Asymmetric Benchmarking in Compensation: Executives are Paid for (Good) Luck But Not Punished for Bad

39 Pages Posted: 12 May 2003

See all articles by Gerald T. Garvey

Gerald T. Garvey

Blackrock

Todd T. Milbourn

Washington University in Saint Louis - Olin Business School

Date Written: September 30, 2003

Abstract

Principal-agent theory suggests that a manager should be paid relative to a benchmark that removes the effect of market or sector performance on the firm's own performance. Recently, it has been argued that we do not observe such indexation in the data because executives can set pay in their own interests, that is, they can enjoy "pay for luck" as well as "pay for performance". We first show that this argument is incomplete. The positive expected return on stock markets reflects compensation for bearing systematic risk. If executives' pay is tied to market movements, they can only expect to receive the market-determined return for risk-bearing. This argument, however, assumes that executive pay is tied to bad luck as well as to good luck. If executives can truly influence the setting of their pay, they will seek to have their performance benchmarked only when it is in their interest, namely when the benchmark has fallen. Using industry benchmarks, we find that there is significantly less pay-for-luck when luck is down (in which case pay-for-luck would reduce compensation) than when it is up. These empirical results are robust to a variety of alternative hypotheses and robustness checks, and suggest that the average executive loses 25% less pay from bad luck than she gains from good luck.

Keywords: Compensation, Benchmarking

JEL Classification: D82, G30, J33

Suggested Citation

Garvey, Gerald T. and Milbourn, Todd T., Asymmetric Benchmarking in Compensation: Executives are Paid for (Good) Luck But Not Punished for Bad (September 30, 2003). AFA 2004 San Diego Meetings. Available at SSRN: https://ssrn.com/abstract=392701 or http://dx.doi.org/10.2139/ssrn.392701

Gerald T. Garvey

Blackrock ( email )

Level 37, Chifley Tower
2 Chfiley Square
Sydney, NSW 2000
Australia
+61 2 9272 2388 (Phone)

Todd T. Milbourn (Contact Author)

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/

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