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IAI Actuarial Core Principles · Business Finance · Ethical responsibilities of owners and managers

A company's board proposes a new executive pay scheme to reduce agency costs. Which design feature is most likely to align managers' interests with those of long-term shareholders?

Share options or shares that vest after several years and depend on sustained performance best align managers with long-term shareholders, because managers' rewards then rise and fall with shareholder value rather than with short-term or unrelated measures.

  1. AA fixed salary that is independent of company performance
  2. BA bonus based solely on this year's revenue growth, regardless of profitability
  3. CShare options or restricted shares that vest only after several years and depend on sustained performanceCorrect
  4. DA guaranteed severance payment even for poor performance
  5. A bonus based on the size of the manager's team

Explanation

Deferred equity-linked pay ties managers' rewards to long-run share value, so they share shareholders' gains and losses. Fixed pay gives no link, revenue-only bonuses encourage growth at any cost, and guaranteed severance rewards failure.

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