Strategic Flexibility and the Optimality of Pay for Sector Performance

Review of Financial Studies, Forthcoming

47 Pages Posted: 21 Sep 2009  

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 17, 2009

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

Suggested Citation

Gopalan, Radhakrishnan and Milbourn, Todd T. and Song, Fenghua, Strategic Flexibility and the Optimality of Pay for Sector Performance (September 17, 2009). Review of Financial Studies, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1475031

Radhakrishnan Gopalan

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 (Contact Author)

Pennsylvania State University - Smeal College of Business ( email )

University Park, PA 16802
United States
814.863.4905 (Phone)
814.865.3362 (Fax)

HOME PAGE: http://www.personal.psu.edu/fxs16

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