Activist shareholders, regulators and lawmakers have argued for years about executive compensation. Critics tend to focus on the amount of pay CEOs receive, and the fact that it has soared relative to workers’ pay. Defenders say this is what supply and demand dictate.

But when you lift the hood at any corporation, executive compensation issues suddenly become much more complicated. Because pay packages often mix salary, perks, bonuses, stock options and stock grants, it is hard to say how well the package as a whole achieves its chief goal: aligning the CEO’s financial interests with those of shareholders.

New research by Wharton finance professor Alex Edmans and two colleagues sheds some light on how an incentive plan can backfire. It shows how an approaching vesting of stock options can cause a CEO to pump up the firm’s earnings, and thus its stock price, by cutting investment in research and development, advertising and capital expenditures. Assuming those would have been beneficial investments, the approaching vesting puts the CEO’s interests at odds with the firm’s.

The research showed that when options were about to vest, firms were more likely to meet or narrowly beat analysts’ earnings forecasts.

“What matters is not just how many [options-related] shares you have, but whether those shares vest in the short term or the long term,” Edmans says.

Boosting Share Price

Edmans, also a professor at the LondonBusinessSchool, collaborated with Vivian W. Fang of the Carlson School of Management at the University of Minnesota, and Katharina A. Lewellen at the Tuck School of Business at Dartmouth. The research, described in their paper, “Equity Vesting and Managerial Myopia,” took advantage of changes in federally mandated corporate disclosures that since 2006 have required firms to reveal details on options grants that had not been available before. The study looked at more than 2,000 firms from 2006 through 2010.

Almost everyone with a stake in corporate performance agrees that compensation packages should be designed to “align” the executive’s interests with those of shareholders. If the company does well, the CEO will earn more; if it does poorly, he or she should earn less.

One approach to this uses stock options for a portion of the CEO’s pay, because the options will have value only if the stock price rises after the options are granted. Typically, the options give the CEO the right to buy a given number of shares at the price they were trading at when the grant was made. Usually, the CEO cannot exercise new options until they “vest” some years after the grant. If the share price falls over that period, the options are worthless. After exercising the options, the executive can keep the shares or sell them, profiting on the difference between the sale price and the grant price.

Edmans, Fang and Lewellen focused on how CEOs behave in the year leading up to the vesting date, a period when the CEO’s options will become more valuable if the share price rises. Over a short period, it can be hard for the CEO to strengthen the company’s performance by developing new products or opening new markets – the kinds of improvements shareholders hope for. But he or she can use short-term techniques to raise the earnings that will be reported after the end of the quarter. Surprising the market with higher-than-expected earnings often boosts the share price.

Indeed, Edmans and his colleagues found that CEOs “reduce R&D when they plan to sell their stock in the near term.” While research and development spending typically grew by about a third of a percentage point per year, the growth rate was 37% slower in years approaching a vesting date. For the companies studied, the options-vesting factor cut average R&D spending by about $1 million a year. Spending for advertising and capital improvements was reduced as well.

“It’s highly statistically significant,” Edmans says, adding: “That’s something very unlikely to result from just a random pattern in the data…. In economic terms, we think a $1 million fall in R&D is a lot.”

(The results, he cautions, merely show the pace at which R&D and other spending grow; by itself, the data does not prove that slowing this growth is bad for these firms.)

The research also showed that when options were about to vest, firms were more likely to meet or narrowly beat analysts’ earnings forecasts. Since the vesting of options by itself has no direct effect on earnings, this indicates the options created an incentive to find ways to boost earnings in the short term, such as trimming expenses like R&D.

The evidence that options grants can be counterproductive could lead companies to design compensation programs better, or to simply be more vigilant.

Ironically, the CEOs’ efforts to nudge the share price, and thus to pad their pay, was not very successful: Share prices did not go up. The reason, the three researchers say: The markets know all about this gambit. Investors are not fooled, and they disregard higher earnings that are due to spending cuts prior to the earnings announcement.

But if the ploy doesn’t work, why do it?  Mainly because the CEOs believe all the other CEOs are doing it, Edmans says. If everyone else is padding their earnings, the CEO who isn’t will show comparatively weak results. The shares could fall, and along with them the value of the CEO’s options. Edmans likens it to the teacher who feels compelled to inflate students’ grades; not doing so will make the teacher stand out as an underperformer.

Long-term Damage

In practice, a CEO cannot rely indefinitely on investment cutbacks to boost stock price, because that could well undermine a company’s performance over the long term, hurting the share price. But researchers have long worried about various counter-productive incentives that make executives put their own interests first. Edmans and his colleagues note that, to be competitive, 21st century firms cannot simply cut costs; they must constantly innovate. Anything that impairs the CEO’s judgment about spending on things like research and development can weaken that effort. The payoff of R&D is often uncertain, and generally comes only over the long term, so the damage done by cuts in this investment are not immediately obvious.

“Since the benefits of intangible investment are only visible in the long run, the immediate effect of such investment is to depress earnings and thus the current stock price,” the researchers write. “Therefore, a manager aligned with the short-term stock price may turn down valuable investment opportunities.”

This new evidence that options grants can be counterproductive could lead companies to design compensation programs better, or to simply be more vigilant, the researchers write. “[Since boards of directors] know the amount of newly-vesting equity at the start of the year, they can predict the CEO’s incentives to cut investment, and if needed, counteract them,” the researchers add.

The research, says Edmans, shows that much of the current debate about the value of CEO pay is off target when it comes to aligning executive and shareholder interests. Boards of directors can strengthen that alignment by using long vesting periods, such as seven to 10 years, to give the executive a strong incentive to raise long-run fundamental value rather than the short-term stock price, and minimize the occasions when vesting could interfere with that incentive, Edmans says. “Really, what matters is not the level of pay, but the incentive provided by pay. It’s not how much you pay, but how you pay.”