This paper summarizes the empirical and theoretical research on executive compensation and provides a comprehensive and up-to-date description of pay practices (and trends in pay practices) for chief executive officers (CEOs). Topics discussed include the level and structure of CEO pay (including detailed analyses of annual bonus plans, executive stock options, and option valuation), international pay differences, the pay-setting process, the relation between CEO pay and firm performance (“pay-performance sensitivities”), the relation between sensitivities and subsequent firm performance, relative performance evaluation, executive turnover, and the politics of CEO pay.

We examine the distribution of incentives across executives with explicit divisional responsibilities, those with broad oversight authority over the firm, and CEOs. Oversight executives have pay-performance incentives that are $1.22 per thousand dollar increase in shareholder wealth higher than those of divisional executives. For CEOs, incentives are $5.65 per thousand higher than for executives with divisional responsibility. The aggregate pay-firm performance sensitivity of the top management team is substantial, at $32.32 per thousand for the median firm. CEO incentives are 42 to 58 percent of the aggregate incentives to the top management team. We match a subset of our divisional executives to the divisions they manage. We document a positive pay-divisional performance sensitivity and show that it is increasing in the precision of the divisional performance measure. The pay-firm performance sensitivity for divisional executives is decreasing in the precision of their divisional performance measure. These results are consistent with a principal-agent model with multiple signals of managerial effort.

This paper studies how firms tie CEO compensation to firms' stock market performance. I demonstrate that in theory and in practice there is a tradeo# between giving CEOs incentives and forcing them to hold an un-diversified position in the firm. Unlike the results of the existing literature, market risk is not necessarily a cost of providing incentives. The cost of giving incentives is the potential loss of diversification for the CEO. As a result, CEO incentive decreases with firm-specific risk, but may not decrease with market risk. In performing the empirical tests, I also incorporate the recent critique by Prendergast (2000), which argues that the relation between risk and incentive level is unreliably estimated when we fail to consider the effect of risk on the benefit of giving incentives. I study both sides of the incentive-diversification tradeoff simultaneously. I am able to show that after controlling for the other side of the tradeoff, incentive increases with the CEOs' ability to affect firm value, and decreases with the firm-specific risk level of the firm.

An innovative business practice attributed to the information technology industry is the aggressive use of employee stock options to compensate executives and other employees. The pervasiveness of stock options among high-tech firms in Silicon Valley is often described as a phenomenon unique to the Valley’s culture. In this study, we investigate whether the greater use of stock options in the information technology industry can be explained on the basis of general economic relationships that apply to firms in all industries. Our empirical model is a system of simultaneous equations that captures the interconnectedness between compensation, performance, and specific forms of compensation. We document the impact of the form of compensation on performance and total compensation. Based on previous literature, we also identify economic factors expected to influence the use of stock options and show that there are significant differences between information technology and other industries. While these factors explain much of the greater use of options in the information technology firms, a significant residual difference remains. Considering these factors, we also find that executives in the information technology industry are not compensated at a level higher than those in other industries.

ibrant public securities markets rely on complex systems of supporting institutions that promote the governance of publicly traded companies. Corporate governance structures serve: 1) to ensure that minority shareholders receive reliable

We study the proposal of manager-sponsored compensation plans linking pay to performance by S&P 500 firms in the 1990s. We look at the market perception of these proposals and the characteristics of the firms that propose them. The concept of tying pay to performance has many supporters, though the complexity of incentive contracts and the possibility that managers could design them to be overly beneficial to themselves at shareholder expense suggests that they are not a cure-all for agency problems. Our work helps determine whether managers are in fact introducing plans that are appropriate for their firms in improving managerial efforts to increase shareholder wealth.

We propose a continuous time utility maximization model to value stock and option compensation from the executive’s perspective. We allow the executive to invest non-option wealth in the market and riskless asset but not in the company stock itself. This enables executives to adjust exposure to market risk, but they are subject to firm-specific risk for incentive purposes. Since the executive is risk averse, this unhedgeable firm risk leads them to place less value on the options than their cost to the company, given by their market or Black Scholes value. By distinguishing between these two types of risks, we are able to examine the effect of stock volatility, firm-specific risk, and market risk on the value to the executive. Executives do not necessarily want to increase stock volatility, as their risk aversion can outweigh the option’s convexity effect. Firm-specific risk generally reduces option value, although if market risk is held fixed and the options are out-of-the-money it is possible for the reverse to hold. Generally, market risk has a positive effect on option value. An implication of the model is that the Black Scholes formula exaggerates the incentives for the executive to increase the company stock price. We examine the relationship between risk and optimal incentives, and find firm-specific risk decreases optimal incentives (regardless

Since alternative forms of compensation have different incentive and risk attributes and may respond differently to observable firm performance measures, analysis of relations between executive pay and performance must consider the interplay between the components of total compensation. In this study, interrelations between compensation components and contemporaneous firm performance measures are considered in an empirical model that relates total compensation to performance through the cash bonus and stock-based shares of total compensation. For this analysis, total compensation and the stock-based share are measured using the ex ante or grant-date value of stock options and restricted stock. The model is specified in a manner that permits substitution across types of pay, relaxes restrictive assumptions about the time-series relations between compensation and performance, and accommodates reciprocal relations between pay and performance. Analysis of the estimation results indicates that both the cash bonus share and the stock-based share of total compensation vary positively with market and accounting returns. The results also support hypotheses that, in the determination of compensation awards, market performance is evaluated relative to industry performance, accounting performance is evaluated relative to previous firm and industry performance, cash bonuses and stock-based awards are substituted for each other, and a premium is paid to substitute stock-based pay for cash bonus pay. With respect to the time series relations between compensation and performance, the estimation results indicate that compensation changes associated with performance shocks are not permanent and that, for the purpose of determining executive bonuses and awards, the time series of accounti...

This paper examines the extent to which agency theory may explain CEO compensation in state-owned enterprises (SOEs) in China during the 1980s. We find that the sensitivity of CEO pay to firm performance decreases with the variance of performance. This is consistent with the prediction of a tradeoff between incentives and insurance in agency theory. On the other hand, the data lend little support to the relative performance evaluation hypothesis. We also find that the performance sensitivity of CEO pay increases with the marginal return to executive action, that is, pay sensitivity increases with managerial control rights, worker incentives, profit retention rates of firms, and the degree of product market competition faced by the firm. While the elasticity of pay to sales is slightly smaller than that found in the literature on conventional firms in the West generally, our estimate of the semi-elasticity of pay with respect to profitability is comparable to estimates for regulated industries in the United States.

The study examines how 166 U.S. banks compensated their top management teams (top 4-5 executives in each bank) during 1993-1996. We observe two tiers of compensation in the executive suite: CEO and the rest. CEOs are paid more, especially in performance contingent compensation. The weight of base salary in CEO's pay is significantly lower than in other senior managers' pay, and CEO's pay performance elasticity is significantly higher. Beyond the CEO, top executives have a similar structure of compensation and similar pay performance elasticities. Our evidence is consistent with agency theory, and with several labor economics models. - 1. Introduction The paper presents evidence on how 166 U.S. banks compensated their top management teams (top four or five executives in each bank) during the 1993-96 period. The main goal is to extend previous studies on bank executive pay, e.g., Houston and James (1995), Hubbard and Palia (1995), and Crawford, Ezzel and Miles (1995), by examining n...