Long-Term Pay for Performance: Cumulative Evidence over CEO Tenure

Abstract

Many firms claim CEO compensation reflects share price performance in their proxy statements. The pay-for-performance literature has largely evaluated these claims using annual regressions of ex-ante compensation on realized stock returns. We identify two issues with this methodology. First, correlating ex-ante compensation with realized returns creates a mismatch in evaluating pay-for-performance. Second, ex-post settling up behavior makes it difficult to use annual designs to study pay-for-performance. To resolve these measurement issues, we use cumulative realized stock returns and cumulative realized compensation over the CEO's tenure. We find strong evidence of pay for performance in the full sample, with a magnitude significantly greater than that reported in previous studies. However, conditional on stock returns underperforming benchmarks, we find that CEOs' realized pay is unrelated to stock returns. This suggests that CEOs are compensated for outperformance but are not penalized for underperformance. Disaggregating the components of CEO pay reveals that equity-related components generate pay for performance among outperformers but not underperformers. We show that this asymmetry is partially driven by incremental stock unit grants to CEOs as stock performance declines. This suggests that boards give CEOs an upside when the stock performs well and "make CEOs whole" with additional grants when the stock does poorly. The lack of relation between cumulative pay and performance over the CEO tenure for underperforming firms provides relevant insights for shareholders and regulators.

Keywords: Executive Compensation, Pay-for-Performance, Total Shareholder Returns (TSR), Corporate Governance, Realized Compensation

JEL Classification: G34, J33, M12, M52