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Executive Compensation and Incentives
Martin J. Conyon*

Executive Overview
The objective of a properly designed executive compensation package is to attract, retain, and motivate CEOs and senior management. The standard economic approach for understanding executive pay is the principal-agent model. This paper documents the changes in executive pay and incentives in U.S. firms between 1993 and 2003. We consider reasons for these transformations, including agency theory, changes in the managerial labor markets, shifts in firm strategy, and theories concerning managerial power. We show that boards and compensation committees have become more independent over time. In addition, we demonstrate that compensation committees containing affiliated directors do not set greater pay or fewer incentives.


Introduction xecutive compensation is a complex and controversial subject. For many years, academics, policymakers, and the media have drawn attention to the high levels of pay awarded to U.S. chief executive officers (CEOs), questioning whether they are consistent with shareholder interests.1 Some academics have further argued that flaws in CEO pay arrangements and deviations from shareholders’ interests are widespread and considerable.2 For example, Lucian Bebchuk and Jesse Fried provide a lucid account of the managerial power view and accompanying evidence.3 Marianne Bertrand and Sendhil Mullainathan too provide an analysis of the ‘skimming view’ of CEO pay.4 In contrast, John Core et al. present an economic contracting approach to executive pay and incentives, assessing whether CEOs receive inefficient pay without performance.5 In this paper, we show what has happened to CEO pay in the United States. We do not claim to distinguish between the contracting and managerial power views of executive pay. Instead, we document the pattern of executive pay and incentives in the United States, investigating whether this pattern is consistent with economic theory. The Context: Who Sets Executive Pay? efore examining the empirical evidence presented in this paper, it is important to consider the pay-setting process and who sets executive pay. The standard economic theory of executive


compensation is the principal-agent model.6 The theory maintains that firms seek to design the most efficient compensation packages possible in order to attract, retain, and motivate CEOs, executives, and managers.7 In the agency model, shareholders set pay. In practice, however, the compensation committee of the board determines pay on behalf of shareholders. A principal (shareholder) designs a contract and makes an offer to an agent (CEO/ manager). Executive compensation ameliorates a moral hazard problem (i.e., manager opportunism) arising from low firm ownership. By using stock options, restricted stock, and long-term contracts, shareholders motivate the CEO to maximize firm value. In other words, shareholders try to design optimal compensation packages to provide CEOs with incentives to align their mutual interests. This is the contract approach to executive pay. Following Core, Guay, and Larcker,8 an efficient (or optimal) contract is one “that maximizes the net expected economic value to shareholders after transaction costs (such as contracting costs) and payments to employees. An equivalent way of saying this is that . . . contracts minimize agency costs.” Several important ideas flow from this definition. First, the contract reduces manager opportunism and motivates CEO effort by providing incentives through risky compensation such as stock options. Second, the optimal contract does not imply a “perfect” contract, only that the firm designs the best contract it can in order to avoid opportunism and malfeasance by the manager, given the

* Martin Conyon is an Assistant Professor of Management at the Wharton School, University of Pennsylvania. Contact:


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contracting constraints it faces.9 Third, in this arrangement, the firm does not necessarily eliminate agency costs, but instead evaluates the (marginal) benefits of implementing the contract relative to the (marginal) costs of doing so. Improvements in regulation or corporate governance can possibly alter these costs and benefits, making different contracts desirable. Moreover, what is efficient at one point in time may not be at another. Improvements in board governance, for example by adding independent directors, may lead to different patterns of compensation, stock, and option contracts that are desirable for one firm but not another.10 An alternative theory is that CEOs set pay. This is the managerial power view, exemplified recently by Bebchuk and Fried.11 In this theory, the board and compensation committee cooperate with the CEO and agree on excessive compensation, settling on contracts that are not in shareholders’ interests. This excess pay constitutes an economic rent, an amount greater than necessary to get the CEO to work in the firm. The constraints the CEOs face are reputation loss and embarrassment if caught extracting rents, what Bebchuk and Fried call “outrage costs.” Outrage matters because it can impose on CEOs both market penalties (such as devaluation of a manager’s reputation) and social costs—the social costs come on top of the standard market costs. They argue that market constraints and the social costs coming from excessively favorable pay arrangements are not sufficient in preventing considerable deviations from optimal contracting. This paper begins by demonstrating what has happened to executive pay in the United States. The next section provides evidence on the growth of executive pay and equity incentives in U.S. publicly traded firms between 1992 and 2003. Specifically, we focus on the importance of stock and options and the link between pay and performance. We consider explanations for why CEO pay and incentives increased remarkably during the 1990s. Then, the paper considers the governance of executive pay, especially the role of independent boards and compensation committees. We show that compensation committees have become more independent over time and the fraction of affiliated directors on boards has de-

clined. The paper ends by offering some conclusions about whether the current pattern of executive pay and incentives in the United States is consistent with economic theory. Executive Compensation here is substantial disclosure about U.S. executive compensation. The Securities and Exchange Commission (SEC) expanded and enhanced disclosure rules for U.S. executives in 1992. As a result, the proxy statements of firms (DEF 14A) contain considerable detail on stock ownership, stock options, and all components of compensation for the top five corporate executives.12 The evidence on U.S. executive compensation provided here was extracted from Standard and Poor’s (S&P’s) “ExecuComp” database, which includes proxy-statement data for top executives in the S&P 500, S&P Mid-Cap 400, S&P SmallCap 600, and other supplemental S&P indices. We focus on CEO and non-CEO executives separately. We used information on share ownership, current and prior option grants, salaries, annual bonuses, benefits, and restricted stock awards, in order to observe component growth. There are four basic components to executive pay, each having been the subject of much research.13 First, executives receive a base salary, which is generally benchmarked against peer firms. Second, they enjoy an annual bonus plan, usually based on accounting performance measures. Third, executives receive stock options, which represent a right, but not the obligation, to purchase shares in the future at some pre-specified exercise price. Lastly, pay includes additional compensation such as restricted stock, long-term incentive plans, and retirement plans. Stock options are an important element of executive pay and are valued at the firm’s cost of making the grant.14 Options are valued as the economic cost to the firm of granting an option to an employee. This is the opportunity cost forgone by not selling the option in the open market. A good approximation of this value is the price of the option given by the Black-Scholes (1973) formula.15 The value of a European call option paying dividends is: option value c Se-qt -rt N(d1) – Xe N(d2), where d1 {ln(S/X) (r





2 q t, d2 d1 t, where S is the /2)t}/ stock price; X the exercise price; t the maturity term; r the risk-free interest rate; q the dividend the volatility of returns; and N(.) the yield; cumulative probability distribution function for a standardized normal variable. In general, options granted to executives have an expected cost to the company of about 30 to 40 percent of the fair market value of the stock. For instance, given some plausible assumptions about inputs, an option on a stock with face value of $100 has an expected value of about $37.16 However, some of the assumptions underlying the Black-Scholes method are unlikely to hold in practice, meaning that employees will value an option differently from the firm. Employees are typically risk averse, undiversified, and may be disallowed from trading the options or hedging their risk by selling short the company stock. In consequence, they will place a lower value on the stock option compared to the Black-Scholes cost to the company.17 This gap is an estimate of the premium that firms must pay employees to accept the risky option versus cash compensation. Firms will want to make sure that the increase in executive performance from using options exceeds this premium.18 Understanding how employees value options is an important challenge for future compensation research, especially since stock options are an increasingly significant component of pay.19 Before considering the general pattern of executive compensation, consider a few examples. Many CEOs, such as Jack Welch of General Electric, receive large pay awards. In 2000, he received total compensation of about $125 million, including a $4 million salary, a $12.7 million bonus, $57 million in options, and $48.7 million in restricted stock grants. Welch managed a large and complex organization and, under his leadership, General Electric’s share price soared. However, in the wake of U.S. corporate scandals, like Enron and Tyco, even CEOs with stellar performance records have faced criticism: the media censured Welch for alleged non-disclosure of lavish retirement benefits. Another example indicates a somewhat unusual pay arrangement. In 2003, Steve Jobs of Apple Computer received a salary of just $1 and no annual bonus or options, instead receiving re-

stricted stock grants worth approximately $75 million. These cases show that the way in which CEOs are paid can differ across firms and that some pay packages are riskier than others. Options and stock provide powerful incentives to focus on increasing shareholder wealth. If a CEO is paid in options, then as the share price increases, the value of their holdings also increases; if the share price declines, so too does the CEO’s wealth. Salaries, in contrast, are unrelated to firm performance. As noted above, this paper examines the general pattern of U.S. executive pay using the population of firms in the ExecuComp data set.20 Total CEO compensation is measured as salary, bonus, long-term incentive payouts, the value of stock options granted during the year (valued on the date of the grant using the Black-Scholes method), and other cash payments (including signing bonuses, benefits, tax reimbursements, and above-market earnings on restricted stocks). This is a “flow” measure of executive pay, capturing compensation received by the executive in a given year. It is consistent with other executive pay research.21 However, it is different from CEO wealth, which would include not only the value of stock and options granted during a given period, but the value of previosuly granted options and other equity as well. The importance of CEO firm wealth in providing incentives is discussed below. Figure 1 plots the CEO pay distribution of ExecuComp firms in 2003.22 Average annual remuneration is approximately $4.5 million, with a median of $2.5 million. The distribution has two important characteristics: considerable pay dispersion and a positive skew (hence the long right tail). This means that most CEOs earn relatively low compensation, and a few CEOs in the right tail receive excessively generous rewards. The notion that all CEOs receive stratospheric sums is incorrect. It is possible to show the same effect in S&P 500 firms. Average annual remuneration for CEOs in the S&P 500 firms was $9 million, with a median of $6.7 million in 2003. Total compensation in S&P 500 firms is, of course, much higher than firms in the entire ExecuComp dataset. This reflects the well-known positive correlation between CEO pay and firm size. Larger firms require


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managers who are more talented, and therefore they award greater compensation.23 Table 1 shows the total pay and the components of total compensation of CEOs and other non-CEO top executives between 1993 and 2003. Over the ten-year period, both CEO and nonCEO executive pay increased. In 2003, the median pay for CEOs was $2.5 million, compared with $1.3 million in 1993, a growth rate of 7.1 percent per year. However, the means for these years are $4.5 million and $2.0 million, respectively, exhibiting the positive skew discussed earlier. Overall, non-CEO executives earn approximately 40 percent of the CEO’s compensation. Since 1993, the percentage of option pay has increased, while the percentage of salary pay has decreased. Since 2001, restricted stock pay has become a more important component of CEO pay and options have become slightly less important. Across all years, however, non-CEO executives receive a larger amount of their compensation from salary than CEOs do, while CEOs receive a larger amount of their compensation from options. In summary, the total pay growth rate for CEOs and other executives is about 7.0 percent annually. Over time, salaries have become less important as a fraction of total pay, the annual bonus fraction has remained constant (approximately 20 percent), and stock options and restricted stock as a fraction of pay have increased.
Figure 1 The Distribution of CEO Compensation in S&P Firms, 2003

Table 2 shows the dollar value of the main components of CEO (top panel) and non-CEO (bottom panel) executives’ total compensation, including base salary, options granted (using the Black-Scholes value method), and restricted stock granted. The base salary of CEOs has grown 2.6 percent per year, just under the rate of inflation. The noticeable increase in CEOs’ total compensation over the ten-year period can be attributed to increases in option grants and restricted stock. These have grown by 10.6 percent and 11.0 percent annually. The salary of non-CEO executives increases slightly more, at 3.9 percent per year. For all years, CEOs earn a salary that is twice that of non-CEO executives. The non-CEO executives also receive more stock options and restricted stocks, which have grown 8.6 percent and 9.4 percent respectively. The empirical evidence suggests the growth in total pay is due to an increase in option and restricted stock compensation rather than salary. These findings are partially consistent with contract theory, which emphasizes incentive pay over salaries. Alternatively, the evidence seems slightly less consistent with the managerial power theory, since risk-averse managers would prefer cash compensation to more risky option compensation. In addition, if managerial power were increasing over time, one might have expected to see greater growth in salaries than the evidence here suggests. However, Bebchuk and Grinstein24 argue that, once one controls for firm characteristics, both equity and non-equity pay grew throughout this period. Since there is no substitution effect, they contend this is inconsistent with contract theory. In summary, the evidence from Tables 1 and 2 indicates that the total level of CEO pay is increasing mainly due to stock option grants.

Source: ExecuComp. Data plotted for variable TDC1 (total compensation) with values less than $60 million.

Executive Incentives e now turn to executive incentives and the link between pay and firm performance.25 The evidence demonstrates that executive compensation and the fraction of pay accounted for by option grants increased during the 1990s. Principal-agent theory predicts that a firm designs contracts in order to yield optimal incentives, therefore motivating the CEO to maximize shareholder value. In designing the contract, the firm




recognizes the CEO is risk averse. Thus, imposing greater incentives requires more pay to compensate the agent for increased risk. In the previous section, the paper demonstrated that CEO pay has increased. Next, we examine what has happened to CEO incentives. The analysis shows that executives have considerable equity incentives that create a strong and increasing link between CEO wealth and firm performance. This finding seems

at odds with the notion that executive pay and performance are decoupled.26 It is, however, consistent with other economic evidence, showing that the link between pay and performance has been increasing in the United States.27 Executives receive incentives from several sources. They receive financial incentives from salary and bonus, as well as new grants of options and restricted stock, which together measure flow

Table 1 Executive Compensation and its Components in the United States 1993–2003 Year CEOs
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Annual Growth Rate (%) Non-CEO Executives 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Annual Growth Rate (%) 1153 1541 1596 1641 1664 1724 1799 1782 1655 1651 1664


Total Pay Median ($thous)
1258.8 1255.9 1311.6 1587.6 1923.3 1962.9 2188.4 2443.5 2527.0 2604.8 2498.6 7.1 478.0 508.3 528.8 618.2 690.2 730.7 829.1 922.5 937.7 940.9 931.7 6.9

Total Pay Mean ($thous)
2045.4 2151.4 2279.8 3145.0 3828.9 4494.5 5224.0 6694.8 6324.3 4909.8 4544.8 8.3 777.8 852.9 913.9 1141.2 1388.1 1511.5 1931.2 2417.7 2094.0 1841.8 1651.6 7.8

Base Salary (%)
43.4 41.9 41.0 36.9 33.8 33.0 31.2 30.9 30.6 30.4 31.5 3.2 49.9 47.7 47.2 42.9 40.3 39.9 37.5 36.4 37.0 37.6 38.3 2.6

Annual Bonus (%)
20.3 20.4 20.7 20.0 20.2 18.1 18.0 17.4 14.5 17.4 19.4 0.5 18.9 19.4 19.5 19.0 19.2 17.4 17.7 17.3 15.1 17.5 18.4 0.3

Option Grants (%)
22.9 26.5 25.0 29.2 32.3 35.6 38.8 38.7 42.3 38.5 32.3 3.5 19.7 22.3 20.9 25.9 28.5 30.7 33.9 34.8 36.6 32.3 28.2 3.7

Restricted Stock (%)
4.3 3.7 4.3 4.6 4.4 4.7 4.0 4.7 5.1 6.0 8.4 6.9 3.5 3.2 3.6 3.9 3.9 4.2 3.6 4.2 4.3 5.2 7.1 7.3

Other (%)
9.1 7.6 9.0 9.2 9.3 8.7 8.0 8.2 7.4 7.7 8.4 0.8 8.0 7.5 8.8 8.3 8.1 7.8 7.3 7.3 6.9 7.3 8.0 0.0

7177 7486 7715 8193 8428 8695 8428 8010 7652 7490 7137

Source: ExecuComp This table shows the total compensation of CEO and non-CEO executives between 1993 and 2003. Total pay is the sum of salary, bonus, long-term incentive payouts, total value of stock options granted (using Black-Scholes), and other cash payments (includes compensation such as signing bonuses, benefits, tax reimbursements, and above market earnings on restricted stocks). This is variable TDC1 in the ExecuComp data set. Base salary is the percentage of an executive’s total compensation that is attributed to salary for a given year; bonus, the percentage attributed to bonus; option grants, the percentage attributed to the value of options granted; restricted stock, the percentage attributed to the value of restricted stock holdings granted.


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compensation. They also receive incentives from changes in their aggregate holdings of stock and options in the firm, as described in detail below. Finally, the probability of termination because of poor performance gives the CEO an incentive to pursue strategies that maximize firm value. In this case, if terminated, an executive suffers reputation loss and human capital devaluation in the managerial labor market. However, this paper— consistent with other recent research in financial eco-

nomics—focuses on compensation and equity incentives, leaving aside career concerns and the labor market for managerial talent. In other words, it restricts attention to financial incentives. The key to understanding financial incentives is recognizing that they arise from the entire portfolio of equity holdings and not simply from current pay. Equity incentives, then, are the incentives to increase the stock price arising from the managers’ ownership of financial securities in the

Table 2 Value of Components of Executive Compensation in the United States 1993–2003 Base Salary ($thousands) Year
CEOs 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Annual Growth Rate (%) Non-CEO Executives 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Annual Growth Rate (%)

Option Grants ($thousands) Median
462.7 590.4 534.6 746.5 931.3 1108.9 1341.3 1547.3 1765.4 1546.0 1268.2 10.6 162.9 194.7 179.1 252.0 297.0 353.6 425.5 465.6 516.2 443.3 372.7 8.6

Restricted Stocks ($thousands) Mean Median
328.9 333.3 389.5 440.2 525.0 513.0 574.4 750.0 847.3 811.1 932.0 11.0 107.4 99.0 123.3 137.5 147.2 169.0 176.9 235.8 219.6 25.16 262.8 9.4

500.0 456.8 472.3 500.0 519.8 525.0 531.5 554.2 583.3 609.8 645.4 2.6 208.8 210.0 217.0 222.8 228.0 236.6 247.5 257.3 273.0 287.3 306.7 3.9

544.1 516.1 533.0 552.1 567.6 582.9 587.9 612.6 651.8 670.8 694.7 2.5 242.9 244.2 252.3 258.2 266.2 276.4 289.4 304.0 319.0 333.3 354.5 3.9

762.7 726.6 822.1 1014.1 1339.3 3315.2 1675.6 2177.7 2211.8 2296.6 2383.5 12.1 302.4 282.3 319.4 394.76 536.4 744.0 683.4 781.2 640.1 647.4 678.0 8.4

1057.7 1312.0 1277.5 2093.1 2692.7 3043.7 4188.6 5946.8 5269.7 3359.5 2469.6 8.8 367.6 463.1 465.6 652.1 890.4 953.2 1420.9 1897.8 1565.8 1044.0 791.7 8.0

Source: ExecuComp. This table shows the dollar value of the main components of CEO and non-CEO executives’ total compensation. The main components include base salary, options granted (using the Black-Scholes value), and restricted stock granted. Growth rate is the average annual growth over the ten-year period. Note that the median and means were calculated for each component only if the executive had the component in a given year. For example, if an executive was not granted restricted stocks in a given year, his observation was not included when calculating the summary statistics for restricted stocks that year.




firm.28 For example, a CEO may receive 100,000 options this year, which might add to 400,000 options granted in previous years, for a total of 500,000 options held. If the stock price decreases, then the value of the 100,000 options granted this year declines— but so does the value of the options accumulated from previous years. Since the CEO will care about the whole stock of 500,000 options, not simply this year’s 100,000, executive compensation received in any given year provides only a partial picture of CEO wealth and incentives. To understand CEO incentives fully, it is important to focus on the aggregate amount of shares, restricted stock, and stock options that the CEO owns in the firm. The analysis begins by noting that the CEO’s wealth from ownership of firm equity is the value of the CEO’s stock and option portfolio. We calculate the wealth as the value of shares and restricted stock plus the Black-Scholes value of the aggregate amount of stock options owned. Following Core and Guay,29 executive portfolio incentives are defined as the dollar change in the value of the CEO’s stock and option portfolio arising from a one percent change in the stock price.30 This “equity stake” measure31 defines incentives as the dollar change in managerial wealth from a 1 percent increase in shareholder wealth and can be written as the following: 1% (share price) (the number of shares held) 1% (share price) (option delta) (the number of options held).32 Notice that by focusing on equity incentives, we are ignoring the incentives arising from salary and annual bonus awards. Research shows that the correlation between salary, bonus, and stock price performance is low, suggesting these elements of flow compensation contribute little to aggregate equity incentives.33 Table 3 provides preliminary estimates of wealth and incentives34 for the set of ExecuComp firms. It shows the value of shares owned, the value of all options, total wealth, and equity incentives of CEO and non-CEO executives between 1993 and 2003. Wealth is defined as the value of an executive’s equity portfolio. Also included are stock owned (calculated as the number of shares owned times the value of the stock at the fiscal year end), value of options (calculated using

the Black-Scholes method), and restricted holdings (the value of the restricted stock holdings at the fiscal year end). In 2003, median CEO wealth was approximately $22 million, whereas non-CEO executive wealth was just under $4 million, indicating that CEOs have more wealth in the firm than other top executives. Agency theory predicts this result: an efficient contract will allocate more incentives to individuals who have the greatest impact on firm value. The results are consistent with CEOs’ critical roles in formulating and implementing firm strategy and change.35 In addition to annual compensation, as shown earlier, the wealth distribution of CEOs and non-CEO executives is right-skewed. For instance, average CEO wealth is about $128 million compared to the median of $22 million. CEO and non-CEO executive wealth had similar growth rates over the period of 9.1 percent and 9.4 percent each year, respectively. Additionally, the value of options has increased significantly, with an average annual growth rate around 15 percent each year for both groups, once again illustrating the importance of options in driving changes in executive compensation. How does the estimate of CEO wealth change as the stock price changes? To illustrate, consider the incentives of the median CEO in 2003. CEO wealth from owning firm stock and options is approximately $22.2 million, about nine times greater than current flow pay (from Table 1, roughly $2.5 million). CEO incentives total approximately $287,000. If the stock price at this CEO’s firm fell by 10 percent, his portfolio wealth would decrease in value by $2.87 million. This $2.87 million decline is greater than median CEO compensation in this year ($2.5 million) indicating that half of CEOs would lose more than an entire years pay. The important point to stress is that executive wealth can decline precipitously as the stock price falls.36 It seems that relative to “flow” compensation, the incentives received by CEOs in the form of stock and options are considerable. The evidence shows that CEOs have plenty of financial incentives, arising primarily from CEO ownership of stock and options in their firms. Again, we would stress that such financial incen-


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tives are only one factor motivating executives. Agents are as likely to be motivated by intrinsic factors of the job, career concerns, social norms, tournaments, and the like. One problem with stock options and other forms of incentive pay is not that they provide too few incentives, but that they may lead to unintended consequences. It is well known that incentives can bring about behavior by the agent that was unanticipated by the

principal. In a classic paper, Steven Kerr37 highlighted the folly of rewarding A while hoping for B. In short, he articulated the notion that one gets what one pays for. If one rewards activity A and not B, then people will exert effort on A, while de-emphasizing B. Kerr illustrates his point with an array of examples from politics, industry, and human resource management. In general, this is a problem of providing appropriate incentives to

Table 3 Wealth and Incentives of Executives in the United States 1993–2003 Equity ($millions) Year
CEOs 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Annual Growth Rate (%) Non-CEO executives 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Annual Growth Rate (%)

Value of options ($millions) Median
2.1 2.0 2.5 3.5 5.2 4.7 5.1 6.4 7.7 6.1 9.1 15.8 0.5 0.5 0.6 0.9 1.2 1.1 1.3 1.5 1.8 1.4 2.1 15.4

Wealth ($millions) Median
9.3 8.9 10.5 12.9 17.9 17.1 18.8 18.5 19.8 16.4 22.2 9.1 1.5 1.3 1.5 1.9 2.5 2.4 2.7 2.9 3.1 2.4 3.7 9.4

Incentives ($thousands) Median
121.9 112.5 134.6 165.0 230.8 217.3 243.4 234.9 255.8 217.0 287.4 9.0 19.9 17.0 20.8 26.5 34.3 32.7 36.7 38.2 41.3 33.0 49.8 9.6

4.8 4.2 4.8 5.6 6.9 6.5 6.9 5.7 5.5 4.4 6.1 2.4 0.4 0.3 0.3 0.4 0.5 0.5 0.5 0.4 0.5 0.4 0.6 4.1

56.9 43.5 58.8 70.7 101.5 138.5 177.6 125.1 109.4 94.6 103.4 6.2 5.5 4.7 6.2 7.9 10.0 12.9 15.1 16.7 14.6 10.6 12.4 8.5

5.3 5.5 7.4 10.5 15.5 19.2 29.8 29.1 22.8 16.4 22.6 15.6 1.5 1.5 2.1 2.8 4.2 4.7 7.6 7.5 5.9 4.2 5.6 14.1

63.0 49.4 67.1 82.4 120.3 161.7 211.7 155.8 133.7 112.4 128.0 7.3 7.2 6.3 8.5 11.0 14.7 18.0 23.3 24.7 21.0 15.2 18.5 9.9

662.5 523.9 714.1 882.4 1284.6 1704.6 2208.0 1660.2 1440.7 1213.4 1404.3 7.8 80.1 72.1 98.0 125.8 168.3 202.3 256.7 275.0 238.0 175.9 216.5 10.5

Source: ExecuComp This table shows the equity, value of options, wealth, and incentives of CEO and non-CEO executives between 1993 and 2003. It relates to holdings in their own firm. Equity is the value of stocks owned (calculated as the number of shares owned times the value of the stock at the fiscal year end). Value of options is the value of exercised and unexercised stock options (calculated using the Black-Scholes equation). Wealth is the value of a CEOs portfolio, which includes equity, options, and restricted holdings. Incentives are defined as 1 percent change in the value of the portfolio (stocks options are weighted by the delta of the option). The growth rate is the growth of components over the ten-year period.




agents engaging in multiple tasks.38 More recently, Robert Gibbons has discussed the design of incentive programs recognizing such problems.39 Another problem with incentive compensation is that it may encourage opportunistic behavior by managers, manipulation of performance measures, or cheating. The powerful and often unanticipated effects of financial incentives on economic outcomes have been documented in diverse contexts such as classroom teaching, real estate markets, vehicle inspection markets, and the behavior of physicians.40 In the corporate context, David Yermack demonstrates that CEOs opportunistically time the award of option grants around earnings announcements in order to increase their compensation.41 Other studies find that private information is used by executives to engineer abnormally large option exercises and hence the payouts from those options. In addition, studies show that firms with more incentives are associated with greater earnings manipulation.42 Recent studies show that the likelihood of a firm being the target of fraud allegations is positively correlated with option incentives.43 In short, options and incentive pay may motivate managerial behavior that is not always anticipated or ideal. When designing compensation plans, boards must be aware of the unwanted as well as beneficial effects of incentives. Explanations for Changes in U.S. Compensation he empirical evidence suggests fundamental shifts in compensation and incentives. Incentive pay such as stock options have increased in importance. What accounts for these changes? The answers are complex, varied, and the subject of contemporary research. Therefore, this section simply outlines some important candidate explanations, centering on agency explanations, the managerial labor market, the board of directors, technological shocks driving corporate strategy and change, misperceptions about stock options, and managerial power and rent extraction.44 The first potential explanation for changes in compensation and incentives is due to principalagent theory. A standard agency model shows that


the optimal amount of incentives given to the CEO are increasing in the (marginal) productivity of the agent.45 If CEOs become more productive, or labor services relatively scarce, then optimal CEO incentives increase. Similarly, agency theory predicts the use of more incentives if agents are less risk-averse. If CEO risk tolerance falls over this period, this might also contribute to increases in incentives. Standard agency theory, however, predicts an inverse relationship between incentives and the variation in firm performance. This relationship is the incentive-risk trade-off. However, studies often show a positive relation between incentives and firm risk (see below). In addition, Prendergast’s46 review of the empirical literature shows that the trade-off between incentives and risk is tenuous. He develops a contract model that reconciles the theory with the empirical evidence, showing incentives are provided in more risky environments when authority is delegated to the agent. In addition, the standard agency model predicts greater expected compensation when incentives are greater. This increase is required to compensate the CEO for the imposition of greater risk and the increased effort induced by higher incentives. Suppose that efficient contracting requires an increase in CEO incentives over time. This would lead to an increase in risk borne by the CEO. Given that both incentives and compensation increased in the 1990s, this trend is consistent with the agency model. If compensation had increased without an increase in incentives, it would have indicated problems with pay setting.47 The second potential explanation for changes in U.S. executive compensation is related to shifts in the managerial labor market. Changes in the demand and supply of managerial talent can have profound effects on executive pay. An increase in the demand for skilled CEOs will increase compensation. Himmelberg and Hubbard48 argue that the supply of highly skilled CEOs who are capable of running large complex firms is relatively inelastic; therefore, shocks to aggregate demand increase both the value of the firm as well as the marginal value of the CEO’s labor services to the firm. They show that, in equilibrium, such shocks lead to greater executive compensation. Murphy


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and Zabojnik49 present a theoretical model explaining CEO pay based on changes in the relative importance of general and specific managerial capital. General managerial capital (such as knowledge of finance, accounting, or management of human capital) is valuable and transferable across companies, whereas specific managerial capital skills (such as knowledge of firm suppliers or clients, etc.) are only valuable within the organization. In their model, the firm decides whether to fill a CEO vacancy by choosing an incumbent or external candidate. A company hiring externally forgoes valuable firm-specific skills but selects from a larger set of managers allowing better matching of managers to firms. Firms will increasingly appoint external CEO candidates as general managerial capital becomes increasingly valuable relative to firm-specific managerial capital. Labor market competition for talent, especially for CEOs with general transferable skills, then determines CEO pay. Murphy and Zabojnik argue that general managerial skills have become more important in the modern firm, driving up pay. Empirically, they show external CEO hires as a percentage of all CEO appointments increased from 15 percent in the 1970s to 27 percent during the 1990s. In addition, external appointments to the CEO position receive a compensation premium—and this premium has increased during the 1990s. The third explanation for changes in U.S. executive compensation is the growth of more diligent boards. Recently, there has been an increase in theoretical research on boards of directors.50 In the context of CEO, pay one might initially believe that more diligent boards would award lower compensation, but this is only the case if pay is excessive. Benjamin Hermalin51 provides a model to explain trends in corporate governance. Because the percentage of outsiders on compensation committees is increasing (see the evidence in the next section), we can conclude that boards are becoming more diligent. Hermalin theorizes that the more diligent a board is, the more likely it will be to monitor the CEO (seek information about his ability). This, in turn, will give the CEO incentives (directly proportional to board diligence) to work harder in equilibrium. Because of

this response, the CEO’s equilibrium utility will have decreased; thus, he will demand more compensation for this decrease. Therefore, Hermalin develops a theory that more-diligent boards will have CEOs who receive a greater compensation to explain the trend in recent years of an increase in both independent directors on compensation committees and CEO pay. The fourth explanation for changes in executive compensation is a shift in corporate strategy brought about by technology and other environmental shocks. As firms adapt to or change with their environment, different compensation contracts may become necessary. Dow and Raposo52 develop a contracting model demonstrating the link between corporate strategy and CEO compensation, predicting greater executive compensation in highly changeable environments. Dramatic corporate change has abounded in the United States since the 1980s. Major U.S. industries were deregulated, and fundamental technological developments led to pressure for U.S. firms to reconsider their corporate strategies and focus.53 These developments acted as important catalysts behind the merger, restructuring, and takeover waves of the 1980s and 1990s.54 For example, the value of U.S. mergers and acquisitions as a percentage of GDP has been increasing since the 1970s. The Dow and Raposo paper55 outlines a model where the CEO has discretion over the firm’s strategy, and that different strategies require different levels of effort. For example, a strategy for dramatic change would require more effort than maintaining the status quo. To extract a greater surplus from shareholders, CEOs select excessively ambitious strategies whose success depends heavily on their own performance. Greater incentives result in overly dramatic strategy choices. Anticipating this distortion, shareholders could commit to handing over large pay packages at the outset. Dow and Raposo show that, in highly changeable environments, where dramatic strategic change is possible and CEOs are better informed about strategy than the shareholders, such a contract may be optimal for shareholders. The model helps interpret the 1990s as a period of




great corporate change where firms committed to high CEO compensation. Inderst and Mueller56 also link strategy to compensation by addressing how to induce a CEO to reveal information to shareholders. They articulate that the firm should alter its corporate strategy— especially if the change in strategy leads to the dismissal of the incumbent CEO. In their model, the firm faces a decision between “change” and “continuation” of its current strategy, which in turn depends on the firm’s business environment (the “state of nature”). In low states of nature, the firm’s expected future profits under the “continuation” strategy are low, meaning “change” is optimal. In high states of nature, “continuation” is optimal. In practice, the CEO typically knows the ideal strategy before others. Because the CEO is likely to favor the continuation strategy, even when change is optimal, the trick is to get the CEO to reveal private information. Inderst and Mueller derive an optimal contract that consists of options, a base wage, and severance pay. The role of severance pay is to encourage the CEO to reveal information that might cost the CEO his job. When deciding between “continuation” and “change” strategies, the CEO’s tradeoff is on-the-job pay (i.e., options) against severance pay. The optimal on-the-job pay scheme is one that minimizes the amount of severance pay required to select the “change” strategy in low states of nature when change is the best choice. Inderst and Mueller show that, as the likelihood that change is desirable for the firm increases, there will be increases in the size of the option grant, as well as the severance pay. Moreover, the likelihood that change will happen also increases. The model is therefore consistent with major governance events of the 1990s, such as the large increases in executive compensation, the increased frequency of forced CEO turnovers, and dramatic corporate change. Other research has also argued that incentives and firm growth opportunities are positively related. Smith and Watts57 argue that the existence and prevalence of growth opportunities (or the firm’s investment opportunity set) make it difficult for owners to know the correct value maximizing strategies. In addition, they are uncertain

whether CEOs are selecting the right actions. The argument suggests that monitoring technology and equity incentives are substitute instruments used to achieve the firms’ goals. Several studies show that firms with growth opportunities have greater equity incentives.58 Demsetz and Lehn59 also argue that more risky and uncertain environments require greater incentives, because shareholder-monitoring costs increase. Rather than enduring the greater monitoring costs to determine if the CEO has taken the right actions, shareholders instead use equity incentives to motivate managers. If the firms’ operating environments have become more uncertain, or growth opportunities more valuable, we would expect to see incentive pay becoming more prevalent. The fifth explanation for changes in executive compensation is misperceptions about the cost and value of options. Murphy60 develops the “perceived cost” hypothesis to explain the growth in executive pay. The accounting treatment of U.S. options during the 1990s means it was effectively “free” for boards to grant them to executives since no cost appears in the profit and loss account. The “perceived cost” to the board is less than the economic cost of the option measured by its Black-Scholes value. In addition, as we showed earlier, a risk-averse and non-diversified employee will value an option less than its economic cost. According to Jensen et al.,61 this means “too many options are granted to too many people, and options with favorable accounting treatment will be preferred to better incentive plans with less favorable accounting treatment.” The final explanation for the growth in executive compensation is the managerial power hypothesis. Bebchuk and Fried62 develop a model where CEOs control the pay-setting process, suggesting managerial power and rent extraction are occurring. For example, research has indeed demonstrated that CEO pay is greater when boards are weak.63 A board is weak or powerless if it is too large, and therefore it is difficult for directors to oppose the CEO, or if the CEO has appointed the outside directors, who are beholden to the CEO for their jobs. In addition, it is weak when directors serve on too many other boards, making them too busy to be effective monitors. Finally, it is


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weak if the CEO is also chair of the board, since conflicts of interest arise. When board governance is poor, excess pay as an agency cost is to be expected. However, during the 1990s boards became less weak because boards increasingly added independent directors and strengthening governance arrangements. In these circumstances, rent extraction becomes less, not more, likely.64 Bebchuk and Fried also claim that important features of stock option plans are inconsistent with optimal contracting and reflect managerial power. Simple agency models predict that the market component of firm performance be removed from the CEOs’ compensation package since CEO actions do not influence the market, incentives are not improved, and the pay contract is riskier.65 Such market indexing is called “relative performance evaluation.” Bebchuk and Fried argue that, since option contracts lack explicit relative performance evaluation, executives receive windfall gains as market value increases. In short, they are paid for observable luck, not their performance or skill. The typical stock option plan does not explicitly filter out general stock price increases that are attributable to market or industry trends and therefore unconnected to the executive’s own performance. This means that, in rising markets, the value of a CEO’s options increases even if firm performance is worse than the market. Using indexed options would be one way to explicitly introduce relative performance evaluation into the contract66 and provide incentives at lower cost. However, the lack of indexed options and the near ubiquity of so-called fixed price options, where the fixed exercise price of the option grant is usually set equal to the stock price, does not necessarily reflect managerial power. Instead, the accounting treatment of options in the last decade means that indexed options would attract an accounting charge. Thus, faced with a decision to use a potentially superior option that would decrease costs, versus using a standard fixed price option, which attracts no charge, firms choose the latter. This choice is not necessarily because of managerial power, but because of an accounting anomaly. However, Bebchuk and Fried argue the accounting explanation for lack of relative perfor-

mance (or reduced-windfall options) is incomplete. In part, this is because management lobbied against expensing options and did not exert effort to get non-expensing for indexed options.67 In addition, not only is explicit indexing in compensation contracts rare, studies also find little evidence of relative performance evaluation in the estimated relationship between pay and performance.68 However, this may not be due to managerial power. For instance, more complicated agency models suggest the value of a CEO’s human capital changes with market fortunes. If so, CEO compensation also moves with the market. Specifically, Paul Oyer69 develops a model where it is optimal to pay the CEO for industry level performance if that sector performance is correlated with the CEOs’ outside opportunities. In addition, recent empirical evidence shows that this hypothesis has validity.70 The managerial power theory advanced by Bebchuk and Fried and Bebchuk and Grinstein also provides a potential explanation for why pay has changed over the recent decade. One reason for the growth in executive pay is the increased acceptance by shareholders of equity-based compensation. This enabled the compensation plan designers (the board and compensation committees) to take advantage of this willingness to provide large payoffs to executives. They also argue that the bull market made investors more forgiving and weakened constraints on pay allowing it to grow. Bebchuk and Grinstein also argue that during this period the barriers to takeovers increased. Managers became more entrenched and enjoyed greater compensation. These power explanations for the growth in pay contrast with other economic based explanations. A challenge for future research is to distinguish between the competing theories to explain the growth in executive pay.


The Governance of Executive Pay ontract theory shows that pay can ameliorate the agency problem by providing incentives that motivate managers to optimize the longterm value or earnings potential of the firm. However, if the CEO controls the contracting process then, as Bebchuk and Fried have argued, compensation can be part of the problem rather than the




solution. It is impossible to evaluate whether pay outcomes are optimal without better understanding the pay-setting process. In this section, we dig a bit deeper into what boards and compensation committees do to shed light on that relationship. The job of the board is to hire, fire, and compensate the CEO.71 When appointing the CEO, the board can choose to offer him an explicit employment contract or not (and, if not, the contract is “implicit”). Gillan et al.72 and Schwab and Thomas71 describe the characteristics of explicit employment contracts. These contracts specify the CEO’s salary, bonus, and incentive (option) package. The employment contracts typically have a fixed duration. They are not socalled “employment-at-will” contracts, but are typically 2-to-3 year renewable. The contracts usually contain information about termination procedures, and provisions and non-compete and arbitration clauses. Schwab and Thomas73 show that employment contracts generally do not contain restrictions on the CEO’s ability to hedge stock options. In addition, the employment contract contains information about perquisites (such as company car, country club membership, pension advice, company aircraft, and spouse travel). Gillan et al. show that less than half of S&P 500 CEOs have explicit contracts; the rest have “implicit” contracts. They demonstrate that contract theory explains whether the employment contract is explicit or not. For example, the contract is more likely to be explicit when there is greater potential for opportunistic behavior post-contracting by the firm, where the CEO is making large firm-specific investments or where there are greater information asymmetries between the parties. We showed earlier that boards and compensation committees furnish CEOs with important incentives via stock and options. The evidence on explicit CEO contracts documented by Gillan et al. and Schwab and Thomas shows that boards consider other elements of compensation, such as pensions and perquisites. Rajan and Wulf74 directly address whether perquisites represent managerial excess. They use proprietary data on a number of company perquisites and conclude that firms offer perquisites in situations where they are most likely to facilitate managerial productivity.

As such, perquisites are not managerial excess, but instead form part of the complex contracting between the CEO and the board. In contrast, Yermack75 focuses on the use of company planes. He shows that when the use of aircraft is disclosed publicly to shareholders, there is a drop in stock prices of about one percent. The optimal provision of pension and perquisite arrangements in firms promises to be an important topic for future research.


Compensation Committees and Executive Pay potential problem with pay arrangements highlighted by the managerial power theory is that compensation committees are inefficient. This section evaluates the effectiveness of this committee. Specifically, what incentives does the committee face to promote shareholder interests? Do compensation committee member incentives align with shareholders or, as managerial power theorists predict, with managers? Conyon and He76 explicitly test the effectiveness of compensation committees using three-tier agency theory77 and contrast it to a managerial power model. At the heart of the three-tier agency model is the idea that shareholders (the principal) delegate monitoring authority to a separate supervisor (e.g., a compensation committee) who evaluates the agent (e.g., CEO). Whether the supervisor will work in the principal’s best interest, or instead collude with the agent, is dependent on whether the supervisor’s interests are more tightly related with those of shareholders (principal) or management (agent). The value of the three-tier agency model is that it focuses attention on the supervisor’s incentives to promote shareholder welfare. To test the model, Conyon and He78 use data on 455 U.S. firms that went public in 1999. The study finds support for the three-tier agency model. The presence of significant shareholders on the compensation committee (i.e., those with share stakes in excess of 5 percent) is associated with lower CEO pay and higher CEO equity incentives. Firms with higher paid compensation committee members are associated with greater CEO compensation and lower incentives. The managerial power model receives little support. They find no evidence that insiders or CEOs of


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other firms serving on the compensation committee raise the level of CEO pay or lower CEO incentives. A number of other studies have addressed the effectiveness of compensation committees as well. The balance of evidence suggests that the composition of the committee does not lead to severe agency problems. Studies show that executive pay is no greater if compensation committees contain affiliated directors.79 Compensation committees, though, have mixed effects on executive incentives. Anderson and Bizjak80 and Vafeas81 find no evidence that CEO incentives are lower when affiliated directors are on the compensation committee. However, Newman and Mozes82 conclude that pay for performance is more favorable to the CEO when the compensation committee contains insiders. In addition, Conyon and Peck83 show the link between pay and performance is greater in firms adopting compensation committees. We use the Investor Responsibility Research Center (IRRC) Directors database to further test the efficiency of compensation committees between 1998 and 2003. The data is of annual frequency and covers board members of the S&P 500, S&P MidCap, and S&P SmallCap firms. The dataset includes information on the board com-

mittees to which a director belongs, board affiliation, demographic characteristics, and other information. Table 4 shows board and compensation committee composition by year. The IRRC classifies a directorship as either “Employee,” “Linked,” or “Independent.” A linked director is “a director who is linked to the company through certain relationships, and whose views may be affected because of such links,” for example a former employee.84 A director is “independent” if elected by the shareholders and not affiliated with the company. In 2003, 18 percent of directors are employees, 13 percent are linked directors, and 69 percent are independent directors. The percentage of independent directors has been increasing annually, coinciding with a decrease in the number of employees and linked affiliated directors on the board. Boards, then, are becoming more independent over time. The lower part of the table focuses on those members of the board of directors who are part of the compensation committee. Compensation committees are becoming more independent over time as well. The percentage of affiliated directors on the committee fell from 12.8 percent in 1998 to 7.7 percent in 2003, and at the same time independence increased. One can hypothesize that affiliated directors

Table 4 Directors in the Investor Responsibility Research Center (IRRC) Data Set
Director Type on Board of Directors Director Type Employee (%) Director Type Linked/affiliated (%) Director Type Independent (%) Total Directors on the Compensation Committee by Director Type Director Type Employee (%) Director Type Linked/affiliated (%) Director Type Independent (%) Total number of directors on Compensation Committee 1998 22.3 17.4 60.3 17,048 1998 1.4 12.8 85.8 6,238 1999 21.9 17.3 60.8 17,420 1999 1.7 12.8 85.6 6,375 2000 21.8 16.6 61.6 16,675 2000 1.4 11.9 86.7 6,088 2001 21.3 15.7 63.0 16,669 2001 1.3 11.5 87.2 6,165 2002 19.7 13.9 66.4 13,499 2002 0.7 9.4 90.0 5,085 2003 18.4 12.8 68.8 13,792 2003 0.4 7.7 91.9 5,188

Table 4 (upper part) shows the composition of the board of directors for firms by year. A director is considered an employee if he is currently working for the firm, considered independent if he is elected by shareholders, having no affiliation with the firm, and considered linked if he is affiliated with the company in such a way that his views may be biased and unfavorable to shareholders — for example, a former employee or a person providing professional services to the firm. Table 4 (lower part) includes only members of the board of directors who are part of the compensation committee (therefore firms without a compensation committee are excluded), showing the percentage of each director type composing compensation committees.




are more likely to set contracts that are more favorable to CEOs relative to shareholders. For example, one might predict that CEO compensation would be greater and that the CEO would receive fewer incentives when the compensation committee contains affiliated directors. Such empirical evidence would be consistent with the managerial power perspective. To test this we performed some simple fixed-effects pay regressions. We defined an independent binary variable equal to one if the compensation committee contains any affiliated directors and zero, otherwise. The measure is consistent with previous research.85 The regression results are contained in Table 5. The results show that, after controlling for firm size, performance, macroeconomic shocks, and unobserved firm heterogeneity, there is no relation between CEO pay and a compensation committee containing affiliated directors. The coefficient of interest (affiliated compensation committee) is negative and insignificant in both regressions, indicating no effect on total CEO compensation or incentives. The results are consistent with the findings of Anderson and Bijack86 and Daily et al.,87 who also find no relation between measures of CEO compensation and the composition of the compensation committee. The relation between incentives and firm size is also interesting. We expect firm size to relate positively to dollar equity incentives. This is because
Table 5 Compensation Committee Structure and CEO Pay Dependent variable log(total compensation)

larger firms require more talented managers,88 who themselves are relatively wealthy compared to managers in smaller firms.89 In addition, Core and Guay90 argue that owners find it more difficult to monitor managers in larger firms and so are more likely to use equity incentives as a substitute for monitoring. The results in Table 5 confirm this prediction and are consistent with other studies also showing a positive relation between incentives and firm size.91


Conclusions xecutive compensation is a controversial and complex subject that continues to attract the attention of the media, policymakers, and academics. Contract theory predicts that shareholders use pay to provide incentives for the CEO to focus on maximizing long-term firm value. Since CEOs have relatively low ownership of firm shares, they might otherwise behave opportunistically. An alternative theoretical perspective, the managerial power view, is that CEOs control the pay-setting process and set their own pay. This theory predicts that compliant compensation committees and boards provide CEOs with excess pay (or compensation “rents”) and that contracts are suboptimal from the shareholders’ perspective. Distinguishing between these two theories is an important challenge for future research. This paper provides evidence on what has hap-

Log (CEO compensation)
0.008 (0.031) 0.34** (0.029) 1.32** (0.52) Yes Yes 7024 0.74

Log (CEO incentives)
0.022 (0.026) 0.83** (0.24) 4.77** (0.43) Yes Yes 6994 0.90

Affiliated compensation committee ( 1) Log(market value) Stock returns ( 10 3) Time effects Firm fixed effects Observations R2

** significant at 1%; * significant at 5%; significant at 10%. Table 5 summarizes the coefficients for each regression model. The dependent variables used are log (total compensation) and log (aggregate CEO incentives).


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pened to CEO pay between 1993 and 2003. It shows that total compensation increased significantly over this period. Grants of stock options to CEOs and executives are the main driver of CEO pay gains. The paper also documents that CEOs have important financial incentives. These arise from the portfolio of firm stock and options owned by the CEO. The important point is that, if the stock price declines significantly, the value of the CEOs’ assets falls. Analogously, if asset prices increase, so does CEO wealth. In consequence, the wealth of the CEO varies with the stock price performance of the firm. An important research challenge is to fully understand the potentially unintended consequences of providing greater incentives to agents. In practice, CEO compensation contracts are determined by compensation committees that may have conflicting incentives to align with the CEO (leading to suboptimal contracts and excess pay) or with shareholders (leading to optimal contracts and appropriate pay). The analysis in this paper illustrates that U.S. boards and compensation committees are becoming more independent (measured by fewer insider directors and a greater number of outside directors). The evidence shows that the presence of affiliated directors on the compensation committee (an instance where greater managerial power is expected) does not lead to greater CEO pay or fewer CEO incentives. In summary, high pay itself is not evidence of inefficient contracts but may simply reflect the market for CEOs and the pay necessary to attract, retain, and motivate talented individuals. Boards of directors need to design compensation contracts to align the interests of owners with managers. One test of whether the corporate governance system is working appropriately, including executive compensation arrangements, is to evaluate economic performance. Holmstrom and Kaplan92 investigate the state of U.S. corporate governance in the wake of corporate scandals. They conclude that the U.S. economy has performed well, both on an absolute basis and relative to other countries over about two decades. Importantly, the economy has been robust even after the scandals were revealed. This is not to deny that improvements in governance arrangements

may be beneficial. Furnishing CEOs with appropriate compensation and incentives is desirable for a healthy economy. However, ensuring that the contracting process is not corrupted is an important goal for corporate governance.
I would like to thank Peter Cappelli, John Core, James Dow, Wayne Guay, Roman Inderst, Mark Muldoon, Lina Page, Graham Sadler, and Steve Thompson for comments when preparing this paper. I am especially grateful to Lucian Bebchuk for his comments and suggestions. Finally, I would like to thank Danielle Kuchinskas for excellent research assistance.


Jensen, M.& Murphy, K.J. 1990. Performance pay and top management incentives. Journal of Political Economy, 98: 225–264. 2 Bebchuk, L. & Fried, J. 2003. Executive compensation as an agency problem. Journal of Economic Perspectives, 17(3): 71–92; Bebchuk, L. & Fried, J. 2004. Pay without performance: The unfulfilled promise of executive compensation. Harvard University Press. 3 Bebchuk, L. & Fried, J. 2004. Pay without performance: The unfulfilled promise of executive compensation. Harvard University Press. See also their article, Pay without performance: Overview of the issues. 2006. Academy Management Perspectives, this issue. 4 See Bertrand, M. & Mullainathan, S. 2000. Agents without principals. American Economic Review, 90:203–208; Bertrand, M. & Mullainathan, S. 2001. Are CEOs rewarded for luck? The one without principals are. Quarterly Journal of Economics, 116: 901–932. 5 On equity incentives see Core, J., Guay, W., & Larcker, D. 2003. Executive equity compensation and incentives: a survey. FRBNY Economic Policy Review, April: 27-44. On evaluating pay for performance see Core, J., Guay, W. & Thomas, R. 2004. Is S&P 500 CEO compensation inefficient pay without performance? A review of Pay without Performance: The unfulfilled promise of executive compensation. Vanderbilt Law and Economics Research Paper No. 05-05; U of Penn, Inst for Law & Econ Research Paper 05-13. 648648 . 6 For an impressive technical account of contract and incentive theory, see Laffont, J. & Martimort, D. 2002. The theory of incentives: The principal-agent model. Princeton University Press. See also Bolton, P. & Dewatripont, M. 2005. Contract Theory. MIT press. Agency theory has been a very powerful tool for understanding the modern firm. The theoretical foundations of executive compensation contracts can traced to: Mirrlees, J. 1976. Optimal structure of incentives and authority within an organization. Bell Journal of Economics, 7: 105–131; Holmstrom, B. 1979. Moral hazard and observability. Bell Journal of Economics, 10: 74 –91; Holmstrom, B. 1982. Moral hazard in teams. Bell Journal of Economics, 13: 324 – 40;




Holmstrom, B. & Milgrom, P. 1987. Aggregation and linearity in the provision of intertemporal incentives. Econometrica, 55: 303–28. 7 Jensen, M., Murphy, K.J., & Wruck, E. 2004. Remuneration: where we’ve been, how we got to here, what are the problems, and how to fix them. Finance, Harvard NOM Working Paper No. 04-28. http://ssrn .com/abstract 561305 . 8 Core, J., Guay, W., & Larcker, D. 2003. Executive equity compensation and incentives: a survey. FRBNY Economic Policy Review, April: 27-44. 9 Core, J., Guay, W. & Thomas, R. 2004. Is S&P 500 CEO compensation inefficient pay without performance? A review of Pay without performance: The unfulfilled promise of executive compensation, Vanderbilt Law and Economics Research Paper No. 05-05; U of Penn, Inst for Law & Econ Research Paper 05-13. 648648 . 10 As in Hermalin, B. 2004. Trends in corporate governance, Journal of Finance (forthcoming). 11 Bebchuk &. Fried, 2004, supra note 2. 12 Some information on perquisites and deferred compensation is not fully disclosed (see Bebchuk & Fried, 2004). 13 Murphy, K. 1999. Executive compensation, in Ashenfelter, O. & David Card, D. (Eds.), Handbook of labor economics, Vol. 3. New York: Elsevier. 14 Core, J. & Guay, W. 1999. The use of equity grants to manage optimal equity incentives. Journal of Accounting and Economics, 28: 151–184; Murphy (1999) supra note 13; Conyon, M. & Murphy, K.J. 2000. The prince and the pauper? CEO pay in the US and UK. Economic Journal, 110: 640 – 671. 15 Black, F. & Scholes, M. 1973. The pricing of options and corporate liabilities. Journal of Political Economy, 81: 637– 59. 16 Typically, stock options are granted “at the money” with a maturity term of 10 years and vest after 3 years. Suppose we define a standard option where S the share price $100; X the exercise or strike price $100; T the time to maturity 10 Years; q the dividend yield 2 1⁄2 %; r the risk free rate of interest 7%; and the standard deviation of returns on the share 25%. These parameters correspond reasonably well to those of an option an executive receives (Murphy (1999), supra note 13; Hall, B. 2000. What you need to know about stock options. Harvard Business Review, March-April: 121-129). This standard option has an expected (BlackScholes) value of about $37. 17 See Lambert, R., Larcker, D., & Verrichia, R. 1991. Portfolio considerations in valuing executive compensation. Journal of Accounting Research, 29: 129 –149; Hall, B. & Murphy, K.J. 2002. Stock options for undiversified executives. Journal of Accounting and Economics, 33: 3– 42. 18 Jensen et al., 2004, supra note 7. 19 Recent research has proposed alternative methods to value options given to risk-averse and undiversified executives. These include Hall & Murphy (2002), supra note 16; Henderson, V. 2005. The impact of the market portfolio on the valuation, incentives, and optimality of

executive stock options. Quantitative Finance, 5: 1–13; Ingersoll, J. 2002. The subjective and objective evaluation of incentive stock options. Journal of Business, Yale ICF Working Paper No. 02-07. abstract 303940 ; Cai, J. & Vijh, A. 2005. Executive stock and option valuation in a two state-variable framework. Journal of Derivatives, 12: 9-27; Kadam, A., Lakner, P., & Srinivasan, A. 2005. Executive stock options: value to the executive and cost to the firm. http:// 353422 . Currently, however, Black-Scholes remains the most popular valuation method. For example, it is frequently used by firms when reporting option compensation in SEC proxy filings. 20 Many studies use only S&P 500 firms. This will cause an upward bias in the estimate of economy wide CEO pay. This is because S&P 500 firms are larger than other firms, and larger firms have greater executive pay. The elasticity of executive pay to firm size is typically in the range 30% to 40% (Murphy, 1999, supra note 13). 21 See for instance, Murphy, 1999, supra note 13. Total compensation is variable TDC1 in ExecuComp. Note it excludes the value of retirement benefits. Murphy argues it is difficult or arbitrary to convert future payments to annual pay. Strong cases for researching executive pensions are made in Yermack, D. 2005. Flights of fancy: Corporate jets, CEO perquisites, and inferior shareholder returns. AFA 2005 Philadelphia Meetings. Journal of Financial Economics. 529822 ; Bebchuk, L. & Jackson. 2005. Putting executive pensions on the radar screen (March). Harvard Law and Economics Discussion Paper No. 507. abstract 694766. They show for the two-thirds of CEOs with defined benefit plans, the value of the plan adds a third to the total career compensation for the median CEO. 694766. 22 We simply report pay information from the ExecuComp database and do not adjust for inflation, purchasing power etc. 23 Murphy, 1999, supra note 13. 24 Bebchuk, L. & Grinstein, Y. 2005. The growth of executive pay, NBER working paper 11443. Forthcoming in Oxford Review of Economic Policy. 25 The material discussed in this section is based largely on Core, Guay, & Larcker, 2003, supra note 8; Core, Guay, & Thomas, 2004, supra note 9. 26 Note that Bebchuk & Fried, 2004 (note 2) do not claim that there is complete decoupling of pay and performance but rather less linkage between pay and performance than firms could have easily accomplished and than investors appreciate. Also, they recognize incentives arising from equity holdings but stress that much of the gains here come form market-wide and industry-wide movements, as well as from short-term spikes that do not last, and that firms could have designed equity compensation in a much more cost-effective way (see chapters 11-14 of their book). 27 For example, Hall, B. & Liebman, J. 1998. Are CEOs really paid like bureaucrats? Quarterly Journal of Economics, 113: 653– 691; Murphy, 1999; Core et al., 2004, supra note 5.


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Hall & Liebman, 1998, supra note 16; Core et al., 2003, supra note 8. 29 Core & Guay, 1999, supra note 14. 30 The literature discusses two broad incentive measures (Core et al., 2003, note 8). Portfolio incentives are the dollar change in CEO wealth from a percentage change in stock price. The Jensen &Murphy (1990, supra note 1) measure is the dollar change in CEO wealth from a dollar change in firm value. It is proportional to the fraction of firm shares owned by the CEO. For a given firm the measures are simple transformations of each other but they can give rise to different rank orderings in a cross section of firms. For a discussion of the merits of each measure, see Baker, G. & B. Hall, B. 1998. CEO incentives and firm size. Journal of Labor Economics. NBER Working Paper Series, No. 6868. 31 Baker & Hall, 1998, supra note 30; Core & Guay, 1999, supra note 14. 32 The option delta (hedge ratio) is calculated as the derivative of Black-Scholes call option value with respect to the share price. In this context the option delta can be thought of as a weight, which varies between 0 and 1, reflecting the likelihood that the stock option will end up in the money. 33 Murphy, 1999, supra note 13. 34 In calculating portfolio wealth and incentives, we need to make estimates of the exercise price and maturity term for previously granted options. We use the algorithm described by Core & Guay (1999, appendix A, supra note 14) to arrive at the Black-Scholes value of the portfolio of options. 35 See Dow, J. & C. Raposo, C. 2003. CEO compensation, change, and corporate strategy. Journal of Finance (forthcoming). 36 See Hall & Liebman, 1998, supra note 16. 37 See Kerr, S., 1975. The folly of rewarding A while hoping for B., Academy Management Journal, 18: 769 –783. 38 See Holmstrom, B. & Milgrom, P. 1991. Multitask principal-agent analyses: Incentive contracts, asset ownership and job design. Journal of Law, Economics and Organization 7: 24 –52. 39 See Gibbons, R. 2005. Incentives between firms (and within). Management Science, 51: 2–17. 40 See Jacob, B. & S. Levitt, S. 2003. Rotten apples: An investigation of the prevalence and predictors of teacher cheating, The Quarterly Journal of Economics, 843– 877; Levitt, S. & C. Syverson, C. 2005. Market distortions when agents are better informed: The value of information in real estate, NBER working paper 11053; Hubbard, T. 1998. An empirical examination of moral hazard in the vehicle inspection market, Rand Journal of Economics, 29: 406 –26; Gruber, J. & Owings. M. 1996. Physician financial incentives and caesarian section delivery, Rand Journal of Economics, 27: 99 –123. 41 Yermack, D. 1997. Good timing: CEO stock option awards and company news announcements, Journal of Finance, 52: 449 – 476. See also, Aboody, D. & Kasznik, R. 2000. CEO stock option awards and the timing of voluntary disclosures, Journal of Accounting and Economics, 29: 73–100.

See Bartov, E. & Mohhanram, P. 2004. Private information, earnings manipulations and executive stock option exercises, The Accounting Review, 79: 889 –920. Bergstresser, D. & Philippon, T. 2005. CEO Incentives and Earnings Management. Journal of Financial Economics, Forthcoming (see 640585) A classic article on the relation between inventive pay and accounting outcomes is Paul Healy 1985. The effect of bonus schemes on accounting decisions, Journal of Accounting and Economics, 7: 85–107. 43 See Denis, D., Hanouna, P., & Sarin, A. 2005. Is there a dark side to incentive compensation, Journal of Corporate Finance, forthcoming. 44 Bebchuk A& Grinstein also review alternative explanations for the growth in CEO pay albeit from the managerial power perspective. See Bebchuk, 2005, supra note 24. 45 An often-used agency model involves the principal offering the agent a linear contract (Holmstrom & Milgrom, 1987, supra note 6). The first order condition for optimal 2 incentives (b) is: b* P’(e)/[1 r c”(e)], where P’(e) is the CEO’s marginal productivity of effort, r is agent risk aversion, 2 is variance in performance (risk) and c”(e) measures how incentives respond to the cost of effort. Incentives are lower for more risk-averse executives ( b/ r 0), and when there is more uncontrollable noise in firm value ( b/ 2 0). Expected CEO compensation is E[w] s bE[q], where “s” is a fixed salary, “b” is incentives, and “q” is firm value. 46 Prendergast, C. 2002. The tenuous trade-off between risk and incentives. Journal of Political Economy, 110: 1071– 1102. 47 This issue is further explored by Conyon, M., Core, J., & Guay, W. 2005. How high is US CEO pay? A comparison with UK CEO pay, University of Pennsylvania working paper. 48 Himmelberg, C. & Hubbard, R. 2000. Incentive pay and the market for CEOs: An analysis of pay-for-performance sensitivity (June 2000). Presented at Tuck-JFE Contemporary Corporate Governance Conference. http://ssrn .com/abstract 236089 . 49 Murphy, K. & Zabojnik, J. 2003. Managerial capital and the market for CEOs. Marshall School of Business (working paper). 50 For example, see Hermalin, B. 2004. Trends in corporate governance, Journal of Finance (forthcoming); Harris, M. & Raviv, A. 2005 A theory of board control and size, University of Chicago working paper; Singh, R. 2005. Board independence and the design of executive compensation, EFA 2005 Moscow Meetings Paper. http://ssrn. com/abstract 673741; Hermalin, B. & Weisbach, M. 1998. Endogenously chosen boards of directors and their monitoring of the CEO, American Economic Review, 88: 96 –118. 51 Hermalin, B. 2004. Trends in corporate governance, Journal of Finance (forthcoming). 52 Dow & Raposo, 2003, supra note 35. 53 Jensen, M. 1993. The modern industrial revolution, exit and the failure of internal control systems. Journal of Finance, 48: 831– 830.




Holmstrom, B. & Kaplan, S. 2001. Corporate governance and merger activity in the United States: Making sense of the 1980s and 1990s. Journal of Economic Perspectives, 15(2): 121–144. 55 Dow & Raposo, 2003, supra note 35. 56 Inderst, R. & Mueller, H. 2005. Keeping the board in the dark. CEO compensation and entrenchment. London School of Economics (working paper). 57 Smith, C. & Watts, R. 1992. The investment opportunity set and corporate financing, dividend and compensation policies. Journal of Financial Economics, 32: 263–292. 58 Core et al., 2003, supra note 8. 59 Demsetz, H. & Lehn, K. 1985. The structure of corporate ownership: causes and consequences. Journal of Political Economy, 93: 1155–1177. 60 Murphy, K. 2002. Explaining executive compensation: managerial power versus the perceived cost of stock options. University of Chicago Law Review, 69: 847– 869. 61 Jensen et al., 2004, supra note 7. 62 Bebchuk & Fried, 2003; 2004, supra note 2. 63 Core, J., Holthausen, R., & Larcker, D.. 1999. Corporate governance, chief executive officer compensation and firm performance. Journal of Financial Economics, 51: 371– 406. 64 Bebchuk & Fried (2004, supra note 2) and Bebchuk & Grinstein (2005, supra note 24) contend that even if boards have become more independent in this period, firms have also become more insulated from takeover threats, insulating boards from shareholders and leading to increased managerial power. 65 See Holmstrom 1979, supra note 6. 66 Rapapport, A. 1999. New thinking on how to link executive pay with performance. Harvard Business Review, 77: 91–101. 67 Firms are now expensing options due to changes in accounting rules. It remains to be seen whether alterative types of options are used in the future. 68 See for instance Gibbons, R. & Murphy, K. 1990. Relative performance evaluation for chief executive officers, Industrial and Labor Relations Review, 43:S30 –S51; Bertrand, M. & Mullainathan, S. 2001. Are CEOs rewarded for luck? The ones without principals are. Quarterly Journal of Economics, 116: 901–932; Garvey, G. & Milbourn, T. 2003. Incentive compensation when executives can hedge the market: Evidence of relative performance evaluation in the cross section, Journal of Finance, 58:1557–1581. 69 See Oyer, P. 2004. Why do firms use incentives that have no incentive effects? The Journal of Finance, 59: 1619 – 1650. 70 See Rajgopal, S., Shevlin, T., & Zamora, V. 2005. CEOs’ outside employment opportunities and the lack of relative performance evaluation in compensation contracts. Journal of Finance, (forthcoming). 71 Jensen, 1993, supra note 53. 72 Gillan, S., Hartzell, J., & Parrino, R.. 2005. Explicit vs. Implicit Contracts: Evidence from CEO Employment Agreements. 687152 . 73 Schwab, S. & Thomas, R. 2004. What do CEOs bargain for? An empirical study of key legal components of CEO

employment contracts. Cornell Law School Research Paper No. 04-024; Vanderbilt Law and Economics Research Paper No. 04-12. 529923 . 74 Rajan, R. G. & Wulf, J. 2004. Are perks purely managerial excess? NBER Working Paper No.W10494. http:// 546291 (forthcoming Journal of Financial Economics). 75 Yermack, D. 2005. Flights of fancy: Corporate jets, CEO perquisites, and inferior shareholder returns. AFA 2005 Philadelphia Meetings. (forthcoming Journal of Financial Economics). 529822 . 76 Conyon, M. & He, L. 2004. Compensation committees and CEO compensation incentives in US entrepreneurial firms. Journal of Management Accounting Research, 16: 35–56. 77 Antle, R. 1982. The auditor as an economic agent. Journal of Accounting Research, 20: 503–527; Tirole, J. 1986. Hierarchies and bureaucracies: on the role of collusions in organizations. Journal of Law, Economics, and Organization, 2:181–214. 78 Conyon & He, 2004, supra note 76. 79 Daily, C., Johnson, M., Ellstrand, J., & Dalton, D. 1998. Compensation committee composition as a determinant of CEO compensation. Academy of Management Journal, 41: 209 –220; Newman, H. & Mozes, H. 1999. Does the composition of the compensation committee influence CEO compensation practices? Financial Management, 28: 41–53; Vafeas, N. 2003. Further evidence on compensation committee composition as a determinant of CEO compensation. Financial Management, 32: 53–70; Anderson, R. & Bizjak, J. 2003. An empirical examination of the role of the CEO and the compensation committee in structuring executive pay. Journal of Banking and Finance, 27 (7): 1323–1348. 80 Anderson Bizjak, 2003 supra note 79. 81 Vafeas, 2003, supra note 79. 82 Newman & Mozes, 1999, supra note 79. 83 Conyon, M. & Peck, S. 1998. Board control, remuneration committees, and top management compensation. Academy of Management Journal, 41:146 –157. 84 The IRRC data defines an affiliated director as follows. The director may be a former employee who previously worked either for the firm of interest or for a majorityowned subsidiary. A director may provide services, such as legal or financial, have been provided by the director personally or by his employer. The director may be a designated director who is a significant shareholder or a “documented agreement by a group,” for example, a union. A director may be a customer or supplier and is affiliated unless the transaction was deemed “not material” in the firm’s proxy materials. A director may be interlocked defined as a situation in which two firms each have a director who sits on the board of the other. A director may be a family member of an executive officer. In practice, former employees and providing professional services are the leading source of “affiliation”. 85 For example, Anderson & Bizjak, 2003, supra note 79; Daily et al., 1998. 86 Anderson & Bijack, 2003, supra note 79.

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Daily et al., 1998, supra note 79. Smith & Watts, 1992, supra note 57. 89 Baker, G. & Hall, B. 1998. CEO incentives and firm size. Journal of Labor Economics. NBER Working Paper Series, No. 6868. 90 Core, J. & Guay, W. 1999. The use of equity grants to manage optimal equity incentives. Journal of Accounting and Economics, 28: 151–184. 91 See Core et al., 2003, supra note 8. In contrast, Schaefer argues that incentives measured as a fraction of common

shares owned are negatively correlated with firm size because the value of providing incentives for effort does not increase with size as fast as the cost of risk bearing by the executive. See Schaefer, S. 1998. The dependence of pay-performance sensitivity on the size of the firm, Review of Economics and Statistics, 80: 436 – 443. 92 Holmstrom, B. & Kaplan, S. 2003. The state of S&P 500 corporate governance: What’s right and what’s wrong? European Corporate Governance Institute Finance Working Paper No. 23/2003.