Is U.S. CEO Compensation Inefficient Pay Without Performance?

45 Pages Posted: 14 Jan 2005 Last revised: 6 Sep 2017

See all articles by John E. Core

John E. Core

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Wayne R. Guay

University of Pennsylvania - Accounting Department

Randall S. Thomas

Vanderbilt University - Owen Graduate School of Management; Vanderbilt University - Law School

Date Written: April 7, 2005


In this paper, we review Pay Without Performance by Professors Lucian Bebchuk and Jesse Fried. The book develops and summarizes the leading critiques of current executive compensation practices in the U.S., and offers a negative, if mainstream, assessment of the state of U.S. executive compensation: U.S. executive compensation practices are failing, and systemic reform is needed. This review summarizes the book in some detail and offers some counter-arguments.

The book's thesis is that executive compensation practices are bad for shareholders (not "optimal") because they are the product of "managerial power." Managerial power arises because boards of directors at public companies are not independent of executives. Weak compensation committees thus do little to protect the firm in its pay negotiations with the CEO, leading to levels of executive pay that are both inappropriately high and have inappropriately low levels of incentives.

The authors offer a four part analysis of CEO pay. First, they describe and critique optimal contracting theory, which posits that executive compensation arrangements are designed to benefit shareholders. Second, they explain managerial power theory, in part through an in-depth analysis of current executive compensation practices. They assert the managerial power theory provides a superior explanation of current practices to the optimal contracting perspective. They also draw the strong implication that if managerial power exists, it means that something is wrong with the contracting process. Third, they claim that CEO compensation does not vary sufficiently with firm performance. They conclude with policy recommendations for changing compensation plans and improving corporate governance, for example by requiring that directors be more independent.

We agree that it is useful to consider the effect of managerial power on compensation, but we disagree with their interpretation of the consequences of this power. It is true that contract structures reflect CEO power, and that CEOs with more power get more pay, but this does not necessarily lead to the conclusion that CEO pay is not optimized for shareholders, nor does it imply that CEO pay needs reform. We show that in many settings where managerial power exists, observed contracts anticipate and try to minimize the costs of this power, and therefore may in fact be written optimally. As a result, the optimal contracting and managerial power perspectives are complementary, and not competing, explanations.

We next examine Bebchuk and Fried's claim that U.S. compensation is inefficient "pay without performance." Their analysis focuses on whether CEO annual pay varies with firm performance. While the book conducts an extensive analysis of the incentives provided by annual grants of stock options and equity it largely ignores the main source of CEO incentives: Large holdings of stock and options. These large equity holdings provide powerful performance incentives and ensure that the wealth of most CEOs varies strongly with their firm's stock price. The books' claim that CEO compensation is "pay without performance" does not appear correct once one considers this main source of CEO incentives. U.S. executives have very large pay-performance incentives, and their overall pay levels do not seem inappropriate.

We conclude by examining some of Bebchuk and Fried's policy recommendations. Bebchuk and Fried have missed some important aspects of executive pay and incentives. They have not shown that there are systematic failures with U.S. CEO compensation, and therefore have not shown that reform is needed.

Keywords: CEO compensation, stock options, equity incentives, corporate governance

JEL Classification: G32, G34, J33, M41

Suggested Citation

Core, John E. and Guay, Wayne R. and Thomas, Randall S. and Thomas, Randall S., Is U.S. CEO Compensation Inefficient Pay Without Performance? (April 7, 2005). Vanderbilt Law and Economics Research Paper No. 05-05, 103 Michigan Law Review 1142 (2005), Available at SSRN: or

John E. Core

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
Cambridge, MA 02138
United States

Wayne R. Guay

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
1329 Steinberg-Dietrich Hall
Philadelphia, PA 19104-6365
United States
215-898-7775 (Phone)
215-573-2054 (Fax)

Randall S. Thomas (Contact Author)

Vanderbilt University - Law School ( email )

131 21st Avenue South
Nashville, TN 37203-1181
United States

Vanderbilt University - Owen Graduate School of Management

401 21st Avenue South
Nashville, TN 37203
United States

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