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The executive compensation puzzle: theory and evidence



Publishing details

IFA Working Paper

Publication Year



I develop a theory of compensation contracts for the chief executive officers (CEOs) of firms and confront the theoretical predictions with CEO compensation data. The theory is motivated in part by the empirical puzzle that the compensation packages of CEOs are not as dependent on performance as existing theories predict. Specifically, Jensen and Murphy (1990a) document that CEOs on average receive only an additional $3.25 for each $1000 increase in shareholder wealth. Jensen-Murphy view this as abnormally low in light of the fact that the divisional manager of an LBO firm typically receives $64 for each $1000 increase in shareholder wealth. My model has the following aspects: a board of directors that behaves strategically in designing the CEO's compensation contract, a financial market in which there are informed investors whose information is noisily incorporated into prices, and a Bayesian belief revision mechanism by which the CEO's past performance impacts his reputation. The theory predicts that the pay-for-performance sensitivity for the CEO is a function of his perceived ability and the liquidity of the financial market. Specifically, the sensitivity increases for favourable realisations of past performance and for increases in the level of price informativeness in the stock market. I also show that CEOs with poor reputations should receive compensation contracts that exhibit little or no stock price dependency. Moreover CEOs who develop better reputations can bargain for greater total compensation. This bargaining power is positively related to the size of the firm. I then confront these predictions with CEO compensation data for the years 1987 to 1994. Using equity-based proxies for CEO reputation, I document a positive relationship between the pay-for-performance sensitivity and a CEO's reputation. In fact, CEOs who place in the highest reputational quartile receive £74.68 for each $1000 increase in shareholder wealth, a pay-for-performance sensitivity that is over twenty times greater than Jensen-Murphy's cross-sectional average. Moreover, CEOs who place among those with the poorest reputations have compensation contacts with insignificant sensitivity to stock price performance. The empirical results also support the predication that a CEO with a better reputation receives greater total compensation. This relationship is shown to be further increasing in firm size. Lastly, I document a positive relationship between the pay-for-performance sensitivity and the measure of informed traders as proxied by the firm's adverse selection component of the bid-ask spread (see Huang and Stoll (1995)). CEOs who place in the highest adverse quartile selection have a pay-for-performance sensitivity of $21.13.

Publication Research Centre

Institute of Finance and Accounting

Series Number

FIN 235


IFA Working Paper

Available on ECCH


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