Asymmetric Benchmarking in Compensation: Executives are Paid for (Good) Luck But Not Punished for Bad
39 Pages Posted: 12 May 2003
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: Suggested Citation
Do you have a job opening that you would like to promote on SSRN?
Recommended Papers
-
Are CEOS Really Paid Like Bureaucrats?
By Brian J. Hall and Jeffrey B. Liebman
-
Are CEOS Really Paid Like Bureaucrats?
By Brian J. Hall and Jeffrey B. Liebman
-
The Other Side of the Tradeoff: The Impact of Risk on Executive Compensation
-
Good Timing: CEO Stock Option Awards and Company News Announcements
-
Good Timing: CEO Stock Option Awards and Company News Announcements
-
The Use of Equity Grants to Manage Optimal Equity Incentive Levels
By John E. Core and Wayne R. Guay
-
The Other Side of the Tradeoff: the Impact of Risk on Executive Compensation
-
Stock Options for Undiversified Executives
By Brian J. Hall and Kevin J. Murphy