Chapter Study Outline
17.1 The Evidence
- The salary component of CEOs of the S&P 500 companies is the smallest part of the compensation package.
- CEOs of the S&P 500 companies are mainly compensated with stock gains.
- The data show that, between 1989 and 2009, CEO pay increased most rapidly from 1996 to 2000 and has, in fact, decreased in real terms since 2000.
- The decrease in CEO compensation since 2000 is largely due to the decrease in the overall performance of the stock market
- The ratio of CEO compensation to median household income has increased since 2003 because of the huge compensation levels of a few CEOs
- CEO pay is generally determined by the recommendations made by an independent compensation committee and consists of
- baseline salary
- bonus payments
- stock options, a contract that gives an employee the right to buy the company’s shares at some prespecified exercise or strike price
- Stock options are in the money if the current share price is greater than the strike price.
- Stock options in the money are valued at the difference between the current share price and the strike price.
- Underwater stock options, which have negative value and thus will never be exercised by the employee, have a current price below the strike price.
- The value of exercised stock options and, consequently, CEO compensation can be best understood by keeping in mind that
- The only reason a stock option realizes positive return is if the company’s value increased under the CEOs stewardship.
- In accepting a stock option contract, the CEO bears the risk that the stock options will eventually prove worthless.
- The CEO’s total yearly compensation includes the value of all stock options exercised that year including those stock options that were granted in previous years.
- Stock option contracts offer risk-sharing benefits between the CEO and the company.
- CEOs are exposed to more limited risk than if they held actual shares of the company’s stock, which can encourage them to undertake risky but valuable projects.
- CEOs haves the incentive to work hard because their options are positively correlated with the increase in the company’s value under their leadership.
- A golden handshake refers to the severance payment that is made to CEOs upon their dismissal or retirement.
17.2 The Theory of Executive Pay
The typical concern on the provision of CEO incentives is not that CEOs will shirk but that they will take actions that are not in the best interest of the firm’s shareholders.
- Managerial talent is an extremely scarce commodity, so observed high levels of compensation simply reflect the proper pricing of ability in a well-functioning labor market for CEOs.
- In a canonical framework, relatively small changes in a CEO’s effort and innate ability can have large marginal effects on a firm’s performance
- The allocation of scarce managerial talent within a competitive assignment framework is characterized by positive assortative matching in the work of Gabaix and Landier (2008) and Tervio (2008).
- Under positive assortative matching, the most talented manager works for the firm that places the highest value on talent at the margin, the second most talented manager works for the firm that places the second highest value on talent, and so on.
- Both models find that marginal return to managerial ability increases rapidly with the firm’s size because of the chain-letter effect.
- Under the positive assortative matching model, behavior of executive pay is fully explained by shifts in the demand for labor within a well-functioning competitive managerial labor market, suggesting that the equilibrium outcome may be close to Pareto efficient.
- The model developed by these authors fits extremely well with the data.
The data suggests that the pattern of executive earnings is consistent with a tournament model, where the position of CEO, and its accompanying compensation, is the ultimate prize.
- CEOs might select projects that make they look good on paper to advance they career prospects.
- CEOs might undertake projects that are either too risky or too safe.
- CEO might attempt to divert their employee’s resources for their own, individual benefit.
- These possibilities all fit the classic principal-agent problem.
CEOs are provided with incentives through stock options and bonus payments.
- If CEO compensation is the prize in a tournament model, it is not wasteful because it incentivizes high levels of effort from workers at all levels of the tournament.
- The tournament model cannot fully describe CEO pay because CEOs must also be provided with work incentives.
According to the entrenchment hypothesis, CEOs are firmly dug into their jobs and thus have gained the ability to set their own salaries.
- The value of a CEO’s stock options are directly determined by the change in value of the company under the CEO’s stewardship.
- Golden handshakes provide incentives for CEOs to pursue risky but prudent business strategies.