Growth Through Rigidity: An Explanation of the Rise of CEO Pay
University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)
Richard R. Townsend
Dartmouth College - Tuck School of Business
March 13, 2015
Tuck School of Business Working Paper No. 2424860
Chicago Booth Research Paper No. 14-22
The dramatic rise in US CEO compensation during the 1990s and early 2000s is a longstanding puzzle. In this paper, we show that much of the rise can be explained by a tendency of firms to grant the same number of options each year. In addition, we show that salary and bonus exhibited downward nominal rigidity. Together, these two forms of rigidity imply that the value of executive pay will grow with firm equity returns, which were very high on average during the Tech Boom. Number-rigidity in options can also explain the increased dispersion in pay, the difference in growth between the US and other countries, and the increased correlation between pay and firm-specific equity returns. We present evidence that number-rigidity arose from a lack of sophistication about option valuation that is akin to money illusion. We show that regulatory changes requiring the disclosure of the grant-date value of options led to a decline in number-rigidity, and helps explain why executive pay increased less with equity returns during the Housing Boom in the mid-2000s.
Number of Pages in PDF File: 69
Date posted: April 15, 2014 ; Last revised: June 19, 2015
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