The Relation between CEO Compensation and Past Performance

Abstract

This study focuses on the relation between current compensation and past performance measures as signals of a chief executive officer's (CEO's) ability. We develop a simple two-period principal-agent model with moral hazard and adverse selection and test theoretical predictions using CEO compensation data from 1993–2006. Consistent with the predictions, we find that salary (bonus) is positively (negatively) associated with past performance for both continuing and newly hired CEOs. We also find that while current salary is positively associated with future performance, current bonus is not. As the model suggests, salary is adjusted to meet the reservation utility and information rent, and is positively correlated over time to reflect ability. Bonus serves to address moral hazard and adverse selection by separating high-ability agents into riskier contracts. Our results indicate that it is important to disaggregate cash compensation into salary and bonus components to understand the dynamic interaction between incentives and performance. Data Availability: Data are available from public sources indicated in the text.

Are more able CEOs getting more compensated? Evidence from the pay-for-performance sensitivity of equity-based incentives

“…While prior studies (e.g., Banker et al, 2013;Fama, 1980;Gibbons & Murphy, 1992;Holmstrom, 1999;Jarque, 2008) suggest that the labor market infers and updates its perception about a CEO's ability through current output and bases the expectation of the CEO's future compensation and future performance on this updated perception, Cai and Walkling (2011) report that both performance and the managerial labor market's perception of a CEO's ability determine the compensation scheme. A firm's CEO, in general, provides a level of talent and skills, thereby influencing the performance of his or her firm.…”

“…The skills and responsibilities that are required to fulfill the job of CEO are of utmost importance. Consequently, firms need to adopt strong incentive contracts to attract and retain talented CEOs, especially when those CEOs still have high mobility in labor market (Arya & Mittendorf, 2005;Banker et al, 2013;Darrough & Melumad, 1995;Rose & Shepard, 1997). As a CEO nears retirement, however, the threat of losing talent to competitors faced by the firm weakens as the CEO's mobility in the labor market decreases (Elsaid, Davidson, & Benson, 2009;Gibbons & Murphy, 1992).…”

“…Demerjian et al (2012) argue that their measures better capture the manager-specific component of ability. Most measures used in prior studies (Banker et al, 2013;Graham et al, 2012;Milbourn, 2003) contain noise, and thus it is difficult to attribute them solely to the manager (Demerjian et al, 2012). That is, existing measures reflect significant aspects of the firm that are outside of management's control.…”

“…Recently, Demerjian, Lev, and McVay (2012) develop a measure of managerial ability, based on managers' efficiency in generating revenues, which captures an economically significant manager-specific aspect of ability. Research also indicates that incentive compensation plans play an important role in screening managers or inducing them to self-select the reward types that can reveal their ability (Arya & Mittendorf, 2005;Banker, Darrough, Huang, & Plehn-Dujowich, 2013;Darrough & Melumad, 1995;Lazear, 2000). Thus, how a CEO's ability, based on the manager-specific aspect of ability, is associated with the CEO's PPS of equity-based compensation is an empirical research question.…”

The Literature Review on Compensation System Design

“…And Banker, R.D., et al [9] divides CEO's compensation into salary and bonus, which enriches related research. The reason for dividing CEO's compensation is that salary is adjusted to meet the reservation utility and information rent, and is positively correlated over time to reflect ability, while bonus serves to address moral hazard and adverse selection by separating high-ability agents into riskier contracts.…”