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Relative performance evaluation, pay-for-luck, and double-dipping in CEO compensation

Review of Quantitative Finance and Accounting volume 44, pages 701–732 (2015)Cite this article

Abstract

We investigate whether chief executive officer (CEO) pay is linked to firm-specific and/or industry-wide performance only when it results in higher compensation. We argue CEOs have incentives to influence the ex post implementation of both relative performance evaluation (RPE) and pay-for-luck (PFL). Specifically, CEOs prefer RPE only when they outperform their reference group regardless of industry performance. Similarly, CEOs prefer PFL only when industry conditions are favorable. CEOs will try, ex post, to influence compensation committees to implement RPE and/or PFL only when implementation makes their compensation higher. Our results, based on both the level of compensation and the sensitivity of compensation to firm-specific and industry-wide performance, suggest CEOs are shielded from the worst performance outcomes, and rewarded through either RPE or PFL when one or the other leads to increased compensation. CEOs do not double-dip, however; compensation does not increase further when both RPE and PFL are in their favor. Our evidence shows that these compensation patterns are even stronger when firms have strong corporate governance mechanisms in place, consistent with optimal contracting between firms and CEOs and not with CEO manipulation of the pay process to expropriate wealth from the shareholders.

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Notes

  1. Data availability limitations of the corporate governance factors reduce our sample size to 4,648 firm-years for this analysis.

  2. Sloan (1993) presents evidence that accounting earnings as a determinant of executive compensation serves a risk-shielding role relative to stock returns, which are more susceptible to market-wide fluctuations. Sloan’s (1993) results, thus, are evidence of an indirect implementation of RPE for cases where accounting earnings are more informative of firm-specific performance than stock returns.

  3. Bannister et al. (2011) argue that the lack of consistent evidence in documenting RPE in prior literature is due to researchers’ assumptions regarding the way in which peer group performance is incorporated in compensation decisions. In a sense, our tests relax the assumptions in the way RPE is incorporated in the CEO pay by conditioning the weights on the systematic and unsystematic component of performance on whether firms beat their industry performance and whether the overall industry performance is positive or negative.

  4. Similarly, Dye (1992) shows that RPE leads to little improvement in contracting when a manager has limited discretion in project selection.

  5. Similarly, Edmonds et al. (2013) analyze the relationship between CEO bonus compensation and firms’ failure to meet analysts’ revenue forecasts, but they do not assess how firms’ corporate governance affects the relationship.

  6. Dowell et al. (2011) use four additive factors to measure CEO power: duality, founder status, shares owned as a percent of total shares outstanding, and attainment of elite education.

  7. This is by no means an exhaustive list of the ways in which corporate governance has been measured, but is meant to be representative of (1) four of the most prevalent measures (board independence, board size, CEO power, and ownership organization), and (2) ways in which the same measure can be associated with either efficient contracting or with rent extraction. Adams et al. (2010) provide a thorough review of recent corporate governance research.

  8. TCOMP includes salary, bonus, stock option awards, restricted stock awards, and other annual compensation paid by firm i during year t.

  9. CCOMP includes salary, bonus, and other annual compensation.

  10. The market value of equity is price multiplied by shares outstanding, both adjusted for stock splits.

  11. Although ANCOVA is not a standard method for testing compensation hypotheses, it is appropriate here due to the partitioning of our sample into a 2 × 2 matrix based on RPE and PFL outcomes. We include this analysis because it corroborates the results in our more standard multivariate regressions discussed in the next section.

  12. In general, any differences in results between our full sample and our governance partitions occur in the options awards component. We believe this is consistent with options awards having significant determinants other than current delivered performance, as shown in Core and Guay (1999) and Blackwell et al. (2007).

  13. Detailed graphs and ANCOVA results are available from the authors upon request.

  14. Results for total compensation are qualitatively similar to those reported for current compensation.

  15. For simplicity, we report in Table 8 parameter estimates for only our experimental variables in each of the two SCG partitions. Untabulated results from estimating Eq. (2) using the full governance subsample are similar to those in Table 7.

  16. Note that the absence of statistical significance on the SROA interaction terms indicates only the main (linear) effect affects the dependent variable.

  17. We thank an anonymous reviewer for suggesting this analysis.

  18. Under the efficient contracting argument, it could also be the case that we observe stronger effects during the post-SOX period.

  19. Controlling for the noise from stock option compensation is particularly important in this part of the analysis because of the effect that SFAS 123R had on the reporting and use of stock options in compensation contracts.

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Acknowledgments

We are grateful to an anonymous reviewer for many helpful suggestions. We thank participants at the 2009 Annual Meeting of the American Accounting Association for their comments, especially Susan Kulp (discussant) and Ana Albuquerque, and participants at the 2013 Management Accounting Section of the American Accounting Association Research and Case Conference for their comments, especially Tim Keune (discussant) and Dirk Black. We also are grateful to Chad Cotti, James Groff, Ivo Jansen, Chris Jones, Steve Makar, Todd Milbourn, J. Manuel Sánchez, Yuyun Sejati, John Wald, Jennifer Yin, and the research workshop participants at the University of South Florida and the University of Texas at San Antonio for their comments and suggestions.

Author information

Authors and Affiliations

  1. Accounting Department, College of Business, The University of Texas at San Antonio, One UTSA Circle, San Antonio, TX, 78249-0632, USA

    Carlos E. Jiménez-Angueira

  2. College of Business, University of Wisconsin Oshkosh, 800 Algoma Boulevard, Oshkosh, WI, 54904, USA

    Nathan V. Stuart

Authors
  1. Carlos E. Jiménez-Angueira
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  2. Nathan V. Stuart
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Correspondence to Carlos E. Jiménez-Angueira.

Appendices

Appendix 1

Table 10 Variable definitions (except for strength of corporate governance)
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Appendix 2

Table 11 Measurement of strength of corporate governance
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Jiménez-Angueira, C.E., Stuart, N.V. Relative performance evaluation, pay-for-luck, and double-dipping in CEO compensation. Rev Quant Finan Acc 44, 701–732 (2015). https://doi.org/10.1007/s11156-013-0423-3

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Keywords

  • CEO compensation
  • Relative performance evaluation
  • Pay-for-luck
  • Accounting performance
  • Efficient contracting
  • Corporate governance

JEL Classification

  • D8
  • G3
  • J33