Is Executive Pay Closely Tied to Performance?

Executives receive compensation from a number of sources. Part of their pay is fixed,

part is contingent on corporate profits, and part is contingent on improvements in the

stock price of their companies. Anecdotal evidence suggests that executive pay became

much more tied to firm performance during the 1980s and 1990s. However, there is

some disagreement about how sensitive CEO compensation is to performance.

The Jensen and Murphy Evidence.In their Harvard Business Reviewarticle,

Michael Jensen and Kevin Murphy (1990a) argued that executive compensation is not

nearly as performance sensitive as it should be. They examined the compensation and

share ownership of 2,505 CEOs from 1974 to 1988 and calculated how much the com-

pensation of the CEOs increased with each $1,000 increase in the value of their com-

panies. They concluded that the pay-for-performance sensitivity of most CEOs’com-

pensation is surprisingly low and that most CEOs are not given sufficient monetary

incentives to cut costs and create value for their shareholders. For example, the Jensen

and Murphy estimates suggest that if an executive at a large U.S. corporation purchased

an extra $10 million jet for his or her personal use, he or she would be penalized only

about $30,000 in lost compensation.

More Recent Evidence.Subsequent evidence by Boschen and Smith (1995) and Hall

and Liebman (1998) suggests that Jensen and Murphy may have underestimated aver-

age pay-for-performance sensitivities and that these sensitivities have been increasing

over time.

Boschen and Smith (1995) examined how the stock returns of a company affect

the future as well as the current compensation of its CEO. This study concluded that

the Jensen and Murphy evidence substantially underestimates the sensitivity of CEO

pay to performance.

¹⁶This

point was made in Diamond and Verrecchia (1982).

Grinblatt1304Titman: Financial	V. Incentives, Information,	18. How Managerial	© The McGraw1304Hill
Markets and Corporate	and Corporate Control	Incentives Affect Financial	Companies, 2002
Strategy, Second Edition		Decisions

646Part VIncentives, Information, and Corporate Control

To understand why it is important to consider the CEO’s future compensation,

consider a CEO who was promised a bonus in each of the next five years equal to

30percent of the amount by which the company’s earnings exceeded a certain level.

If the CEO took actions that doubled earnings in his or her first year, the stock price

would probably increase substantially upon the announcement of the higher earnings,

reflecting not only this year’s earnings but also the higher earnings predicted in the

future. In this case, one would observe only a weak relation between the CEO’s com-

pensation in a given year and the firm’s stock return in that year. In the first year of

the contract, the firm’s stock price would increase substantially and the CEO would

receive a bonus reflecting the higher earnings in that year. In subsequent years, how-

ever, one would not expect the firm’s stock price to respond to favorable earnings since

the expectation of good earnings was already reflected in the stock price at the end of

the first year. However, the CEO would continue to receive the same bonus he or she

received in the first year. Hence, the correlation between the firm’s stock returns in a

given year and the CEO’s compensation in that year would not be particularly strong.

However, if one looked across firms, one might find a relation between stock returns

and compensation levels cumulated over many years. Boschen and Smith found that

the cumulative response of pay to performance is about 10 times as large as the pay-

to-performance sensitivity found by comparing stock returns and compensation levels

in individual years.

Cross-Sectional Differences in Pay-for-Performance Sensitivities.The Jensen and

Murphy study along with the new evidence in Murphy (1999) reveal that the pay-for-

performance sensitivities differ substantially across firms. For example, the CEOs of

media companies generally have compensation contracts with substantial pay-for-

performance sensitivities, while the compensation contracts of regulated utility com-

pany CEOs exhibit very little pay-for-performance sensitivities. This difference proba-

bly reflects the fact that the CEOs of media companies have many more opportunities

to “consume on the job” and are more difficult to monitor than an executive at a reg-

ulated utility.

It is also the case that CEOs of small firms have much higher pay-for-performance

sensitivities than the CEOs of large firms. This is not particularly surprising given the

way Jensen and Murphy calculate pay-for-performance sensitivities. For example, sup-

pose that the CEO of a $100 billion company such as IBM had a pay-for-performance

sensitivity of 1 percent, meaning that he or she would receive an extra $10 in com-

pensation for every $1,000 in value improvement. With such a compensation contract

the CEO would be given a bonus of more than $100 million for increasing the value

of the firm by just 10 percent. While a 1 percent pay-for-performance sensitivity is

probably not feasible at a company as large as IBM, far larger sensitivities are often

observed at much smaller companies. In addition, because the CEOs of growth com-

panies generally have more discretion than the CEOs of more mature companies, a

number of authors have argued that the compensation of growth company CEOs should

be more closely tied to their companies’performance. However, the empirical evidence

on this is somewhat mixed.¹⁷

¹⁷Clinch

(1991), Smith and Watts (1992), and Gaver and Gaver (1993) found that equity and options

are used more extensively in the compensation of executives in growth firms. However, Bizjak, Brickley,

and Coles (1993) and Gaver and Gaver (1995) found no significant relation between growth opportunities

and compensation in their samples.

Grinblatt1306Titman: Financial	V. Incentives, Information,	18. How Managerial	© The McGraw1306Hill
Markets and Corporate	and Corporate Control	Incentives Affect Financial	Companies, 2002
Strategy, Second Edition		Decisions

Chapter 18

How Managerial Incentives Affect Financial Decisions

647

One reason why growth firm executives may not have higher pay-for-performance

sensitivity is that these firms tend to be very risky. Recall that the most important cost

of increasing performance-base pay is the added risk that must be borne by managers.

This implies that holding all else equal, we expect more risky firms to employ less per-

formance base compensation. Arecent study by Aggarwal and Samwick (1999) of the

pay-for-performance sensitivities of the top executives of large U.S. firms finds that

this is indeed true. In general, executives working for companies with less volatile stock

prices have higher pay-for-performance sensitivity than executives that work for com-

panies with more volatile stock prices.

Is Pay-for-Performance Sensitivity Increasing?

Hall and Liebman (1998) and Murphy (1999) report that over the past 20 years exec-

utive compensation in the United States has become much more sensitive to perfor-

mance. The observed increases in pay-for-performance sensitivities have been driven

almost exclusively by the increased use of stock option grants.

How Does Firm Value Relate to the Use of Performance-Based Pay?

If performance-based compensation improves incentives, then firms that implement

incentive-compensation programs should realize higher values. Empirical studies,

which have documented the positive reaction of stock prices to the adoption of per-

formance-based executive compensation plans, tend to support this hypothesis. For

example, Tehranian and Waegelein (1985) examined stock returns at the time of the

adoption of 42 performance-based compensation plans during the 1970s. They found

that stock prices increased about 20 percent, on average, from seven months before the

announcement of the adoption of the plans until the adoption date. Amore recent study

by Mehran (1995) looked cross-sectionally at the relationship between the ratio of the

market-to-book value of a firm’s shares and the extent of performance-based compen-

sation for top management. He found that these two variables are positively correlated,

indicating that, on average, firms using more performance-based compensation have

higher stock prices.

Unfortunately, it is difficult to infer causality from these studies. Performance-based

compensation is associated with higher stock prices; however, it is difficult to tell

whether this compensation causes stock prices to be higher or, alternatively, whether

managers are more willing to adopt performance contracts after observing increases in

their stock prices. Perhaps it would be easier to sell managers on the idea of adopting

performance-based compensation if the managers would have made more money in the

recent past had the plan been adopted earlier. In addition, managers are more willing

to adopt performance-based compensation plans when they have special information

suggesting that the firm may be undervalued.

Example 18.5 illustrates why the adoption of a performance-based compensation

plan conveys information to investors.

Example 18.5:The Information Conveyed from Adopting a Performance-Based

Compensation Plan

Consider the CEOs of two firms, Jack and Peggy.The two firms currently have stocks priced

at $20 per share.Jack has favorable proprietary information that leads him to believe that his

firm’s stock is really worth $30 per share.Peggy has unfavorable proprietary information that

leads her to believe that her firm’s stock is worth only $15 per share.Both CEOs are considering

Grinblatt1308Titman: Financial	V. Incentives, Information,	18. How Managerial	© The McGraw1308Hill
Markets and Corporate	and Corporate Control	Incentives Affect Financial	Companies, 2002
Strategy, Second Edition		Decisions

648Part VIncentives, Information, and Corporate Control

proposals that would lower their fixed salary in exchange for stock options exercisable in one

year at $20 per share.Which manager would be more inclined to accept such an offer? How

would agreeing to a performance-based incentive plan affect the company’s stock price?

Answer:Jack is more willing than Peggy to adopt the performance plan because his pro-

prietary information implies that the expected value of the options on his firm is higher.If

investors understand these incentives, they will view Jack’s acceptance of the performance

plan as good news and bid up the price of his firm’s stock.

As Example 18.5 illustrates, stock prices may react positively to the adoption of a

performance-based compensation plan even if the plan has no effect on the managers’

productivity.