CEO Pay For Performance, Not Luck

Standard compensation theory says that a firm’s sector performance is outside its manager’s control and should be removed from the ultimate measure of the CEO’s performance. That is, the CEO’s compensation contract should be based on the firm’s performance relative to its sector performance. The lack of such relative performance evaluation observed in the CEO compensation data has been spun under the auspice that CEOs receive compensation contracts that exhibit “pay for luck,” rather than “pay for performance.” 

However, Fenghua Song, assistant professor of finance at Penn State’s Smeal College of Business, and coauthors Radhakrishnan Gopalan and Todd Milbourn of Washington University in St. Louis, disagree. They say that an important part of a CEO’s job is to forecast the movement of the firm’s operating sector and choose the firm’s optimal exposure to such movement. Therefore, an increase in sector performance should be reflected in the CEO’s pay because the observed link between CEO pay and sector performance may not be all about pay for luck. 

Receiving the Citigroup Award for best paper in 2009, their study, “Strategic Flexibility and the Optimality for Pay for Sector Performance,” published in Review of Financial Studies, develops a model that defines a CEO’s job as one that provides a vision for the firm and guides its strategic direction. 

“When things go wrong, people always point to the CEO first,” says Song. “Our study looks at a CEO’s job function and because of their strategic involvement within a firm, a CEO cannot be treated as a regular worker.” 

In addition, the researchers stress the importance of providing incentives for the CEO through optimal contracts, which “rewards the CEO for firm performance caused by sector movements by providing her incentives to exert effort to forecast the sector movements and choose the firms’ optimal exposure to them,” they say. 

Song adds that greater incentives for CEOs are more costly for shareholders because CEOs have to be compensated with a greater portion of the firm’s wealth. “What incentive does a CEO have for predicting the market if they are not being compensated for it? Not much,” he says. 

The researchers find that the sensitivity of pay-to-sector performance is greater for CEOs of multi-segment firms than those of single-segment firms. “The idea is that multi-segment firms provide greater opportunity for the CEO to actively shift resources toward sectors that are likely to outperform,” says Song. 

Similarly, industries with higher research and development expenditures offer more flexibility and a greater potential for CEOs to vary a firm’s risk exposure. Industries with higher market-to-book ratios also offer more strategic flexibility for the CEO, in addition to greater investment and growth opportunities. 

They also test their model to see if there is greater pay for sector performance for more talented CEOs. The researchers used three substitutes to measure CEO talent: a firm’s stock return under the CEO’s watch, the classification of CEOs as internal or external to the firm (the researchers identified external CEOs as more talented than those promoted from within), and the evaluation of the stock performance of the CEO’s previous employer. In each case, they find that there is greater pay for sector performance for more talented CEOs. 

Song mentions that compensation committees and consulting companies should pay attention to this information when designing compensation contracts for their CEOs. “If John Browne’s (past CEO of British Petroleum) incentive pay were insulated from oil shocks, it would affect the way he thinks about exploration and how he reacts to price shocks once they occur,” he says, quoting Bengt Holmstrom, a world renowned economist from MIT. 

He goes on to say that corporate governance regulators may present problems in terms of regulating CEO compensation, but argues that corporate governance failure is not always a clear scapegoat. “While I admit there are some badly governed firms, it is not always about corporate governance failure,” he says. “There may be some deeper economic issues within the firm.”