Strategic Flexibility and the Optimality of Pay for Sector Performance

Abstract

While standard contract theory suggests that a CEO should be paid relative to a benchmark that removes the effects of sector performance, there is evidence that CEO pay is strongly and positively related to such sector performance. Many have coined this relationship as pay for luck. In this paper, we offer an explanation. We model a CEO charged with selecting the firm's strategy which determines the firm's exposure to sector performance. To incentivize the CEO to choose optimally, pay contracts will be positively and sometimes asymmetrically related to sector performance. Consistent with our predictions, our empirical analysis indicates that the observed sensitivity of pay to sector performance is almost fully confined to multi-segment firms and is greater in firms that offer greater strategic flexibility to alter sector exposure, for more talented CEOs, and for CEOs as compared to their subordinate executives. Our evidence is robust to alternate explanations such as CEO entrenchment.

JEL Classification: G30, J33