Indexing Executive Compensation Contracts

We analyze the efficiency of indexing executive pay by calibrating the standard model of executive compensation to a large sample of US CEOs. The benefits from linking the strike price of stock options to an index are small and fully indexing all options would increase compensation costs by about 50% for most firms. Indexing has several effects with overall ambiguous impact; the quantitatively most important effect is to reduce incentives, because indexed options pay off when CEOs’ marginal utility is low. The results also hold if CEOs can extract rents and extend to the case of indexing shares.