified or non-qualified to provide accurate tests of the hypotheses. 6
In addition, we find that 23 cases (i.e., 12 companies and 13 different pension plans) out of 3,093 CEO-year observations from the pension dataset have potential data coding problems. For these cases, we take information directly from the proxy statement. For example, the reported pension name of Genuine Parts is the Original Deferred Compensation Plan, and it seems to be a CEO s deferred compensation plan rather than a pension plan by its name. As a result of examining the company s proxy statement, we conclude that it can be considered as a pension plan because it is paid out as an annuity upon retirement. Similarly, we classify some ambiguous cases as pension plans if the payment structure is either lump-sum or annuity upon retirement. In another example, the pension name of KIRBY Corp. is Kirby Inland Marine, LP. Deferred Compensation Plan. As a result of examining the proxy statement for these similar 11 cases, we determine them to be coding errors and record them to the CEO deferred compensation portion. In addition, two CEO pension plans are overseas plans. We delete them from our sample because foreign pension plans have different terms and are subject to different regulatory rules compared to pension plans of U.S. CEOs. 7 After constructing the compensation dataset, we merge corporate governance and other executive information from RiskMetrics, firm financial statement data from Compustat, common stock returns from CRSP, institutional ownership from Thomson Financial Spectrum, and analyst forecast information from I/B/E/S, respectively. Our sample from ExecutiveComp contains 3,093 CEO year observations for the period from 2006 to 2008. However, our final sample size reduces to 2,242 observations (i.e., 1,040 largecap, 520 mid-cap, 502 small-cap as a result of matching other company and executive information.) Table I provides the descriptive statistics of the key variables, which are defined in the Appendix in detail. Panel A of Table I reports the dollar amount and ratios of the major components of the CEO compensation data. 8 Mean (median) total annual CEO compensation is approximately $7.1 ($4.8) million. 7 Additionally, we also find that 17 cases (i.e., four companies and four different plans) out of 18,807 executive year observations in the pension dataset have incentive as a part of their pension name. Although these are not in our CEO sample, we check for data coding problems and find that two long-term incentive plans should be recorded in other CEO compensation and two plans can be considered each as a pension plan. 8 Reported statistics of inside debt and equity compensation are based on the positive balances of 1,744 and 1,959 observations, respectively, given that some firms do not grant their CEOs either equity or inside debt compensation. 7
Mean (median) annual cash compensation composed of base salary and bonus is approximately $1.2 ($0.9) million. The dollar amount of the mean (median) annual equity compensation, comprised of restricted stock and stock option grants based on the fair value at the grant date, is $4.8 ($3.0) million, which accounts for a significant portion of a CEO s total annual compensation. These are similar to other reported figures in similar samples of other executive compensation studies. Focusing on CEO compensation variables of inside debt, we find that non-qualified pension plans and deferred compensation arrangements represent 55% and 77% of our sample, respectively. In addition, their average accumulated actuarial present values are $7.2 million and $5.1 million, respectively. Given that most companies have deferred compensation plans, estimated at approximately 70% of total pension plan value, we infer that deferred compensation plans constitute a significant portion of inside debt. Consequently, omitting them from the inside debt will likely lead to misleading results. In particular, the mean (median) values of the annual and aggregated accumulated actuarial present value of inside debt composed of pension and deferred compensation plans are $1.1 ($0.4) million and $9.1 ($3.9) million respectively. We also report that the ratio of inside debt-to-equity as mean and median value is 0.83 and 0.19, respectively, where the inside equity value is obtained by computing a CEO s accumulated equity and option holding values. 9 Therefore, we find that inside debt compensation is significant and varies considerably across companies. Panels B, C, and D of Table I report various CEO and firm characteristics as insight into the two hypotheses. In terms of CEO characteristics reported in Panel B of Table I, the average age of the CEOs in our sample is 56 and their average tenure is 7.3 years. In addition, approximately 57% of the CEOs chair their respective boards. Panel C of Table I shows various governance characteristics of our sample firms. In the first two rows, we report two widely used ATP indices based on Gompers, Ishii, and Metrick (GIM, 2003) and Bebchuk, Cohen, and Ferrell (BCF, 2009). The GIM index is based on 24 APTs and the BCF index is 9 The average value of the inside debt-to-equity ratio is larger than the 0.18 found in Sundaram and Yermack (2007). However, their inside debt measure does not include deferred compensation. 8
based on six out of the 24 ATPs. These indices are calculated by adding the ATPs. Therefore, CEOs at the firms with higher indices are viewed as having more managerial power than CEOs at companies with lower indices because it is more difficult and costly for shareholders to remove managers at these firms. Additionally, the average number of directors is ten, and 57% of our sample firms have a staggered board. Also, approximately 78% of all board members are independent and 98% of the members of the compensation and audit committees are independent. Furthermore, institutional investors own approximately 57% of all outstanding shares. Panel D of Table I shows the descriptive statistics of our sample firm characteristics. To measure bankruptcy, we transform the Altman Z-score to a discrete-time hazard model based on a logit estimation, following Hillegeist, Keating, Cram, and Lundstedt (2004). 10 The average total assets are approximately $29 billion and average leverage based on equity book value and equity market value is 23% and 17%, respectively. Firm age is measured as the number of years since the IPO and accounting information quality is measured as the absolute value of performance-matched discretionary accruals (Kothari, Leone, and Wasley, 2005). IV. Determinants of CEO s annual inside debt compensation A. Hypothesis and related literature Given the significant differences between non-tax qualified plans available to executives and taxqualified plans available to non-executive employees, the use of SERPs and other similar compensation arrangements may reflect an arm s length bargaining in an executive remuneration package. Excessive compensation is a direct way of shifting wealth from shareholders to managers, and influential CEOs can negotiate contracts in their interests with fewer constraints from the labor market (Bebchuk and Fried, 2003; Hermalin and Weisbach, 1998; Adams, Almeida and Ferreira, 2005). Unlike stock-based 10 We also measure bankruptcy probability based on the Shumway bankruptcy score, which incorporates several market-driven factors, such as market size, historical stock returns, and idiosyncratic risk, in addition to Altman s Z- score variables. For robustness analysis, we also transform the Shumway bankruptcy score to the hazard model to measure the probability of bankruptcy, as explained in Shumway (2001), and find similar results throughout the analyses. 9
compensation, which is designed to provide greater alignment of CEO compensation with a CEO s own performance and shareholders interest (Jensen and Murphy, 1990; Bizjak, Brickley, and Coles, 1993; Mehran, 1995; Core and Guay, 1999; Core, Guay, and Larcker, 2003; Ryan and Wiggins, 2004), executive benefit plans are usually based on years of service and pre-retirement salary. Therefore, the ability to obtain a higher level of compensation through pension and deferred compensation plans is more likely for entrenched CEOs. H1. CEO rent extracting hypothesis: Entrenched CEOs use their power to obtain a higher level of pay through executive pension and deferred compensation plans. B. Annual inside debt compensation regression B.1.1. Dependent variables: CEO s annual inside debt compensation We measure the dependent variable as the ratio of a CEO s annual inside debt to cash-based compensation (i.e., annual salary and bonuses), where the CEO s annual inside debt compensation is the sum of the annual pension increment and deferred compensation contributed by the company. B.1.2. Treatment variables In most public corporations, the compensation decision is left to the board of directors. Thus, the delegation mechanism has a crucial effect on CEO compensation (Fama, 1980; Fama and Jensen, 1983; Jensen, 1993; Bebchuk and Fried, 2003, 2004). In particular, larger boards are less effective and more susceptible to the influence of the CEO (Fahlenbrach, 2009; Guest, 2009; Jensen, 1993; Yermack, 1996) than smaller boards. Consequently, many studies find a positive association between board size and executive compensation (Core et al., 1999). Therefore, we select the board size, as measured by the natural logarithm of the number of directors on the board, as a proxy for CEO power (Jensen, 1993; Yermack, 1996; Core et al., 1999). 11 11 While previous studies often use the percentage of outside directors (Hermalin and Weisbach, 1998) and the existence of independent audit and compensation committee (Newman and Mozes, 1999; Anderson and Bizjak, 10
Related to CEO characteristics, prior studies suggest CEOs with longer tenure and who also chair the board are likely to have greater bargaining power over the board, implying significant agency problems (Yermack, 1996; Hermalin and Weisbach, 1998). As a result, we can infer that both CEO tenure and CEO/chair duality can serve as proxies for CEO influence. Therefore, we use the number of years served as the CEO (CEO tenure) and a CEO/chair duality indicator as additional proxies for CEO power. In addition, managers protected by ATPs tend to face weaker discipline from the market for corporate control. Thus, the number of ATPs is often used as a proxy for managerial entrenchment (Bebchuk, Cohen, and Ferrell, 2009). In this context, many studies document a negative relationship between various indices of ATPs and both firm value and stock return performance (Gompers, Ishii, and Metrick, 2003; Cremers and Nair, 2005; Bebchuk, Cohen, and Ferrell, 2009). Therefore, we also include the GIM index to measure the market for corporate control. 12 B.1.3. Control variables We also include other control variables, such as the log of total assets, the ratio of PPE to total assets, the number of years since the firm s IPO (firm age), the absolute value of residuals from the discretionary accruals model based on Kothari et al. (2005) (accounting quality), the standard deviation of analysts earnings forecasts, the daily excess stock return volatility over the past one year, bankruptcy probability, a leverage ratio, a ratio of R&D to sales, the number of business segments, an indicator of whether a firm has net operating loss carry-forwards on its balance sheet (tax carry-forward indicator), an indicator of whether the firm has negative operating cash flow (liquidity constraint indicator), an indicator of whether a CEO is near retirement, the percentage of institutional ownership, and return on assets (ROA). 13 2003) as CEO power measures, we include only the board size because our sample period is post-sarbanes-oxley, and as Table I reveals, not much cross-sectional variations of these measures exists. Nevertheless, our results are consistent with including the percentage of independent directors in our analysis. 12 We also use the BCF index and the staggered board indicator as an alternative measure of APTs. The results are consistent across the measures. 13 We find that the number of business segments contains approximately 600 missing observations when we merge this information from the COMPUSTAT Industrial Segment Tapes to our compensation data. To alleviate this problem, we replace the missing business segments observations by one and create a missing segment indicator 11
In particular, depending on a CEO s marginal tax rates relative to that of the firm, a CEO could have a degree of tax deferral or net tax saving opportunities through inside debt compensation, so we include a tax carry-forward indicator. In addition, this debt compensation does not require an immediate cash outlay. For this reason, firms may prefer debt-based compensation to cash-based compensation when they have liquidity constraints. Thus, we include a liquidity constraint indicator. As for the percentage of institutional ownership, we include this variable as a control variable as an alternative monitoring mechanism affecting CEO compensation (Chhaochharia and Grinstein, 2009) rather than as a proxy for CEO power because previous studies find conflicting results of the impact of institutional investors on CEO compensation (Hartzell and Starks, 2003; Smith and Swan, 2009). Finally, we include year and industry fixed effects to capture time-variant market conditions and unobserved industry factors. B.2. Estimation methods We use a Tobit estimator as our baseline because a significant portion of our dependent variables is censored at zero due to the absence of inside debt for some CEOs. Recently, Graham, Li, and Qiu (2009) examine firm- and manager-specific heterogeneities in executive compensation and find that these time-invariant firm and manager fixed effects explain a majority of the variation in executive pay. To begin, we note that identical CEOs in terms of gender, education, tenure, and duality of CEO/chair can earn different levels of debt compensation due to unobservable firm characteristics, such as corporate culture. As well, CEOs in firms with nearly identical cultures can also obtain different levels of debt compensation due to the heterogeneity of their managerial characteristics, such as innate ability, social capital, and personal risk preference. Therefore, we incorporate unobservable firm and CEO heterogeneity into the determinants of a CEO s annual debt compensation. As Graham et al. (2009) explain, there are three approaches to incorporate firm and manager heterogeneities in a panel regression analysis: spell effects, mover dummy variable, and group connection separately. By doing this, we can evaluate the impact of the number of business segments on a CEO s inside debt analysis with a full sample of observations. We also discard observations without the number of business segments and find consistent results. 12
(Abowd, Kramarz, and Margolis, 1999). The spell effects approach is a standard two-way model that is frequently used in executive compensation studies. However, this approach cannot clearly disentangle manager effects from firm effects if there is no managerial turnover during the sample period. The problem can be resolved by restricting the sample to managers who have moved across companies. However, this mover dummy variable approach necessarily results in a significant decrease in sample size. Adding to the problem, we observe that a potential sample selection issue arises along the classic mover-stayer model (Greene, 2008, p. 888). Succinctly, managers who switch firms may be very different from managers who do not. While the approach of Abowd et al. (1999) disentangles the effects of the manager and the firm through group connections, and therefore permits an analysis of managers who have switched firms versus those who have never done so, it is not ideal for our sample. This is because we have an insufficient number of firm-year observations of CEO turnover occurring during our sample period, 2006-2008. 14 As a result, we use the spell effects. The Tobit outcome with the unobserved firm or manager effects in the panel data has the following form: (1) where and t represent either a firm or manager and year, respectively, and is the unobserved firm or manager effect. In order to allow and to be correlated that is, unobservable firm heterogeneities could be correlated with observable firm and manager characteristics we need to estimate a firm fixedeffects Tobit model. However, a Tobit model that handles conditional fixed effects does not exist, and the estimates from an unconditional fixed-effects Tobit model are biased. Therefore, we use a Chamberlainlike random effects model (Wooldridge, 2001, p. 540-542), which allows correlations between and. As a result, it has the power to be more realistic in our study than a regular random effects model. In addition, we can include time-invariant variables. 14 Graham et al. (2009) discards about 45% of the sample firms for the period of 1992-2006 in order to perform the group connection approach. 13
B.3. Empirical results The results in Table III provide insights into the CEO rent extracting hypotheses. The dependent variables of the first four regressions are the ratios of a CEO s annual debt to salary and the dependent variables of the next four regressions are the ratios of a CEO s annual debt to cash compensation, which is comprised of the base salary and bonuses. Columns (1) and (5) present estimates of a pooled Tobit model and the other columns present estimates of a Chamberlain-like random effects model, which allows correlations between and. In particular, columns (2) and (6) include firm effects that account for unobservable firm heterogeneity and columns (3) and (7) include manager effects that account for unobservable manager heterogeneity. Finally, in columns (4) and (8), we control for both unobservable firm and manager heterogeneities using the spell approach. Succinctly, the CEO rent extracting hypothesis predicts a positive association between inside debt and proxies for CEO power. In column (1) and (5) of Table III, the board size, CEO tenure, the CEO/chair duality indicator, and a higher degree of ATPs, as measured by the GIM index, are significantly associated with higher ratios of a CEO s annual inside debt to salary and annual inside debt to cash-based compensation. This pattern is consistent when we incorporate firm and manager heterogeneity, although the coefficient on CEO tenure is no longer statistically significant. Alternatively, we include the percentage of independent directors on the board and replace the GIM index by other ATP measures, such as the BCF index and the existence of the staggered board indicator, and find qualitatively similar results (unreported, but available upon request). Therefore, the evidence supports the CEO rent extracting hypothesis. In terms of other control variables, firm size and the ratio of tangible assets are positively associated with a CEO s inside debt. In addition, the ratio of R&D expenditures to sales is negatively associated with a CEO s inside debt, as is leverage for non-manufacturing firms. In terms of industry, CEOs in financial firms are likely to have a lower inside debt compensation compared to manufacturing 14
firms in Panel A, and CEOs in the utility industry are likely to have higher inside debt compensation compared to the other industry in Panel B. Interestingly, the coefficients on year 2007 and 2008 indicators are not significant, suggesting that CEOs obtained a similar amount of inside debt compensation during the recent financial crisis. V. Determinants of a CEO s inside-debt-to-equity balance ratio In the previous section, we investigate how entrenched CEOs can use their power to obtain a larger amount of annual inside debt compensation. In this section, we investigate the determinants of the relative strength of inside debt and inside equity holdings of CEOs. A. Hypothesis and related literature Because the value of stock-based compensation is intended to be tied to the equity value of the firm, we observe notable increases in the use of stock-based compensation for executive pay in the 1990s as a means of aligning incentives of managers with the interests of shareholders. Recently, however, widespread concerns have emerged that increased stock-based compensation has provided excessive risktaking incentives, especially given the convex payoff structure of stock options. Although equity compensation may improve CEOs incentives to raise share value, CEOs have been known to enrich themselves at the expense of shareholders by manipulating earnings and stock prices. 15 Because executives are typically given unrestricted freedom to cash out their equity compensation once options and shares vest, such incentives to raise share-value may no longer exist. For this reason, it is suggested that executive compensation should be tied to total firm value rather than only to the value of the common shares. Because such a compensation structure would expose executives to a broader fraction of the negative consequences of risks taken, it would reduce their incentives to take excessive risks. One of the practical ways to resolve the problem of excessive risk-taking may be to employ pension and deferred compensation plans in an executive s compensation package. Because they are often 15 Accounting scandals involving Enron, Global Crossing, and WorldCom are good examples. 15
unsecured, unfunded obligations of the company, they yield an equal claim with other creditors in bankruptcy. Although this form of inside debt can constitute a significant portion of total executive compensation, only a few studies suggest an optimal level of inside debt in the executive compensation package. Jensen and Meckling (1976) first suggest that a manager s inside debt-to-equity holdings should occur in a ratio that mimics the firm s capital structure. In addition, if the inside debt ratio is sufficiently higher than a firm s leverage ratio, then a CEO may tend to manage a firm more conservatively; that is, reduce its exposure to risk. Unlike Jensen and Meckling (1976), Edmans and Liu (2011) argue that the equal proportion of the inside debt compensation as the firm s leverage ratio is inefficient, but a higher proportion of equity compensation is desired when the chance of bankruptcy is insignificant. Sundaram and Yermack (2007) first examine factors affecting CEO pension arrangements in 237 large firms. They find a positive relationship between the accumulated CEO pension value and firm leverage. They also uncover a decreased probability of a firm s external debt default as the inside debt comprises a larger share of executive compensation, suggesting that firms use inside debt compensation to reduce the potential agency costs of debt. Therefore, our second hypothesis can be stated as follows: H2. Incentive alignment hypothesis: The ratio of a CEO s inside debt-to-equity balance is positively associated with the probability of bankruptcy and/or firm leverage. B. Inside debt-to-equity-balance ratio regression B.1.1. Dependent variable: ratio of a CEO s inside debt-to-equity balance The dependent variable is the ratio of a CEO s inside debt-to-equity balance. We measure the value of a CEO s inside debt as the actuarial present value of a CEO s pension and deferred compensation holdings and the inside equity as the market value of a CEO s stock and stock option holdings. B.1.2. Treatment and control variables Since the payoff structure of inside debt depends on the incidence of bankruptcy, Sundaram and Yermack (2007) examine the relation between the leverage ratio and inside debt-to-equity balance ratio. 16
In our study, we examine a more direct measure of the probability of bankruptcy as measured by the hazard model based on the Altman Z-score to test the incentive alignment hypothesis in addition to the leverage ratio based on the book value of equity. 16 We also include various control variables. In particular, Cassell et al. (2011) show that a CEO s inside debt-to-equity balance ratio is negatively associated with a firm s riskiness of investment policies. Therefore, we include R&D expenditures scaled by sales (Bhagat and Welch, 1995; Kothari, 2001, and Coles, Daniel, and Navenn, 2006) and a firm s diversification, which is measured by the number of business segments (Amihud and Lev, 1981; Comment and Jarrell, 1995; May, 1995; Tufano, 1996; Coles et al. 2006), as a firm s risky policy choices. 17 Other control variables include the board size, CEO tenure, a CEO/Chair duality indicator, the GIM index, a tax carry-forward indicator, a liquidity constraint indicator, an indicator of whether a CEO is near retirement, the percentage of institutional ownership, ROA, and year and industry fixed effects. B.2. Estimation methods and empirical results Because a significant portion of our dependent variable is censored at zero due to the absence of a CEO s inside debt balance, we estimate a pooled Tobit model and a Chamberlain-like random effects Tobit model. The incentive alignment hypothesis suggests that inside debt can constitute a part of CEO compensation by aligning the CEO s interest with that of debt holders rather than that of equity holders. Therefore, it predicts a positive relationship between a CEO s inside debt-to-equity balance ratio and a firm s probability of bankruptcy and/or leverage ratio. In addition, a CEO s inside debt-to-equity ratio is negatively associated with a firm s risk and risky investment policy choices. Table IV presents the pooled Tobit regression estimates (column (1)) and Chamberlain-like random effects Tobit regression estimates on the determinants of the ratio of inside debt-to-equity 16 We use the book value rather than market value of equity to avoid a mechanical association between the leverage and a CEO s equity balance holdings. 17 We also use the Herfindahl Index, which is the sum of the square of segment sales divided by the square of firm sales, as an alternative measure of firm diversification and find consistent results. 17
balances for CEOs. Columns (2) includes only firm random effects, column (3) only includes manager random effects, and column (4) includes both firm and manager random effects. Regardless of model specifications and sample, the probability of bankruptcy is significantly and positively associated with the CEO inside debt-to-equity balance ratios. We find consistent results when we measure the probability of bankruptcy based on the Shumway hazard model, the original Altman Z- score, or the Shumway score (unreported for brevity, but available upon request), supporting the incentive alignment hypothesis. However, the leverage ratios based on the book value of equity do not have significant coefficients, which is inconsistent with the theoretical prediction by Jensen and Meckling (1976) and the results found by Sundaram and Yermack (2007). Although Sundaram and Yermack only examine CEO pensions and do not include CEO deferred compensation, we further examine this inconsistency. Looking at the correlation matrix in Table II, we find a significant correlation between the probability of bankruptcy and the book value of leverage ratios (0.31). Therefore, we repeat the analysis using only one of these variables to mitigate an apparent multicollinearity problem. We find that the leverage ratio is marginally significantly associated with the ratios of a CEO s inside debt-to-equity balance ratio, while the bankruptcy probability continues to be statistically significant. As for control variables, we first find negative relationships between a CEO s debt-to-equity balance ratio and a firm s risk and risky policy choices. In other words, the results show that the number of business segments, which measures a firm s diversification across product lines, is significantly associated with higher ratios of a CEO s inside debt-to-equity balance ratio. Both R&D expenditures over sales and excess stock return volatility are negatively associated with a CEO s debt-to-equity ratio, although the effect of R&D expenditures is not statistically significant. In addition, powerful CEOs may increase their overall compensation not only through debt-based compensation but also through stock-based compensation, which makes it difficult to predict 18
unambiguously the relationship between CEO entrenchment and the inside debt-to-equity ratio. 18 Consequently, CEO entrenchment measures, such as the board size, CEO tenure, CEO/chair duality, and the GIM index, are generally insignificantly associated with a CEO s inside debt-to-equity ratio. More transparent firms, such as older firms and firms with higher ratios of tangible assets and a lower degree of discretionary accruals, are positively associated with a CEO s inside debt-to-equity ratio. Additionally, CEOs near retirement are more likely to have higher ratios of inside debt-to-equity balances than other CEOs. Firms pressed for liquidity are likely to have higher ratios of debt-to-equity associated with their CEOs, while firms with higher ROAs are likely to have lower ratios of inside debt-to-equity. In terms of industry, we consistently find that CEOs in the financial services industry exhibit more balance in equity than debt compared to CEOs in manufacturing and other industries. 19 In summary, our regression analysis supports the incentive alignment hypothesis that inside debt can constitute a part of CEO compensation by aligning a CEO s incentives with that of debt holders rather than only equity holders. VI. Deferred compensation withdrawal While pension and deferred compensation share similar characteristics, their vesting requirements are very different. While executives are generally able to withdraw their pension money upon retirement, deferred compensation can be flexibly vested before retirement at the scheduled distribution date. We provide detailed examples of vesting requirements in the Appendix. Given the flexibility of deferred compensation withdrawal, we observe a significant portion of deferred compensation withdrawn in our sample. For example, we find that 10.3% of CEOs withdraw their deferred compensation and the average (median) amount of withdrawal is $2.8 million ($0.3 million). Therefore, we further investigate whether firm and manager characteristics are significantly different between firms with and without deferred 18 Morse, Nanda, and Seru (2009) provide evidence that powerful CEOs increase their pay through stock-based compensation. They argue that powerful CEOs are likely to rig the incentive part of their pay by inducing their boards to shift the weight toward the better-performing performance metrics. 19 In our regression analyses, the default industry of the industry fixed effects is the manufacturing industry. We also take others as a default industry and find a consistent result. 19
compensation withdrawal. From Table V, we first find that the mean (median) of inside debt-to-equity balance ratios decreases from 0.74 (0.30) to 0.68 (0.26) for CEOs as a result of their deferred compensation withdrawal, while the mean (median) of inside debt-to-equity ratios increases from 0.42 (0.15) to 0.49 (0.17) for CEOs who do not exercise withdrawal. This decreased ratio of inside debt-toequity could be a result of either a decrease in inside debt or an increase in inside equity or both. However, during our sample period, stock prices decrease, suggesting the latter reason is less likely. Nevertheless, we also find that CEOs who exercise withdrawals are likely to maintain a significantly higher balance of inside debt as well as a higher inside debt-to-equity ratio after the withdrawals compared to CEOs who do not withdraw. Concerning CEO and firm characteristics, we find that board size is significantly larger for firms with deferred compensation withdrawal. In addition, firms experiencing deferred compensation withdrawal are likely to be larger, less transparent in terms of a lower ratio of tangible assets and higher analysts forecast dispersion, are less financially distressed, and are less diversified. In general, our univariate analysis implies that more entrenched CEOs are likely to withdraw their deferred compensation when their firms are subject to more information asymmetry issues. However, they tend to maintain a higher inside debt balances as well as inside-debt-to-equity balance ratios before and after the withdrawals, which aligns their interests with those of debt holders. However, this evidence can be misleading if there are confounding effects between key variables and a CEO s deferred compensation withdrawal decision. In addition, we still need to control for manager and firm heterogeneity as part of a CEO s withdrawal decision. Therefore, we investigate this in a regression framework in which we control for a number of other CEO and firm characteristics, and report the results in Table VI. Panel A of Table VI presents the pooled probit regression estimates (columns (1)) and the probit estimates from the Chamberlain-like random effects form. The Chamberlain-like approach allows not only for correlations between and but also the inclusion of time-invariant variables that measure the determinants of a CEO s deferred compensation withdrawal decision. During our sample period, the 20