Incentive Pay and the Market for CEOs: An Analysis of Pay-For-Performance Sensitivity
Charles P. Himmelberg
Goldman, Sachs & Co.
R. Glenn Hubbard
Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)
Presented at Tuck-JFE Contemporary Corporate Governance Conference
Significant increases in CEO compensation in recent years have coincided with an unprecedented bull market for stocks. They have also coincided with increasingly frequent arguments from academics and practitioners that CEO pay is excessive. Academics in particular point to departures from relative performance evaluation as a major puzzle. Observing that the sensitivity of CEO compensation to market returns is inconsistent with the predictions of principal-agent theory; they have increasingly been tempted to resort to political explanations to explain the compensation of CEOs. The sensitivity of CEO compensation to market returns is not so puzzling, however, when one recognizes the special feature of the labor market for CEOs. The combination talent sorting of CEOs among firms and aggregate shocks that affect the marginal value of CEO services to the firm predicts a positive relationship between CEO pay and aggregate stock market returns. We argue that the supply of highly skilled CEOs capable of running large, complex corporations is relatively inelastic, so shocks to aggregate demand for CEOs simultaneously raise firm value and raise the marginal value of CEO services to the firm. In equilibrium, such shocks bid up the value of their compensation packages. This phenomenon makes it appear as if (some) firms are violating relative performance evaluation. Using Standard and Poor's Execucomp data for a large panel of U.S. firms, we show that the empirical "failure" of RPE is systematically restricted to the CEOs of certain types of firms. In our data, there is less of a puzzle for the firms in the bottom quartile of the size distribution. The behavior of these firms is in closer accordance with the predictions of agency theory. We interpret this as evidence that the supply of CEOs sufficiently skilled to manage such firms is relatively elastic. The compensation packages for the CEOs of larger, more complex firms, however, require highly skilled CEOs. Empirically, the compensation packages for the CEOs of these firms are more sensitive to aggregate shocks, which we interpret as evidence that the supply of highly skilled CEOs is relatively inelastic. These results are robust to robustness checks against alternative hypothesis such as "skimming" and strategic considerations. Finally, the paper's findings suggest three extensions to i) analysis rent sharing between CEOs and firms, ii) comparisons of pay-performance sensitivities of CEOs and divisional managers, and iii) studies of cyclical patterns in earnings inequality.
Number of Pages in PDF File: 55
Keywords: Executive compensation
JEL Classification: G34, J44
Date posted: July 24, 2000