Optimal CEO Compensation with Search: Theory and Empirical Evidence

The Harvard Law School Forum on Corporate Governance and Financial Regulation 2013-07-15

Summary:

Editor's Note: The following post comes to us from Melanie Cao of the Finance Area at York University and Rong Wang of the Finance Group at Singapore Management University.

Two issues concerning executive compensation deserve particular attention. The first is how a firm’s risk affects the executive’s pay-to-performance sensitivity (hereafter PPS), i.e., the ratio of incentive pay to firm performance. Standard agency models predict that the PPS does not change with the firm’s risk if the agent is risk neutral and decreases with the firm’s risk if the agent is risk averse. Notable examples are Bolton and Dewatripont (2005), Holmstrom (1982), and Murphy (1999). In contrast to this theoretical prediction, the empirical evidence on the effect of the firm’s risk on the PPS is ambiguous. For example, Core and Guay (1999) and Oyer and Shaefer (2005) find a positive relationship while Aggarwal and Samwick (1999) document a negative relationship.

The second issue is the large increase in CEO compensation along with the increase in firm size in the past three decades. This large increase has generated an intense debate in the public and the academia on whether CEOs are over-compensated. Although the increase in firm value contributed partly to the increase in CEO pay, a closer look at the data reveals two notable features (see section IV for a detailed description of the data). First, incentive pay, which is the predominant component of CEO pay, has increased more rapidly than the increase in firm value. From 1994 to 2009, median incentive pay increased by 244% in real terms, compared with a 40% increase in median firm value, and its share in total pay increased from 41% to 78.8%. Second, and related to the first feature, total CEO pay outpaced firm value. The ratio between CEO pay and firm value increased from $1.59 in 1994 to $1.73 in 2009 per a thousand dollars. These features suggest that the key to understanding the increase in CEO compensation is to understand what factors determine the PPS.

Click here to read the complete post...

Link:

http://blogs.law.harvard.edu/corpgov/2013/07/15/optimal-ceo-compensation-with-search-theory-and-empirical-evidence/

From feeds:

Blogs.law Aggregation Hub » The Harvard Law School Forum on Corporate Governance and Financial Regulation

Tags:

academic research empirical research incentives executive compensation systemic risk management risk shocks agency model equilibrium melanie cao rong wang

Authors:

R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation,

Date tagged:

07/15/2013, 15:40

Date published:

07/15/2013, 09:08