Higher Executive Comp Equals Higher Credit Risk

July 27, 2005 (PLANSPONSOR.com) - Research by Moody's Investors Service found that companies that pay their CEOs greater than expected for the company's size, past performance, and other factors, experience higher credit default rates and more frequent large downgrades than do other similarly rated companies.

The research report gave three possible explanations for this correlation:

  • excessive compensation may be indicative of weak management oversight.
  • large pay packages that are highly sensitive to stock price and/or operating performance may induce greater risk taking by managers, perhaps consistent with stockholders’ objectives, but not necessarily bond holders’ objectives.
  • large incentive-pay packages may lead managers to focus on accounting results, which may, at best divert management attention from the underlying business or, at worst, create an environment that ultimately leads to fraud.

Moody’s also found that salary, the non-incentive portion of compensation, makes up only 19% of total compensation as of 2003, compared to 38% of total compensation in 1993.   The largest growth in incentive compensation is in stock option grants, now the most significant component of overall compensation.

Moody’s warned that the correlation between greater than expected executive compensation and greater credit risk was based on historical data and may not be constant over time.   “Therefore, while the model could provide valuable early-warning information in terms of assessing potential credit problems, analysts should also evaluate the relationship between CEO compensation and expected credit risk on a case-by-case basis,” the company said in its report.