Payout-linked manager pay drives firm underinvestment
A new Bank of Canada working paper shows that manager compensation tied to total payouts induces endogenous short-termism and underinvestment. The study demonstrates that limited commitment and outside equity access create a persistent capital wedge.
The dilution channel of short-termism
The paper demonstrates that when managers cannot commit to future equity issuance, compensation tied to total payouts creates a severe time-inconsistency problem.
Managers rationally front-load dividends through follow-up equity issuances, discounting the marginal benefit of investment below the common subjective discount rate.
This wedge raises the perceived cost of capital and depresses long-run investment.
Paradoxically, the distortion intensifies when external equity markets function more efficiently, as easier issuance allows managers to dilute incumbent shareholders more effectively.
Per-share indexing as the first-best remedy
To resolve this inefficiency, the authors propose a straightforward and implementable governance remedy: indexing managerial compensation to per-share payouts rather than absolute totals.
This simple adjustment completely eliminates the dilution channel, realigning the manager with continuing shareholders and successfully restoring the first-best investment path.
The analysis cautions policymakers and boards that governance safeguards intended to prevent overinvestment can inadvertently backfire without proper structural per-share alignment.
A vital warning for corporate boards
This study challenges the conventional wisdom that payout-driven managerial discipline is universally beneficial.
By revealing how standard compensation contracts can undermine capital formation, it exposes a hidden governance flaw.
Corporate boards must rethink executive pay structures to avoid sabotaging long-term firm value.