The effect of equity compensation on voluntary executive turnover

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Journal of Accounting and Economics 43 (2007) 95–119 www.elsevier.com/locate/jae

The effect of equity compensation on voluntary executive turnover$ Steven Balsama,, Setiyono Miharjoa,b a Department of Accounting, Fox School of Business, Temple University, Philadelphia, PA 19122, USA Department of Accounting, Faculty of Economics, Universitas Gadjah Mada, Yogyakarta 55281, Indonesia

b

Received 30 August 2004; received in revised form 22 September 2006; accepted 28 September 2006 Available online 17 November 2006

Abstract Equity compensation provides incentives for executives to remain with the firm to avoid forfeiture of restricted shares and some or all of the value of stock options held. Empirically we show that the intrinsic value of unexercisable in-the-money options, the time value of unexercised options, and the value of restricted shares are inversely related to voluntary executive turnover. These findings which are most pronounced for strong performers, hold for CEOs and non-CEOs alike. While paying excess cash compensation also reduces turnover, the effect is less pronounced than that of equity compensation. r 2006 Elsevier B.V. All rights reserved. JEL classification: J33; J63; M52 Keywords: Executive compensation; Executive retention; Equity compensation; Stock compensation; Stock options

$ We would like to thank Sharad Asthana, Eli Bartov, Seong Cho, John Deckop, Richard Gifford, Sungsoo Kim, Harry Newman, Nagpurnanand R. Prabhala, Eric Press, David Reeb, Austin Reitenga, Heibatollah Sami, Debra Sinclair, Jennifer Yin, and seminar participants at Rutgers University–New Brunswick, Temple University, Texas Tech University, the University of Maryland and the University of Nebraska-Lincoln for their helpful comments. Corresponding author. Tel.: +1 215 204 5574; fax: +1 215 204 5587. E-mail address: [email protected] (S. Balsam).

0165-4101/$ - see front matter r 2006 Elsevier B.V. All rights reserved. doi:10.1016/j.jacceco.2006.09.004

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1. Introduction This study examines the association between equity compensation and voluntary executive turnover. Equity compensation, or more precisely, forfeitable equity compensation, can reduce voluntary executive turnover by imposing a cost on the executive, which a prospective employer may not be willing to reimburse. Examining one of the asserted benefits of equity compensation, employee retention (Ittner et al., 2003), is important because equity compensation has been increasing over time, both in absolute value and as a percentage of the executive compensation package (Perry and Zenner, 2001), and is becoming increasingly costly to shareholders in terms of cash expended on share repurchases and dilution (Balsam, 2002). It is also timely, as many corporations are reviewing their use of equity compensation in light of Statement of Financial Accounting Standards (SFAS) 123R which mandated expensing for employee stock options. The vast majority of publicly traded corporations provide equity compensation, usually stock options, to their executives in an effort to retain them and motivate them to act in the shareholders’ interests. Equity compensation provides a direct link between executive compensation and shareholder wealth and consequently aligns the interests of a firm’s executives with those of its shareholders (see for example, Jensen and Meckling, 1976; Murphy, 1985; Abowd, 1990; Jensen and Murphy, 1990a, b, and Murphy, 1998). Research, for example, Smith and Watts (1992) and Gaver and Gaver (1993), has shown that firms with the greatest demand for incentive alignment, e.g., high investment opportunities, are more likely to use stock options. Other research, for example, Mehran (1995) has looked at the effectiveness of stock/option-based compensation, finding that performance is positively associated with the percentage of compensation that is equity based. In contrast, there is little research on whether equity compensation is effective in retaining executives, and the results of that research are mixed. In theoretical papers, Oyer and Schaefer (2003, 2005) conclude that retention and sorting, rather than incentive alignment, are the reason for issuing stock options. Empirically, while Mehran and Yermack (1999) find option compensation inversely related to turnover,1 neither Fee and Hadlock (2003), nor Hasenhuttl and Harrison (2002) find equity compensation affects retention. Two additional papers look at the effect of repricing of existing options on executive turnover, as repricings are partially justified on retention grounds. The evidence from these two studies is also mixed. Carter and Lynch (2004) ‘‘find little evidence that repricing affects executive turnover,’’ whereas Chidambaran and Prabhala (2003) find the exclusion of the CEO from the repricing is likely to be associated with CEO departure. In this paper, we reexamine the effect of equity compensation on executive turnover, using a more recent time period, larger sample size, and focusing on voluntary turnover. Our results show that executive turnover is inversely related to the intrinsic value of unexercisable in-the-money stock options, the time value of unexercised options, the value of restricted stock held, and to a lesser extent, the degree to which the executive receives cash compensation in excess of that of his/her peers. In contrast the value of exercisable inthe-money stock options does not affect the likelihood of CEO turnover and is associated 1

A key difference between this paper and Mehran and Yermack (1999) is while they examine the effect of compensation on retention, e.g., option compensation, we focus on the amounts that would be lost if executive left the company, e.g., intrinsic value of unexercisable in-the-money stock options, time value of unexercised options, and value of restricted stock to be forfeited.

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with an increase in non-CEO turnover. With the one exception just noted, these results hold for CEOs and non-CEOs alike, after controlling for the value of stock options and shares granted to directors, executive age, insider ownership, firm performance, growth opportunities, CEO tenure (CEO regression only), and concurrent and lagged CEO turnover (non-CEO regression only). After this initial analysis we then perform a sensitivity analysis, adding additional variables to control for additional characteristics of the board. Including these additional variables, e.g., board composition, existence of the founder of the corporation on the board of directors, does not alter the overall findings of our primary analysis, although the degree to which the executive receives cash compensation in excess of his/her peers is no longer significantly associated with either CEO or non-CEO turnover. Additional analysis also shows our results do not change if we drop those departures coded as ‘‘retirement,’’ or if we limit our analysis to executives below the traditional retirement age. In our final analysis we examine whether compensation plans help firms retain their most productive executives. While we find some evidence that ‘‘weak’’ executives respond to the incentives provided by the compensation package, we find voluntary turnover lower and the link between the equity compensation and voluntary turnover to be more significant for ‘‘strong’’ executives. This is a particularly important finding consistent with the compensation package countering the greater opportunities ‘‘strong’’ executives are likely to have in the market. Differences in sample composition appear to explain why our results differ from that of Fee and Hadlock (2003) and Hasenhuttl and Harrison (2002). For example, Fee and Hadlock (2003) limit their sample to executives who take positions with other large public corporations. In contrast we begin with all turnovers except those caused by death, excluding turnover most likely to be involuntary in nature. Consequently while our study includes executives who take positions with other large public corporations, it also includes executives who take other positions, e.g., smaller corporations, non-public entities, government, as well as those who do not take subsequent positions. When we restrict our sample as in Fee and Hadlock we also find that equity compensation does not affect turnover. The lack of findings may be because the smaller sample lacks power, or because for this subset of executives, equity incentives do not matter because their new employer can make them whole by replacing their options and/or restricted shares. Similarly, Hasenhuttl and Harrison (2002) also have a much smaller sample, as they limit their sample to CEOs and only look at 1995. When we examine 1995 alone, we also find weaker results, as only one of our variables, the time value of unexercised options, significantly affects turnover. The rest of the paper is organized as follows. Section 2 reviews the related literature and develops the hypothesis. Section 3 discusses the data collection and model. Section 4 presents the analysis of the relation between voluntary executive turnover and equity compensation, while Section 5 examines whether those results differ for strong and weak executives. The conclusions are summarized in Section 6. 2. Related literature and hypothesis In addition to the literature discussed above, which pertains to the characteristics of firms using options and the effect of options on firm performance, this study is also relevant to the stream of research on CEO turnover. Previous studies show that CEO

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turnover is associated with firm performance (Benston, 1985; Coughlan and Schmidt, 1985; Warner et al., 1988; Weisbach, 1988; Puffer and Weintrop, 1991), board composition (Weisbach, 1988; Perry, 1999), CEO stock ownership (Denis et al., 1997), and availability of replacements (Parrino, 1997). Performance may affect turnover in several ways. For example, besides increasing the probability they will be fired or encouraged to resign/retire, CEOs have less incentive to stay when their options become worthless, which is more likely when performance is poor. The effect of firm performance on turnover can be dramatic. Coughlan and Schmidt (1985) report that the probability of CEO turnover for firms in the lowest percentile was seven times that for CEOs in the highest percentile (21.3 percent vs. 3.1 percent). Board composition can affect turnover if outsiders are more likely to respond to poor performance by replacing the CEO. Weisbach (1988) finds that boards dominated by outside directors are more likely to replace their CEO in response to poor performance. Perry (1999) goes one step further, showing that when directors of independent boards receive incentive-based compensation, the likelihood of CEO turnover following poor performance increases. In contrast, insider ownership has the effect of entrenching management. Denis et al. (1997) examine the relation between ownership structure and CEO turnover and find that CEO turnover is significantly less sensitive to stock price performance in firms with high managerial ownership. The focus of the above literature is involuntary turnover. In contrast, the focus of our study is on voluntary executive turnover. The executive has the choice to remain with the firm, retire early, or seek employment with another company. His or her decision will, in part, be influenced by the monetary cost of leaving his or her current employer. Potential employers can, and often do, reimburse executives for the monetary losses incurred by the executive leaving his/her current employer, as illustrated by the recent hiring by Boeing of Jim McNerney as CEO. McNerney, at the time CEO of 3M, forfeited significant amounts of unvested equity compensation in moving to Boeing. However, as reported in Boeing’s 8K filed 6 July 2005 the package he received at Boeing made provisions for equity that Mr. McNerney left behind. As compensation to replace unvested 3M equity awards that Mr. McNerney will forfeit, he was granted, effective July 1, 2005, the following Buy-Out Restricted Stock Awards: (i) for forfeited 3M stock options, 159,000 shares of restricted Boeing stock with vesting and restrictions lapsing in five equal annual installments beginning on May 10, 2006; (ii) for forfeited 3M restricted stock awards, 162,000 shares of restricted Boeing stock with vesting and restrictions lapsing in six equal annual installments beginning on January 1, 2006; and (iii) for forfeited 3M restricted stock awards, 70,000 shares of restricted Boeing stock with vesting and restrictions lapsing in three equal annual installments beginning on July 1, 2006. The aggregate value of the Buy-Out Restricted Stock Awards as of July 1, 2005 was $25,289,880. In general, an executive can be reimbursed for monetary losses through a one-time signing bonus that includes an equity component to replace the amounts left behind at his/ her prior employer and/or through an increased level of compensation that continues into the future.2 However, our expectation is the greater the amount involved, the less likely the 2

Analysis of the subset of observations where we can trace the executive to a new employer shows a combination of the two, i.e., a large grant of equity compensation in his/her first year with the new employer that

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potential employer would be willing to reimburse the employee. From the viewpoint of the current employer the amount should be large enough to deter raiding of executives, and given the willingness of a potential employer to pay for certain executives (e.g., Boeing’s willingness to reimburse McNerney for the more than $25 million that he left behind), the amount has to be greater for more highly valued executives. While other parts of the compensation package can tie the executive to the company, for example a pension plan where the payout is structured to increase with years of service, our focus in this study is on equity compensation, i.e., stock options and restricted stock. We limit ourselves for two reasons. First equity compensation as a percent of total compensation has increased dramatically in recent years, and is, in many cases the largest component of the executive compensation package. Second, information on pensions, in particular the value of the plan benefit and the amount that would be forfeited should the executive leave the company, does not currently appear in public disclosures.3 Consequently, although the monetary cost of leaving includes the costs of all compensation foregone, including, but not limited to the value of equity compensation forgone, we only examine the latter. To estimate the value of a share of restricted stock we use the value of its unrestricted counterpart at the end of the prior year. The value of an option is comprised of two components, the intrinsic value, which measures the excess of the market price of the share over the exercise price of the option at a point in time, plus the time value, which factors in the probability the share price will increase prior to the time the option expires. If an option is unexercisable, the holder cannot exercise it until one or more conditions are satisfied and will suffer a total loss if he or she leaves the company. If an option is exercisable, the holder can exercise the option prior to leaving the company. Thus, while the holder realizes the intrinsic value from the exercise of the option, they forgo the time value component. Whereas the intrinsic value of an option can be readily measured at any point in time, the time value is not easily measured. Further, academics (e.g., Lambert et al., 1991) have argued that optionpricing models overestimate the value of the options to the executive, in particular because undiversified executives tend to exercise their options early (Huddart and Lang, 1996). We use the intrinsic value of unexercisable in-the-money stock options4 at the end of the prior year to proxy for the intrinsic value forfeited if the executive leaves the firm, and calculate the time value of unexercised options using the algorithm in Core and Guay (2002) to proxy for the time value forfeited if the executive leaves the firm. Our expectation is the greater the monetary cost, the less likely the executive will leave his/her position.

(footnote continued) replaces a significant portion of the compensation left behind, plus an increased level of compensation that persists in future years. 3 Bebchuk and Jackson (2005) write ‘‘Although the value of executive pension benefits do not appear in public disclosures, the existence of the pension plans and the method for determining the amount of annual benefits must be disclosed in the firm’s SEC filings.’’ They continue ‘‘such estimates are not accessible to outsiders without closely analyzing company disclosures and making a series of actuarial assumptions and calculations.’’ For a sample of 51 executives they use this information to estimate the present value of the pension benefit. While their methodology is feasible for their relatively small sample, it would not be for a sample of the size used in this study. 4 If the option is out-of-the money, the intrinsic value is zero.

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3. Data and model 3.1. Data collection Our primary data source is the S&P ExecuComp database. ExecuComp includes financial data, as well as compensation data reported in proxy statements for the firms comprising the S&P 500, Midcap 400 and Smallcap 600. ExecuComp provides information for the 5 highest paid executives of each company, assigning a unique identity (EXECID) to each individual in the database. In addition, information on insider ownership and age were hand collected from Compact Disclosure and information on board composition was obtained from The Corporate Library’s Board Analyst database. Executive turnover is measured when the executive is identified as departing the firm by ExecuComp. ExecuComp classifies executive departure into four categories: (1) deceased; (2) retired; (3) resigned; and (4) unknown. For obvious reasons, we eliminate turnover caused by death. To identify involuntary turnover we use the criteria in Huson et al. (2001, p. 2273) as a guide, and Factiva and Lexis-Nexis, as well as corporate proxy statements as our data sources. To be precise, we classify as involuntary, turnover where press articles suggest the executive was fired, forced from his/her position, or was departing due to unspecified policy differences. We also classify as involuntary, turnover where the executive was under 60 and the departure was not announced at least 6 months in advance and the press announcement of departure was silent as to his or her taking a new position. We classify 496 observations, or just over 25 percent of our turnover observations, as involuntary, which while higher than the 16.2 percent reported in (Huson et al. 2001, Table 2), is consistent with their evidence that forced turnover has increased over time. Table 1 provides information on the sample composition. There are 146,014 unique executive year combinations on ExecuComp from its initiation to April 2006. Data requirements and exclusion of turnovers classified as involuntary, reduce our sample to 42,037 observations, of which 1,467 are executive years in which voluntary turnover occurs. Panel C shows the distribution of turnover by year. The database began in 1992, but there were no usable turnover observations in 1992, and far fewer observations in 1993 than in succeeding years. Similarly, even though we use the April 2006 cutoff, we lack many observations with 31 December 2005 fiscal year ends.5 3.2. Models Our hypothesis is that as the value of equity compensation to be forfeited increases, voluntary executive turnover decreases. We test this hypothesis using two models, one for CEOs and one for all other executives. We present separate models for two reasons. First, presenting results for the CEO only will allow a comparison of our results to the prior literature which has primarily focused on the CEO. Second, it will allow us to incorporate different variables into each model. In particular, CEO turnover is likely to affect turnover among lower level executives, e.g., Fee and Hadlock (2003) find that ‘‘the probability of a non-CEO leaves office is elevated around CEO dismissals.’’ Consequently using a separate 5

In untabulated sensitivity analysis we rerun our model after excluding observations from 1992, 1993, and 2005. Our conclusions are unchanged.

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Table 1 Panel A: Sample selection Number of observations on April 2006 ExecuComp Less: Incomplete ExecuComp data Missing age data Turnover observations classified as involuntary Number of usable observations

146,014 70,127 33,354 496 42,037

Panel B: Sample composition Voluntary executive turnover Non-turnover Total

1,467 40,570 42,037

Panel C: Voluntary executive turnover by year Year

Turnover

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Total

35 71 92 84 123 132 165 180 152 127 122 114 70 1,467

model for non-CEOs allows us incorporate CEO turnover as an additional explanatory variable. To measure the value of equity compensation that would be forfeited if the executive leaves the firm we use the intrinsic value of the options that have not vested, the time value of all options held, and the fair value of restricted stock held. To proxy for the intrinsic value of the options that would be forfeited if the executive leaves the company we use the intrinsic value of unexercisable in-the-money stock options (INMONUN) at the end of the prior year as reported in ExecuComp.6 To control for scale differences across executives and firms we deflate INMONUN by total direct compensation (TDC1) as reported by ExecuComp for the year prior to turnover, where total direct compensation includes salary, bonus, other current compensation, long-term incentive payments, restricted stock grants valued at grant date, and the Black-Scholes value of stock option grants valued at grant

6 To the extent that those options vest and are exercised subsequent to year end but prior to departure our variable contains measurement error. However the value of unexercisable options at time of departure is not available.

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date. We expect this deflated variable, which we refer to as unexercisable in-the-money options, to be inversely related to turnover. Analogous to INMONUN, ExecuComp provides the intrinsic value of exercisable in-themoney stock options, INMONEX, at the end of each fiscal year. As with INMONUN we deflate INMONEX by total direct compensation to calculate exercisable in-the-money options. Since by definition, this value could be realized from the options should the executive decide to leave the company, we do not expect exercisable in-the-money options to be related to turnover. As mentioned earlier, to proxy for the time value forfeited if the executive leaves the firm we calculate the time value of unexercised options using the algorithm in Core and Guay (2002). As with the prior variables, we deflate this amount by total direct compensation to calculate time value of unexercised options. We expect time value of unexercised options to be inversely related to turnover. To proxy for the value of restricted stock forfeited if the executive leaves the firm we use the market value of those shares (RSTKHLDV) as provided by ExecuComp at the end of the prior year. As with the prior variables we deflate RSTKHLDV by total direct compensation to calculate restricted shares. We expect restricted shares to be inversely related to turnover. The higher paid an executive is, relative to his or her opportunity cost, the less likely he or she is going to voluntarily leave the firm. We use residual to control for this effect, where residual is the difference between the total cash compensation received by the executive and the average earned by an executive of the same rank, within the same two digit SIC code, size decile, and year.7 To be consistent with our other variables, we deflate the excess by total direct compensation, so that residual represents the amount the executive is over/ underpaid in percentage terms. Since prior literature shows turnover may be affected by other factors, we also include the value of options and stock granted to directors, executive age, insider ownership, and variables proxying for the performance of the firm and the firm’s growth opportunities as control variables.8 The value of options and shares granted to outside directors are used to control for the incentives caused by director compensation, i.e., we expect monitoring to be greater when director compensation is tied to share price. The value of stock options granted to directors is not provided by ExecuComp, so it is estimated by dividing the Black Scholes value of options granted to the top five executives by the aggregate number of stock options granted to those executives, which yields a per option grant date value. We then take that per option value and multiply it by the number of stock options granted to each director to arrive at the value of the director’s option grants. Similarly the value of shares granted to directors is calculated by multiplying the number of shares granted to each director by the average price for the calendar year. Both values are then deflated by total director compensation to yield the percentage of director compensation represented by option (director option grants) and share grants (director stock grants).9 As with our other variables director option grants and director stock grants are measured for the year 7

We exclude the value of stock and option grants as they are already included in model (1), i.e., unexercisable inthe-money options, exercisable in-the-money options, time value of unexercised options and restricted shares. 8 We include board composition and ownership variables in a sensitivity analysis because they are only available for a subset of our observations. 9 As an alternative to proxy for the effect of director compensation on turnover we used indicator variables that take the value of 1 if the firm grants any options/shares to its directors and zero otherwise. We do so because a

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prior to turnover. We expect director option grants and director stock grants to be positively associated with turnover. Executive age is included to control for the possibility that as the executive gets older he or she retires, either voluntarily or in some cases, as the result of company policy/tradition. We expect executive age to be positively associated with turnover. If insider ownership has the effect of entrenching management, turnover will be inversely related to the percentage of shares owned by insiders. Consequently we expect insider ownership to be negatively related to turnover. To control for performance, which based upon prior literature we expect to be inversely related to turnover, we use prior year stock (return to shareholders) and accounting (return on assets) returns. We include the market to book value of equity (market to book value) measured at the end of the prior year to control for growth, and an indicator variable if the company operates in a high technology industry (hightech), as we expect turnover to be greater for growth firms operating in dynamic industries (Henderson et al., 2006). In our CEO model, we include CEO tenure as an additional independent variable, as the CEO may become more entrenched over time. In our non-CEO model, we include both contemporaneous and lagged CEO turnover, as while CEO turnover is likely to lead to an increase in turnover of lower level executives, the impact may not be immediate. The formal models are as follows: CEO model: Turnover ¼ a þ b1 Unexercisable inthemoney options þ b2 Exercisable inthemoney options þ b3 Time value of unexercised options þ b4 Restricted shares þ b5 Residual þ b6 Director option grants þ b7 Director stock grants þ b8 Executive age þ b9 Insider ownership þ b10 Return to shareholders þ b11 Return on assets þ b12 Market to book value þ b13 Hightech þ b14 CEO tenure þ .

ð1Þ

Non-CEO model: Turnover ¼ a þ b1 Unexercisable inthemoney options þ b2 Exercisable inthemoney options þ b3 Time value of unexercised options þ b4 Restricted shares þ b5 Residual þ b6 Director option grants (footnote continued) large number of firms, more than 50 percent in the case of shares, do not grant options and/or shares in a given year. The results are unchanged.

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þ b7 Director stock grants þ b8 Executive age þ b9 Insider ownership þ b10 Return to shareholders þ b11 Return on assets þ b12 Market to book value þ b13 Hightech þ b14 CEO turnover þ b15 Lag CEO turnover þ ,

ð2Þ

where Turnover is equal to one if the executive leaves during the year and zero otherwise, and all other variables are as described above. To control for the econometric issues that may arise from the pooling of multiple executives from a single firm over a period of years we use the SAS procedure GLIMMIX. GLIMMIX controls for both firm and time fixed and random effects in a logistical setting. 4. Relation between voluntary executive turnover and equity compensation 4.1. Descriptive statistics Table 2 reports descriptive statistics using the turnover/non-turnover classification, with panel A reporting on the CEO sample and panel B the non-CEO sample.10 For both samples we see unexercisable in-the-money options, time value of unexercised options and restricted shares are higher for the non-turnover sample. While not expected, we also find exercisable in-the-money options higher for CEOs in the non-turnover classification, perhaps because of its correlation with unexercisable in-the-money options (see Table 3). Residual is also less negative for the non-turnover sample groups.11 These differences are all consistent with voluntary turnover being lower when the executive’s monetary loss from leaving is greater. Table 3 presents the Pearson correlation coefficients for the independent variables in our models. The correlations are relatively low, with the largest in the CEO (non-CEO) model being 0.47 (0.41) between unexercisable in-the-money options and exercisable in-the-money options, indicating that multicollinearity should not be a problem. 4.2. Regression results Table 4 reports the results for our multivariate analysis. Supporting our hypothesis, in both the CEO and non-CEO models, we find the coefficients on unexercisable in-the-money options, time value of unexercised options, and restricted shares to be negative and significant. We also find the coefficients on residual to be negative and significant in both models, albeit at slightly lower significance levels. In contrast the coefficient on exercisable in-the-money options is insignificantly different from zero in the CEO model and positive and significant in the non-CEO model. We interpret these results as follows. Unexercisable 10

The values reported in the tables are after winsorizing the variables at 1 percent and 99 percent. As discussed above, we calculate the residual as the difference between the total cash compensation received by the executive and the average earned by an executive of the same rank, within the same two digit SIC code and size decile—which we then deflate by total direct compensation. By construction the sum of the undeflated residuals within each rank, SIC code, and size decile combination should equal zero. However the sum of the deflated residuals can be either positive or negative. 11

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in-the-money options, time value of unexercised options, and restricted shares, as well as residual, proxy for the monetary loss the executive would suffer if he or she left the company, so they provide disincentive to leave. In contrast exercisable in-the-money options, the intrinsic value of options that can be exercised if the executive decides to leave the company, provide no disincentive for the CEO to leave, and perhaps some incentive for lower level executives to leave. We then examine the standardized coefficients, which are the change in probability of turnover from a one standard deviation change in an independent variable, to compare the strength of the relationship between the dependent and independent variables. By standardizing the coefficients, the independent variables can be compared directly to determine which has the largest impact on the dependent variable. The standardized coefficients indicate that unexercisable in-the-money options are most important in reducing CEO turnover with a one standard deviation increase reducing voluntary CEO turnover by almost 40 percent, while the time value of unexercised options is most important in reducing non-CEO turnover with a one standard deviation increase reducing voluntary non-CEO turnover by almost 24 percent. Of the compensation variables, in both the CEO and nonCEO regressions, residual is the least important in reducing turnover as a one standard deviation increase reduces voluntary CEO (non-CEO) turnover by seven percent and six percent, respectively. Turning to the control variables, as expected we find some evidence that director option grants and director stock grants influence turnover, as in the non-CEO model their coefficients are positive and significant, consistent with turnover being greater when directors are paid with equity, and thus have better incentives to monitor management. However the coefficients on both of these variables are insignificant in the CEO model. In both models we find executive age to be positively and significantly related to turnover, which is consistent with executives being more likely to retire as they age, and insider ownership to be negative and significant, which is consistent with entrenchment. In the nonCEO model both return to shareholders and return on assets are negative and significantly associated with turnover, while in the CEO model only return on assets is negative and significant. Both of these results are consistent with turnover being lower when the firm is performing well. The results for market to book value and hightech are mixed. Market to book value is positive in both models, but only significant in the non-CEO model. Hightech is also positive in both models, but while the coefficient is significant in the non-CEO model, it is also insignificant in the CEO model. Still the results provide some support for turnover being higher in growth and high technology firms. Turning to CEO tenure, which is used in the CEO model, we find a negative and strongly significant coefficient, consistent with CEO entrenchment. We also find CEO turnover and lag CEO turnover, which are used in the non-CEO model, to be positively related to turnover, although only the coefficient on lag CEO turnover is significant. 4.3. Sensitivity analysis 4.3.1. Board composition Prior literature (e.g., Weisbach, 1988; Perry, 1999) shows that board composition affects turnover. We examine the effect of inclusion of board variables as a sensitivity analysis, rather than as our primary analysis, because the data is only available for the years 2001–2005, which decreases our sample size by approximately two-thirds. In this analysis,

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Table 2 Descriptive statistics for turnover and non-turnover observations Panel A: CEO sample Turnover (n ¼ 239) Mean

1st quartile

Median

3rd quartile Std. Dev.

Mean

1st quartile

Median

3rd quartile Std. Dev. (p-value)

0.0000

0.1368

1.1127

0.7661

0.0000

0.2118

0.7716

1.5887

0.1605 0.2578 0.0000 0.0286 0.1492 0.0000 61 1.68 3.32 3.40 1.9051 0.0000 6

1.2076 1.2274 0.0125 0.0204 0.4023 0.2696 65 6.34 34.27 7.35 3.0850 0.0000 10

3.2868 1.1978 0.3772 0.4128 0.2755 0.2101 7.3945 11.3938 50.1943 10.2506 3.4513 0.2837 7.0969

2.0142 1.1071 0.2700 0.0900 0.2911 0.1262 55.8218 7.6703 19.7670 4.5157 3.2192 0.1005 7.5749

0.0414 0.0000 0.0000 0.1290 0.0000 0.0000 51 0.64 10.86 1.54 1.5694 0.0000 2

0.6032 0.7730 0.0000 0.0000 0.1690 0.0000 56 2.22 12.35 4.70 2.3167 0.0000 5

2.1339 1.5809 0.2319 0.0593 0.5671 0.2171 61 9.04 38.67 8.65 3.7430 0.0000 11

3.9608 1.3006 0.6699 0.3490 0.3288 0.2160 7.4356 12.3504 52.8383 8.5736 3.1404 0.3006 7.8028

6.64 (o.0001) 3.00 4.23 4.73 2.98 3.20 1.30 8.18 1.66 2.39 4.42 1.68 0.64 0.50

(0.0029) (o.0001) (o.0001) (0.0032) (0.0016) (0.1933) (o.0001) (0.0976) (0.0171) (o.0001) (0.0945) (0.5210) (0.6167)

Panel B: Non-CEO sample Variable

Turnover (n ¼ 1,228) Mean

Unexercisable in-the-money options Exercisable in-the-money options Time value of unexercised options Restricted shares

t-statistic

Non-turnover (n ¼ 27,688)

1st quartile Median

3rd quartile

Std. Dev.

Mean

1st quartile Median

3rd quartile

Std. Dev.

(p-value)

0.3602

0.0000

0.0000

0.2082

1.1296

0.7142

0.0000

0.2073

0.7694

1.3746

10.64 (o.0001)

1.2560

0.0000

0.1226

1.1543

2.9043

1.3283

0.0025

0.3495

1.3595

2.7171

0.86 (0.3922)

0.5637

0.0000

0.0000

0.7968

0.9905

0.8477

0.0000

0.6036

1.2069

0.9900

9.84 (o.0001)

0.1649

0.0000

0.0000

0.5081

0.5168

0.2053

0.0000

0.0000

0.0596

0.5570

2.67 (0.0077)

ARTICLE IN PRESS

Unexercisable in-the-money 0.2791 0.0000 options Exercisable in-the-money options 1.3672 0.0000 Time value of unexercised options 0.7754 0.0000 Restricted shares 0.1513 0.0000 Residual 0.1701 0.2261 Director option grants 0.2334 0.0000 Director stock grants 0.1446 0.0000 Executive age 59.7908 55 Insider ownership 6.4316 0.53 Return to shareholders 11.5465 18.00 Return on assets 1.5671 0.42 Market to book value 2.8417 1.2964 Hightech 0.0879 0.0000 CEO tenure 7.8075 3

t-statistic

Non-turnover (n ¼ 12,882)

S. Balsam, S. Miharjo / Journal of Accounting and Economics 43 (2007) 95–119

Variable

0.0600 0.2612 0.1321 56.7923 7.7081 7.7728 2.2413 2.8621 0.0953 0.0407 0.0326

0.1354 0.0000 0.0000 51 0.59 21.730 0.785 1.3987 0.0000 0.0000 0.0000

0.0000 0.1232 0.0000 58 1.92 3.435 3.560 2.1027 0.0000 0.0000 0.0000

0.1292 0.5151 0.2381 63 8.03 28.985 7.585 3.3617 0.0000 0.0000 0.0000

0.3630 0.3107 0.2164 8.5281 13.5371 49.4097 11.6205 2.8472 0.2937 0.1977 0.1776

0.0286 0.2908 0.0979 51.8412 10.1881 22.5498 4.4969 3.1785 0.0991 0.0287 0.0144

0.0930 0.0000 0.0000 46 0.930 10.695 1.470 1.5740 0.0000 0.0000 0.0000

0.0000 0.1083 0.0000 52 3.710 14.000 4.750 2.3390 0.0000 0.0000 0.0000

0.1169 0.5878 0.0000 57 13.545 42.370 8.815 3.7744 0.0000 0.0000 0.0000

0.2891 0.3393 0.1998 8.3160 14.6554 57.3267 8.9382 2.9181 0.2989 0.1671 0.1192

2.99 3.26 5.44 20.39 6.26 10.18 6.71 3.72 0.44 2.09 3.55

(0.0029) (0.0012) (o.0001) (o.0001) (o.0001) (o.0001) (o.0001) (0.0002) (0.6573) (0.0370) (0.0004)

Variable definitions (all variables are measured during or at the end of year t1)

Director option grants Director stock grants Executive age Insider ownership Return to shareholders Return on assets Market to book value Hightech CEO tenure CEO turnover Lag CEO turnover

The value of unexercisable in-the-money options deflated by total direct compensation The value of exercisable in-the-money options deflated by total direct compensation Estimate of time value of unexercised options using Core and Guay (2002) algorithm deflated by total direct compensation The value of restricted shares deflated by total direct compensation Estimated of amount by which executive is over/underpaid (based on firm size, industry and executive rank within firm) divided by total direct compensation Value of options granted to directors as a percentage of total director compensation Value of shares granted to directors as a percentage of total director compensation Executive age Percentage of shares owned by insiders Percentage common stock return including dividends Percentage return on assets Market to book value of equity 1 if firm belongs to high-tech industry, 0 otherwise; where SIC codes 3570–3579 (computer and office equipment), 4800–4899 (communication), and 7370–7379 (computer hardware and software-related services) are considered high-tech Length of time in CEO position 1 if CEO leaves firm in year t, zero otherwise 1 if CEO leaves firm in year t1, zero otherwise

ARTICLE IN PRESS

Unexercisable in-the-money options Exercisable in-the-money options Time value of unexercised options Restricted shares Residual

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Residual Director option grants Director stock grants Executive age Insider Ownership Return to shareholders Return on assets Market to book value Hightech CEO turnover Lag CEO turnover

107

108

Panel A: CEO model (n ¼ 13; 121)

Unexercisable in-the-money options Exercisable in-the-money options Time value of unexercised options Restricted shares Residual Director option grants Director stock grants Executive age Insider ownership Return to shareholders Return on assets Market to book value Hightech

Correlation coefficients (p-value) Exercisable in- Time value the-money opt unexercised options

Restricted shares

Residual

Director option grants

Director stock grants

Executive age

Insider ownership

Return to Return on shareholders assets

Market to book value

Hightech

CEO tenure

0.4726 (o.0001)

0.0153 (0.0797) 0.0099 (0.2565) 0.0974 (o.0001)

0.0005 (0.9531) 0.0288 (0.0010) 0.0555 (o.0001) 0.0555 (o.0001)

0.1308 (o.0001) 0.1376 (o.0001) 0.3365 (o.0001) 0.1130 (o.0001) 0.0144 (0.0989)

0.0432 0.0844 (o.0001) (o.0001) 0.0399 0.0067 (o.0001) (0.4417) 0.0517 0.1029 (o.0001) (o.0001) 0.1700 (o.0001) 0.0337 (0.0001) 0.0716 0.0309 (o.0001) (0.0004) 0.3613 0.1618 (o.0001) (o.0001) 0.0499 (o.0001)

0.0164 (0.0607) 0.0048 (0.5866) 0.0811 (o.0001) 0.0839 (o.0001) 0.0883 (o.0001) 0.0565 (o.0001) 0.1470 (o.0001) 0.0430 (o.0001)

0.3389 (o.0001) 0.1886 (o.0001) 0.0214 (0.0143) 0.0250 (0.0042) 0.0768 (o.0001) 0.0434 (o.0001) 0.0136 (0.1183) 0.0345 (o.0001) 0.0270 (0.0020)

0.2962 (o.0001) 0.2303 (o.0001) 0.0561 (o.0001) 0.0255 (0.0035) 0.0626 (o.0001) 0.1553 (o.0001) 0.0065 (0.4543) 0.0672 (o.0001) 0.0501 (o.0001) 0.2981 (o.0001) 0.3068 (o.0001)

0.1121 (o.0001) 0.0744 (o.0001) 0.1506 (o.0001) 0.0646 (o.0001) 0.0531 (o.0001) 0.2196 (o.0001) 0.0997 (o.0001) 0.1447 (o.0001) 0.0475 (o.0001) 0.0183 (0.0364) 0.0629 (o.0001) 0.1134 (o.0001)

0.0020 (0.8193) 0.0762 (o.0001) 0.0183 (0.0358) 0.0355 (o.0001) 0.0051 (0.5623) 0.0046 (0.5967) 0.1023 (o.0001) 0.4075 (o.0001) 0.1217 (o.0001) 0.0127 (0.1461) 0.0772 (o.0001) 0.0002 (0.9859) 0.0145 (0.0964)

0.0410 (o.0001) 0.0844 (o.0001)

0.1599 (o.0001) 0.1263 (o.0001) 0.0726 (o.0001) 0.0305 (0.0005) 0.0962 (o.0001) 0.0066 (0.4468) 0.0086 (0.3270) 0.0575 (o.0001) 0.0495 (o.0001) 0.1694 (o.0001)

ARTICLE IN PRESS

Variable

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Table 3 Pearson correlation coefficients for the independent variables

Panel B: non-CEO model (n ¼ 28; 916) Variable

Residual

Director option grants

Director Executive age stock grants

Insider ownership

Return to Return on shareholders assets

Market to book value

Hightech

CEO turnover

Lag CEO turnover

0.4064 (o.0001)

0.0354 (o.0001) 0.0008 (0.8988) 0.0236 (o.0001) 0.0119 (0.0425)

0.1364 (o.0001) 0.0913 (o.0001) 0.3339 (o.0001) 0.1219 (o.0001) 0.0180 (0.0021)

0.0364 (o.0001) 0.0047 (0.4230) 0.0265 (o.0001) 0.1900 (o.0001) 0.0278 (o.0001) 0.3020 (o.0001)

0.0472 (o.0001) 0.0058 (0.3274) 0.0555 (o.0001) 0.0986 (o.0001) 0.0265 (o.0001) 0.0297 (o.0001) 0.1471 (o.0001) 0.0686 (o.0001)

0.3752 (o.0001) 0.1754 (o.0001) 0.0008 (0.8989) 0.0271 (o.0001) 0.0678 (o.0001) 0.0518 (o.0001) 0.0024 (0.6823) 0.0524 (o.0001) 0.0310 (o.0001)

0.3471 (o.0001) 0.2497 (o.0001) 0.1042 (o.0001) 0.0368 (o.0001) 0.0728 (o.0001) 0.1794 (o.0001) 0.0131 (0.0255) 0.0567 (o.0001) 0.0282 (o.0001) 0.3238 (o.0001) 0.2854 (o.0001)

0.1172 (o.0001) 0.0535 (o.0001) 0.1492 (o.0001) 0.0643 (o.0001) 0.0256 (o.0001) 0.1893 (o.0001) 0.0725 (o.0001) 0.1123 (o.0001) 0.0489 (o.0001) 0.0187 (0.0014) 0.0990 (o.0001) 0.1131 (o.0001)

0.0372 (o.0001) 0.0375 (o.0001) 0.0087 (0.1380) 0.0031 (0.5952) 0.0171 (0.0037) 0.0033 (0.5716) 0.0031 (0.6015) 0.0021 (0.7220) 0.0373 (o.0001) 0.0550 (o.0001) 0.0820 (o.0001) 0.0164 (0.0052) 0.0032 (0.5802)

0.0163 (0.0056) 0.0209 (0.0004) 0.0040 (0.4945) 0.0029 (0.6191) 0.0011 (0.8469) 0.0017 (0.7730) 0.0030 (0.6134) 0.0049 (0.4037) 0.0371 (o.0001) 0.0016 (0.7851) 0.0407 (o.0001) 0.0109 (0.0651) 0.0080 (0.1735) 0.0170 (0.0038)

0.0697 (o.0001) 0.0855 (o.0001)

Residual

0.0099 (0.0921) 0.0097 (0.0985) 0.0871 (o.0001)

Director option grants Director stock grants Executive age Insider Ownership Return to shareholders Return on assets Market to book value Hightech CEO turnover

0.1073 (o.0001) 0.0507 (o.0001) 0.0820 (o.0001) 0.0582 (o.0001) 0.0745 (o.0001) 0.1626 (o.0001) 0.0946 (o.0001)

0.1588 (o.0001) 0.1211 (o.0001) 0.0354 (o.0001) 0.0305 (o.0001) 0.0876 (o.0001) 0.0243 (o.0001) 0.0182 (0.0020) 0.0394 (o.0001) 0.0422 (o.0001) 0.1876 (o.0001)

Variable definitions (all variables are measured during or at the end of year t1) Unexercisable in-the-money options Exercisable in-the-money options Time value of unexercised options Restricted shares Residual

The value of unexercisable in-the-money options deflated by total direct compensation The value of exercisable in-the-money options deflated by total direct compensation Estimate of time value of unexercised options using Core and Guay (2002) algorithm deflated by total direct compensation The value of restricted shares deflated by total direct compensation Estimated of amount by which executive is over/underpaid (based on firm size, industry and executive rank within firm) divided by total direct compensation

ARTICLE IN PRESS

Exercisable Time value Restricted in-theunexercised shares money options options

S. Balsam, S. Miharjo / Journal of Accounting and Economics 43 (2007) 95–119

Unexercisable in-themoney options Exercisable in-themoney options Time value of unexercised options Restricted shares

Correlation coefficients (p-value)

109

110

Table 3 (continued ) Variable definitions (all variables are measured during or at the end of year t1)

ARTICLE IN PRESS

CEO tenure CEO turnover Lag CEO turnover

Value of options granted to directors as a percentage of total director compensation Value of shares granted to directors as a percentage of total director compensation Executive age Percentage of shares owned by insiders Percentage common stock return including dividends Percentage return on assets Market to book value of equity 1 if firm belongs to high-tech industry, 0 otherwise; where SIC codes 3570–3579 (computer and office equipment), 4800–4899 (communication), and 7370–7379 (computer hardware and software-related services) are considered high-tech Length of time in CEO position 1 if CEO leaves firm in year t, zero otherwise 1 if CEO leaves firm in year t1, zero otherwise

S. Balsam, S. Miharjo / Journal of Accounting and Economics 43 (2007) 95–119

Director option grants Director stock grants Executive age Insider ownership Return to shareholders Return on assets Market to book value Hightech

ARTICLE IN PRESS S. Balsam, S. Miharjo / Journal of Accounting and Economics 43 (2007) 95–119

111

Table 4 Regression analysis: executive turnover as a function of the incentives provided by equity compensation Variable

CEO (n ¼ 13,121)

Intercept Unexercisable in-the-money options Exercisable in-the-money options Time value of unexercised options Restricted shares Residual Director option grants Director stock grants Executive age Insider ownership Return to shareholders Return on assets Market to book value Hightech CEO tenure CEO turnover Lag CEO turnover

Coeff.

p-value

7.7045 0.4561

o.0001 0.0005

0.0012

Non-CEO (n ¼ 28,916) Coeff.

p-value

0.3980

6.5414 0.2148

o.0001 o.0001

0.1619

0.9564

0.0026

0.0230

0.0483

0.0346

0.2271

0.0015

0.1627

0.4330

o.0001

0.2367

0.5161 0.3415 0.0159 0.4903 0.0754 0.0109 0.0004 0.0305 0.0343 0.1041 0.0235

0.0026 0.0235 0.9507 0.1334 o.0001 0.0867 0.7951 o.0001 0.1318 0.6706 0.0088

0.1895 0.0660 0.0029 0.0584 0.3098 0.0741 0.0116 0.1449 0.0595 0.0172 0.1009

0.2880 0.3422 0.4362 0.8843 0.0691 0.0136 0.0191 0.0035 0.0232 0.2732

o.0001 0.0002 0.0002 o.0001 o.0001 o.0001 o.0001 o.0001 0.0695 0.0262

0.0882 0.0552 0.0813 0.0978 0.3194 0.1096 0.6012 0.0175 0.0373 0.0450

0.0618 0.6454

0.6978 0.0004

0.0057 0.0435

Std. estimate

Std. estimate

Variable definitions (all variables are measured during or at the end of year t1) Unexercisable in-themoney options Exercisable in-themoney options Time value of unexercised options Restricted shares Residual Director option grants Director stock grants Executive age Insider ownership Return to shareholders Return on assets Market to book value Hightech

CEO tenure CEO turnover Lag CEO turnover

The value of unexercisable in-the-money options deflated by total direct compensation The value of exercisable in-the-money options deflated by total direct compensation Estimate of time value of unexercised options using Core and Guay (2002) algorithm deflated by total direct compensation The value of restricted shares deflated by total direct compensation Estimated of amount by which executive is over/underpaid (based on firm size, industry and executive rank within firm) divided by total direct compensation Value of options granted to directors as a percentage of total director compensation Value of shares granted to directors as a percentage of total director compensation Executive age Percentage of shares owned by insiders Percentage common stock return including dividends Percentage return on assets Market to book value of equity 1 if firm belongs to high-tech industry, 0 otherwise; where SIC codes 3570–3579 (computer and office equipment), 4800–4899 (communication), and 7370–7379 (computer hardware and software-related services) are considered high-tech Length of time in CEO position 1 if CEO leaves firm in year t, zero otherwise 1 if CEO leaves firm in year t1, zero otherwise

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we examine if the inclusion of two additional board variables, i.e., proportion of outside directors and existence of founder on the board, affects our results. The results, which are presented in Table 5, are generally consistent with those presented earlier for both the CEO and non-CEO. In both models we find the coefficients on unexercisable in-the-money options, time value of unexercised options, and restricted shares to be negative and significant. However in contrast to the findings of Table 4 we do not find residual to be significant in either. Turning to our control variables we find that director stock grants are positive and significant in the non-CEO model, while return on assets is negative and significant and age and market-to-book value are positive and significant in both. Of the two new variables, neither is significant in the CEO model, and only proportion of outside directors is significant (positive) in the non-CEO model. 4.3.2. Exclusion of retirement Our empirical analysis is complicated by the fact that retirements at many firms are to some extent involuntary, e.g., an executive is expected to retire once he or she reaches a certain age. Consequently including these observations would add noise to our study and potentially bias our results. As one sensitivity test, we replace age with the indicator variable AGEDUM, which takes the value of 1 when the CEO is either 64 or 65, as in Murphy and Zimmerman (1993), and rerun our analysis. We then rerun our analysis three more times dropping observations most likely to be retirement. We first drop terminal-year observations coded as retirement, then we drop observations where the executive was either 64 or 65, and last we drop observations where the executive was 64 or older. The results, which are not tabulated, are almost identical to those presented in Table 4 for the full sample.12 4.3.3. Analysis by age Beyond retirement, the possibility exists that equity compensation may have different effects on executives at different points during their career and/or executives that have accumulated substantial amounts of wealth. For example, a younger executive may be more willing to forfeit unvested equity compensation in taking a new position as he/she has more years in which to recover the amounts lost. More directly, unvested equity compensation may be a less effective means of reducing turnover in younger executives. Consequently we partitioned our non-CEO sample by executive age (less than 45, 45–49, 50–54, 55–59, and 60–63) and ran five separate regressions.13 Overall the results, which are not tabulated, are highly significant and consistent with the results presented in Table 4, with the coefficients on unexercisable in-the-money options and restricted shares being negative and significant in three of the five regressions, and the coefficient on time value of unexercised options being negative and significant in four regressions. We also computed the Fama and MacBeth (1973) t-statistic. The p-values of the Fama MacBeth t-statistic for unexercisable in-the-money options, time value of unexercised options and restricted shares are all negative and significant at po0:03 or better, while those on exercisable in-the-money options and residual are statistically insignificant. 12 The one difference is in the CEO model dropping observations coded as retirement. While both unexercisable in-the-money options and time value of unexercised options are negative, neither is significant. 13 Due to small sample size in some age ranges we were unable to partition the CEO sample this way.

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113

Table 5 Regression analysis: executive turnover as a function of the incentives provided by equity compensation with board composition and founder as additional control variables Variable

CEO (n ¼ 5,067)

Intercept Unexercisable in-the-money options Exercisable in-the-money options Time value of unexercised options Restricted shares Residual Director option grants Director stock grants Executive age Insider Ownership Return to shareholders Return on assets Market to book value Hightech CEO tenure CEO turnover Lag CEO turnover Percentage of outside directors Founder on the board

Non-CEO (n ¼ 8,495)

Coeff.

p-value

Std. estimate

Coeff.

p-value

Std. estimate

7.7215 2.2954

o.0001 o.0001

1.4038

7.7885 0.5792

o.0001 o.0001

0.3219

0.0211 0.2413 0.6301 0.3041 0.1745 0.5291 0.0741 0.0194 0.0029 0.0184 0.0567 0.1588 0.0222

0.6088 0.0214 0.0199 0.2339 0.6933 0.3067 o.0001 0.1600 0.2572 0.0802 0.0957 0.6741 0.1642

0.0437 0.2149 0.2391 0.0567 0.0318 0.0700 0.2934 0.1049 0.0689 0.0901 0.0850 0.0268 0.0899

0.0318 0.4482 0.3610 0.2112 0.2382 0.7226 0.0738 0.0053 0.0005 0.0132 0.0534 0.3096

0.0769 o.0001 0.0040 0.2154 0.2693 0.0111 o.0001 0.3752 0.7019 0.0146 0.0572 0.1470

0.0511 0.3021 0.1172 0.0334 0.0453 0.0918 0.3377 0.0321 0.0125 0.0766 0.0644 0.0521

0.6309 0.1805 1.5219 0.0628

0.0955 0.6164 0.0003 0.6527

0.0615 0.0137 0.1344 0.0169

0.5719 0.0886

0.4613 0.7669

0.0492 0.0216

Variable definitions (all variables are measured during or at the end of year t1) Unexercisable in-themoney options Exercisable in-the-money options Time value of unexercised options Restricted shares Residual Director option grants Director stock grants Executive age Insider ownership Return to shareholders Return on assets Market to book value Hightech

CEO tenure CEO turnover Lag CEO turnover Percentage of outside directors Founder on the board

The value of unexercisable in-the-money options deflated by total direct compensation The value of exercisable in-the-money options deflated by total direct compensation Estimate of time value of unexercised options using Core and Guay (2002) algorithm deflated by total direct compensation The value of restricted shares deflated by total direct compensation Estimated of amount by which executive is over/underpaid (based on firm size, industry and executive rank within firm) divided by total direct compensation Value of options granted to directors as a percentage of total director compensation Value of shares granted to directors as a percentage of total director compensation Executive age Percentage of shares owned by insiders Percentage common stock return including dividends Percentage return on assets Market to book value of equity 1 if firm belongs to high-tech industry, 0 otherwise; where SIC codes 3570–3579 (computer and office equipment), 4800–4899 (communication), and 7370–7379 (computer hardware and software-related services) are considered high-tech Length of time in CEO position 1 if CEO leaves firm in year t, zero otherwise 1 if CEO leaves firm in year t1, zero otherwise Percentage of directors classified as independent by the Corporate Library 1 if Corporate Library indicates a founder of the company sits on the board of directors, zero otherwise

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5. Strong vs. weak performers From the point of view of the firm, executives fall into one of three categories: those firm wishes to retain; those firm does not want to retain but rather than fire encourages to leave, perhaps to avoid the payment of severance;14 and those firm fires. In theory, the executive compensation package should be structured to retain those strong performers, while encouraging weaker ones to depart. In practice we may observe just the opposite, i.e., strong performers departing at a higher rate than weak performers, as while strong performers have other opportunities, weak performers do not. By examining voluntary turnover across strong and weak performers we can infer whether or not the compensation package is doing its part to counter external incentives and encourage productive retention. As discussed in the data section, considerable difficulty exists in determining which executives have been fired and which leave the firm voluntarily. However, using the preexisting metric from Huson et al. (2001) we have classified turnover into voluntary or involuntary. Unfortunately the literature provides no guidance on how to distinguish between those executives the firm wishes to retain and those it is encouraging to leave. Further, we cannot directly observe managerial performance rather we have to infer it using proxy measures. One measure is raise received, i.e., the firm may send a signal to executives by not giving them a raise and/or bonus when other executives get one. Partitioning our sample based upon this variable we see that turnover is greater for the weak performer subsample. For illustration purposes, voluntary turnover for non-CEOs is 4.44 percent per year. However when we look at non-CEOs who did not receive a raise in the prior year, voluntary turnover is even higher, 12.40 percent, while for those who did, voluntary turnover is 3.20 percent. To examine whether it is the incentives provided by the compensation package that drive this higher turnover, we first examine the retention incentives for each group of executives. For this analysis we classify executives as weak if they did not receive an increase in either salary, total cash compensation, or total direct compensation, whereas the average executive at their firm did. Table 6 shows that the values of unexercisable in-the-money options, time value of unexercised options, restricted shares, and residual are all statistically greater for the strong performer subsample, consistent with the compensation package being designed to retain those executives. Consequently while weak executives will suffer a monetary loss if they leave the firm, that is unexercisable in-the-money options, time value of unexercised options, and restricted shares are all positive and statistically significant, their loss will be less than that of strong executives. Table 7 contains the results of our analysis in which models (1) and (2) have been augmented with interactions between an indicator variable strong and the four variables unexercisable in-the-money options, time value of unexercised options, restricted shares, and residual shown to affect voluntary executive turnover in Table 4. Thus the coefficient on unexercisable in-the-money options represents the relationship between that variable and voluntary turnover for weak executives, while the coefficient on unexercisable in-the-money

14 Severance can be costly (e.g., the reported $140 million package Michael Ovitz received when dismissed by Disney) consequently the corporation may attempt to avoid paying it by encouraging the executive to look for employment elsewhere, as Disney reportedly did with Ovitz (see Stewart, 2005).

Table 6 Descriptive statistics for subsamples of strong and weak executives

t-statistic (p-value)

Time value of unexercised options

Restricted shares Residual

Strong

Weak

Strong

Weak

Strong

Weak

Strong

0.768 0.000 0.223 0.785

0.644 0.000 0.005 0.415

1.102 0.045 0.789 1.578

1.088 0.000 0.362 1.527

0.271 0.000 0.000 0.242

0.239 0.000 0.000 0.019

1.564

1.762

1.263

1.639

0.665

0.672

2.28 (0.023)

0.28 (0.781)

1.53 (0.125)

Unexercisable in-the-money options

Time value of unexercised options

Restricted shares Residual

Weak

Strong

Weak

Strong

Weak

Strong

Weak

Strong

Weak

0.074 0.118 0.000 0.063

0.276 0.360 0.057 0.000

0.727 0.000 0.219 0.790

0.464 0.000 0.007 0.362

0.851 0.000 0.611 1.227

0.700 0.000 0.321 0.915

0.211 0.000 0.000 0.074

0.142 0.000 0.000 0.000

0.019 0.085 0.000 0.123

0.123 0.191 0.010 0.062

0.320

0.550

1.376

1.262

0.980

1.081

0.562

0.487

0.278

0.387

12.17 (o.0001)

10.68 (o.0001)

7.33 (o.0001)

7.22 (o.0001)

14.25 (o.0001)

Variable definitions (all variables are measured during or at the end of year t1) Strong Weak Unexercisable in-the-money options Time value of unexercised options Restricted shares Residual

Indicator variable taking the value of 1 if the executive’s salary, total cash compensation, or total direct compensation was higher in year t1 than year t2 Indicator variable taking the value of 1 if the executive’s salary, total cash compensation, and total direct compensation in year t1 were all less than or equal to their values in year t2 The value of unexercisable in-the-money options deflated by total direct compensation Estimate of time value of unexercised options using Core and Guay (2002) algorithm deflated by total direct compensation The value of restricted shares deflated by total direct compensation Estimated of amount by which executive is over/underpaid (based on firm size, industry and executive rank within firm) divided by total direct compensation

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Mean 1st quartile Median 3rd quartile Std. Dev.

Unexercisable in-the-money options

Non-CEO sample: Strong group (n ¼ 25,907); Weak group (n ¼ 3,009)

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CEO sample: Strong group (n ¼ 11,989); Weak group (n ¼ 1,132)

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Table 7 Regression analysis: executive turnover as a function of the incentives provided by equity compensation with interactions for strong executives Variable

CEO (n ¼ 13,121)

Intercept Unexercisable in-the-money options Unexercisable in-the-money options * strong Exercisable in-the-money options Time value of unexercised options Time value of unexercised options*Strong Restricted shares Restricted shares * Strong Residual Residual*Strong Director option grants Director stock grants Executive age Insider ownership Return to shareholders Return on assets Market to book value Hightech CEO tenure CEO turnover Lag CEO turnover

Coeff.

p-value

7.4931 0.1185 0.4807

o.0001 0.3821 0.0151

0.0007 0.0787 0.1971 0.1417 0.4664 0.5885 0.4836 0.0240 0.5225 0.0724 0.0119 0.0006 0.0284 0.0386 0.0882 0.0231

Non-CEO (n ¼ 28,916) Coeff.

p-value

0.1034 0.4004

6.2022 0.0999 0.1441

o.0001 0.1217 0.0573

0.0753 0.1050

0.9735 0.4384 0.0975

0.0015 0.0564 0.1354

0.0169 0.1500 0.3473

0.1513 0.0174 o.0001

0.0254 0.0820 0.1844

0.6486 0.1941 0.0049 0.0799 0.9260 0.1096 o.0001 0.0656 0.6615 o.0001 0.0865 0.7191 0.0098

0.0520 0.1647 0.1137 0.0817 0.0043 0.0622 0.2975 0.0809 0.0175 0.1349 0.0670 0.0146 0.0992

0.2704 0.7101 1.0984 1.4377 0.4122 0.8789 0.0631 0.0137 0.0034 0.0182 0.0247 0.2230

0.0161 o.0001 o.0001 o.0001 0.0004 o.0001 o.0001 o.0001 o.0001 o.0001 0.0535 0.0697

0.0828 0.2099 0.1773 0.2084 0.0769 0.0972 0.2917 0.1104 0.1070 0.0911 0.0397 0.0367

0.0186 0.6448

0.9079 0.0004

0.0017 0.0435

Std. estimate

Std. estimate

Variable definitions (all variables are measured during or at the end of year t1) Strong Unexercisable in-themoney options Exercisable in-the-money options Time value of unexercised options Restricted shares Residual Director option grants Director stock grants Executive age Insider ownership Return to shareholders Return on assets Market to book value Hightech

CEO tenure CEO turnover Lag CEO turnover

Indicator variable taking the value of 1 if the executive’s salary, total cash compensation, or total direct compensation was higher in year t1 than year t2 The value of unexercisable in-the-money options deflated by total direct compensation The value of exercisable in-the-money options deflated by total direct compensation Estimate of time value of unexercised options using Core and Guay (2002) algorithm deflated by total direct compensation The value of restricted shares deflated by total direct compensation Estimated of amount by which executive is over/underpaid (based on firm size, industry and executive rank within firm) divided by total direct compensation Value of options granted to directors as a percentage of total director compensation Value of shares granted to directors as a percentage of total director compensation Executive age Percentage of shares owned by insiders Percentage common stock return including dividends Percentage return on assets Market to book value of equity 1 if firm belongs to high-tech industry, 0 otherwise; where SIC codes 3570–3579 (computer and office equipment), 4800–4899 (communication), and 7370–7379 (computer hardware and software-related services) are considered high-tech Length of time in CEO position 1 if CEO leaves firm in year t, zero otherwise 1 if CEO leaves firm in year t1, zero otherwise

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options*strong represents the incremental effect for strong executives, which we expect to be negative if the compensation plan is more effective at retaining strong executives. Empirically while we find our test variables have an effect on the retention of weak executives, we generally find the retentive effect to be greater for strong executives. In our CEO regression we find a negative and significant coefficient on residual for weak executives, while we find negative and significant, overall and incremental effects for unexercisable in-the-money options and time value of unexercised options for strong executives. In our non-CEO regression, we find negative and significant coefficients on time value of unexercised options, restricted shares, and residual for weak executives, finding negative and significant, overall and incremental effects for unexercisable in-the-money options, time value of unexercised options, and restricted shares for strong executives. In a somewhat surprising observation, we find that while residual appears to be associated with lower turnover for weak executives, it is not associated with turnover for strong executives.15 Our explanation for the findings regarding retention of weak performers is that they do not have the same choices as strong performers. While a large bond might be required to retain strong managers and dissuade their raiding by competitors, a much smaller bond (or none at all) can retain a weak manager without any comparable job opportunities. To elaborate, even though the bond is smaller, it can be retentive because the executive has fewer alternative employment options. 6. Conclusions By showing that the intrinsic value of unexercisable in-the-money options, time value of unexercised options, and value of restricted shares are negatively associated with voluntary executive turnover, this study shows that equity compensation, both stock and options, can provide incentive for an executive to remain with his or her current employer. Further we show that the effect is productive retention. That is, even though we expect stronger executives to have greater employment opportunities, we find that their turnover is lower than that of weak executives. These results are robust to the inclusion of a number of control variables shown by previous research to effect turnover, as well as to a number of partitions used to isolate voluntary non-retirement turnover. These findings have practical implications for corporations and compensation consultants at a time when many companies are reexamining equity compensation in the wake of SFAS 123R, which for the first time requires the expensing of stock options on the income statement. In particular, most companies are looking for ways to control that expense. One way would be to reduce the number of stock options granted. Yet as we show, corporations can lower executive turnover by designing compensation packages so that executives have a significant amount of their wealth in unvested options or restricted stock. Compensation plan designers can do so by either increasing the amount of restricted shares and options granted, by increasing their vesting and exercise periods, by granting inthe-money options, or by a combination of the three. Since increasing the number of restricted shares and options granted may not be feasible in the post SFAS 123R environment, designers need to look at the grant parameters to maximize the retentive effect with the same number or even fewer shares available. 15

The results for our control variables are generally consistent with those in Table 4 and are not discussed for brevity.

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