Strategic Flexibility and the Optimality of Pay for Luck

45 Pages Posted: 8 Sep 2007 Last revised: 17 Sep 2009

See all articles by Radhakrishnan Gopalan

Radhakrishnan Gopalan

Washington University in St. Louis - John M. Olin Business School

Todd T. Milbourn

Washington University in Saint Louis - Olin Business School

Fenghua Song

Pennsylvania State University - Smeal College of Business

Date Written: September 9, 2008

Abstract

While standard contract theory suggests that a CEO should be paid relative to a benchmark that removes the effects of sector performance (otherwise referred to as luck), there is overwhelming evidence that CEO pay is strongly and positively related to such luck. In this paper we offer an explanation for the observed pay for luck. We model a CEO charged with selecting the firm's strategy which in turn affects the firm's exposure to sector performance. To incentivize the CEO to optimally choose her firm's sector exposure, pay contracts will be positively and sometimes asymmetrically related to sector performance. Using a multitude of proxies to capture the extent of strategic flexibility offered by firms to alter sector exposure we find strong empirical support for our model prediction of greater pay for luck. Our results indicate that the pay for luck is almost fully confined to firms in industries with high R&D expenditure and in multi-divisional firms. Our evidence is robust to alternate explanations such as CEO entrenchment.

Keywords: CEO Compensation, Strategy, Pay for Luck, Corporate Governance

JEL Classification: G30, G34, J33

Suggested Citation

Gopalan, Radhakrishnan and Milbourn, Todd T. and Song, Fenghua, Strategic Flexibility and the Optimality of Pay for Luck (September 9, 2008). Available at SSRN: https://ssrn.com/abstract=1012975 or http://dx.doi.org/10.2139/ssrn.1012975

Radhakrishnan Gopalan (Contact Author)

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

Todd T. Milbourn

Washington University in Saint Louis - Olin Business School ( email )

1 Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-6392 (Phone)
314-935-6359 (Fax)

HOME PAGE: http://www.olin.wustl.edu/faculty/milbourn/

Fenghua Song

Pennsylvania State University - Smeal College of Business ( email )

University Park, PA 16802
United States
814.863.4905 (Phone)

HOME PAGE: http://sites.google.com/site/fenghua8song/

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