2006 Conyon 25

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 compensation is the principal-agent model.6 The

E
xecutive compensation is a complex and con-
troversial subject. For many years, academics,
policymakers, and the media have drawn atten-
tion to the high levels of pay awarded to U.S.
chief executive officers (CEOs), questioning
whether they are consistent with shareholder in-
terests.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 mana-
gerial 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 pa-
per, 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?
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 com-
mittee 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 defini-
tion. First, the contract reduces manager oppor-
tunism and motivates CEO effort by providing in-
centives through risky compensation such as stock

B
efore examining the empirical evidence pre- options. Second, the optimal contract does not im-
sented in this paper, it is important to consider ply a perfect contract, only that the firm designs
the pay-setting process and who sets executive the best contract it can in order to avoid opportun-
pay. The standard economic theory of executive ism and malfeasance by the manager, given the
* Martin Conyon is an Assistant Professor of Management at the Wharton School, University of Pennsylvania. Contact: conyon@wharton.upenn.edu
26 Academy of Management Perspectives
contracting constraints it faces.9 Third, in this ar-
rangement, 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 regu-
lation 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 di-
rectors, may lead to different patterns of compensa-
tion, 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 compensa-
tion, settling on contracts that are not in share-
holders interests. This excess pay constitutes an
economic rent, an amount greater than necessary
to get the CEO to work in the firm. The con-
straints 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 man-
agers reputation) and social coststhe social
costs come on top of the standard market costs.
They argue that market constraints and the social
costs coming from excessively favorable pay ar-
rangements are not sufficient in preventing con-
siderable 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 perfor-
mance. We consider explanations for why CEO
pay and incentives increased remarkably during
the 1990s. Then, the paper considers the gover-
nance of executive pay, especially the role of
independent boards and compensation commit-
tees. We show that compensation committees
have become more independent over time and the
fraction of affiliated directors on boards has de-
February
clined. The paper ends by offering some conclu-
sions about whether the current pattern of exec-
utive pay and incentives in the United States is
consistent with economic theory.
Executive Compensation
T
here is substantial disclosure about U.S. exec-
utive compensation. The Securities and Ex-
change Commission (SEC) expanded and en-
hanced 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 execu-
tives.12 The evidence on U.S. executive compen-
sation provided here was extracted from Standard
and Poors (S&Ps) ExecuComp database, which
includes proxy-statement data for top executives
in the S&P 500, S&P Mid-Cap 400, S&P Small-
Cap 600, and other supplemental S&P indices.
We focus on CEO and non-CEO executives sep-
arately. 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 re-
search.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 mea-
sures. 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 ex-
ecutive pay and are valued at the firms 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
N(d1) Xe-rt N(d2), where d1 {ln(S/X) (r
2006
q 2/2)t}/t, d2 d1 t, where S is the stricted stock grants worth approximately $75 mil-
stock price; X the exercise price; t the maturity
term; r the risk-free interest rate; q the dividend
yield; the volatility of returns; and N(.) the
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 op-
tion 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 exec-
utive performance from using options exceeds this
premium.18 Understanding how employees value
options is an important challenge for future com-
pensation research, especially since stock options
are an increasingly significant component of pay.19
Before considering the general pattern of exec-
utive compensation, consider a few examples.
Many CEOs, such as Jack Welch of General Elec-
tric, receive large pay awards. In 2000, he received
total compensation of about $125 million, includ-
ing 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
Electrics 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 bene-
fits. Another example indicates a somewhat un-
usual pay arrangement. In 2003, Steve Jobs of
Apple Computer received a salary of just $1 and
no annual bonus or options, instead receiving re-
Conyon 27
lion. 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 hold-
ings also increases; if the share price declines, so too
does the CEOs wealth. Salaries, in contrast, are
unrelated to firm performance.
As noted above, this paper examines the gen-
eral pattern of U.S. executive pay using the pop-
ulation 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 re-
muneration is approximately $4.5 million, with a
median of $2.5 million. The distribution has two
important characteristics: considerable pay disper-
sion 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 no-
tion 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 compen-
sation in S&P 500 firms is, of course, much higher
than firms in the entire ExecuComp dataset. This
reflects the well-known positive correlation be-
tween CEO pay and firm size. Larger firms require
28
managers who are more talented, and therefore
they award greater compensation.23
Table 1 shows the total pay and the compo-
nents of total compensation of CEOs and other
non-CEO top executives between 1993 and 2003.
Over the ten-year period, both CEO and non-
CEO executive pay increased. In 2003, the me-
dian 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, respec-
tively, exhibiting the positive skew discussed ear-
lier. Overall, non-CEO executives earn approxi-
mately 40 percent of the CEOs 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 annu-
ally. Over time, salaries have become less impor-
tant 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
Source: ExecuComp. Data plotted for variable TDC1 (total compen-
sation) with values less than $60 million.
Academy of Management Perspectives February
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 compen-
sation 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 per-
cent 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 re-
spectively. 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 sala-
ries. Alternatively, the evidence seems slightly less
consistent with the managerial power theory, since
risk-averse managers would prefer cash compensa-
tion 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 sub-
stitution 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.
Executive Incentives
W
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 share-
holder value. In designing the contract, the firm
2006 Conyon 29

recognizes the CEO is risk averse. Thus, imposing
greater incentives requires more pay to compen-
sate 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 exec-
utives 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, con-
sistent 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 19932003
Base Annual Option Restricted
Year N Total Pay Total Pay Salary Bonus Grants Stock Other
Median Mean
CEOs ($thous) ($thous) (%) (%) (%) (%) (%)
1993 1153 1258.8 2045.4 43.4 20.3 22.9 4.3 9.1
1994 1541 1255.9 2151.4 41.9 20.4 26.5 3.7 7.6
1995 1596 1311.6 2279.8 41.0 20.7 25.0 4.3 9.0
1996 1641 1587.6 3145.0 36.9 20.0 29.2 4.6 9.2
1997 1664 1923.3 3828.9 33.8 20.2 32.3 4.4 9.3
1998 1724 1962.9 4494.5 33.0 18.1 35.6 4.7 8.7
1999 1799 2188.4 5224.0 31.2 18.0 38.8 4.0 8.0
2000 1782 2443.5 6694.8 30.9 17.4 38.7 4.7 8.2
2001 1655 2527.0 6324.3 30.6 14.5 42.3 5.1 7.4
2002 1651 2604.8 4909.8 30.4 17.4 38.5 6.0 7.7
2003 1664 2498.6 4544.8 31.5 19.4 32.3 8.4 8.4
Annual Growth Rate (%) 7.1 8.3 3.2 0.5 3.5 6.9 0.8

Non-CEO Executives
1993 7177 478.0 777.8 49.9 18.9 19.7 3.5 8.0
1994 7486 508.3 852.9 47.7 19.4 22.3 3.2 7.5
1995 7715 528.8 913.9 47.2 19.5 20.9 3.6 8.8
1996 8193 618.2 1141.2 42.9 19.0 25.9 3.9 8.3
1997 8428 690.2 1388.1 40.3 19.2 28.5 3.9 8.1
1998 8695 730.7 1511.5 39.9 17.4 30.7 4.2 7.8
1999 8428 829.1 1931.2 37.5 17.7 33.9 3.6 7.3
2000 8010 922.5 2417.7 36.4 17.3 34.8 4.2 7.3
2001 7652 937.7 2094.0 37.0 15.1 36.6 4.3 6.9
2002 7490 940.9 1841.8 37.6 17.5 32.3 5.2 7.3
2003 7137 931.7 1651.6 38.3 18.4 28.2 7.1 8.0
Annual Growth Rate (%) 6.9 7.8 2.6 0.3 3.7 7.3 0.0
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 executives 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.
30 Academy of Management Perspectives February

compensation. They also receive incentives from nomicsfocuses on compensation and equity
changes in their aggregate holdings of stock and incentives, leaving aside career concerns and the
options in the firm, as described in detail below. labor market for managerial talent. In other words,
Finally, the probability of termination because of it restricts attention to financial incentives.
poor performance gives the CEO an incentive to The key to understanding financial incentives
pursue strategies that maximize firm value. In this is recognizing that they arise from the entire port-
case, if terminated, an executive suffers reputation folio of equity holdings and not simply from cur-
loss and human capital devaluation in the mana- rent pay. Equity incentives, then, are the incen-
gerial labor market. However, this paper consis- tives to increase the stock price arising from the
tent with other recent research in financial eco- managers ownership of financial securities in the
Table 2
Value of Components of Executive Compensation in the United States 19932003
Option Grants Restricted Stocks
Base Salary ($thousands) ($thousands) ($thousands)
Year Median Mean Median Mean Median Mean
CEOs
1993 500.0 544.1 462.7 1057.7 328.9 762.7
1994 456.8 516.1 590.4 1312.0 333.3 726.6
1995 472.3 533.0 534.6 1277.5 389.5 822.1
1996 500.0 552.1 746.5 2093.1 440.2 1014.1
1997 519.8 567.6 931.3 2692.7 525.0 1339.3
1998 525.0 582.9 1108.9 3043.7 513.0 3315.2
1999 531.5 587.9 1341.3 4188.6 574.4 1675.6
2000 554.2 612.6 1547.3 5946.8 750.0 2177.7
2001 583.3 651.8 1765.4 5269.7 847.3 2211.8
2002 609.8 670.8 1546.0 3359.5 811.1 2296.6
2003 645.4 694.7 1268.2 2469.6 932.0 2383.5
Annual Growth Rate (%) 2.6 2.5 10.6 8.8 11.0 12.1

Non-CEO Executives
1993 208.8 242.9 162.9 367.6 107.4 302.4
1994 210.0 244.2 194.7 463.1 99.0 282.3
1995 217.0 252.3 179.1 465.6 123.3 319.4
1996 222.8 258.2 252.0 652.1 137.5 394.76
1997 228.0 266.2 297.0 890.4 147.2 536.4
1998 236.6 276.4 353.6 953.2 169.0 744.0
1999 247.5 289.4 425.5 1420.9 176.9 683.4
2000 257.3 304.0 465.6 1897.8 235.8 781.2
2001 273.0 319.0 516.2 1565.8 219.6 640.1
2002 287.3 333.3 443.3 1044.0 25.16 647.4
2003 306.7 354.5 372.7 791.7 262.8 678.0
Annual Growth Rate (%) 3.9 3.9 8.6 8.0 9.4 8.4
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.
2006 Conyon
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 op-
tions accumulated from previous years. Since the
CEO will care about the whole stock of 500,000
options, not simply this years 100,000, executive
compensation received in any given year provides
only a partial picture of CEO wealth and incen-
tives. 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 CEOs
wealth from ownership of firm equity is the value
of the CEOs stock and option portfolio. We cal-
culate the wealth as the value of shares and re-
stricted stock plus the Black-Scholes value of the
aggregate amount of stock options owned. Follow-
ing Core and Guay,29 executive portfolio incen-
tives are defined as the dollar change in the value
of the CEOs 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 incen-
tives, 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 in-
centives of CEO and non-CEO executives be-
tween 1993 and 2003. Wealth is defined as the
value of an executives equity portfolio. Also in-
cluded 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
31
the Black-Scholes method), and restricted hold-
ings (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, indi-
cating 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 im-
plementing firm strategy and change.35 In addi-
tion 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 an-
nual growth rate around 15 percent each year for
both groups, once again illustrating the impor-
tance 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 ap-
proximately $287,000. If the stock price at this
CEOs 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) indicat-
ing 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 con-
siderable.
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-
32 Academy of Management Perspectives February

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 be-
havior by the agent that was unanticipated by the
principal. In a classic paper, Steven Kerr37 high-
lighted 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 19932003
Value of options Incentives
Equity ($millions) ($millions) Wealth ($millions) ($thousands)
Year Median Mean Median Mean Median Mean Median Mean
CEOs
1993 4.8 56.9 2.1 5.3 9.3 63.0 121.9 662.5
1994 4.2 43.5 2.0 5.5 8.9 49.4 112.5 523.9
1995 4.8 58.8 2.5 7.4 10.5 67.1 134.6 714.1
1996 5.6 70.7 3.5 10.5 12.9 82.4 165.0 882.4
1997 6.9 101.5 5.2 15.5 17.9 120.3 230.8 1284.6
1998 6.5 138.5 4.7 19.2 17.1 161.7 217.3 1704.6
1999 6.9 177.6 5.1 29.8 18.8 211.7 243.4 2208.0
2000 5.7 125.1 6.4 29.1 18.5 155.8 234.9 1660.2
2001 5.5 109.4 7.7 22.8 19.8 133.7 255.8 1440.7
2002 4.4 94.6 6.1 16.4 16.4 112.4 217.0 1213.4
2003 6.1 103.4 9.1 22.6 22.2 128.0 287.4 1404.3
Annual Growth Rate (%) 2.4 6.2 15.8 15.6 9.1 7.3 9.0 7.8

Non-CEO executives
1993 0.4 5.5 0.5 1.5 1.5 7.2 19.9 80.1
1994 0.3 4.7 0.5 1.5 1.3 6.3 17.0 72.1
1995 0.3 6.2 0.6 2.1 1.5 8.5 20.8 98.0
1996 0.4 7.9 0.9 2.8 1.9 11.0 26.5 125.8
1997 0.5 10.0 1.2 4.2 2.5 14.7 34.3 168.3
1998 0.5 12.9 1.1 4.7 2.4 18.0 32.7 202.3
1999 0.5 15.1 1.3 7.6 2.7 23.3 36.7 256.7
2000 0.4 16.7 1.5 7.5 2.9 24.7 38.2 275.0
2001 0.5 14.6 1.8 5.9 3.1 21.0 41.3 238.0
2002 0.4 10.6 1.4 4.2 2.4 15.2 33.0 175.9
2003 0.6 12.4 2.1 5.6 3.7 18.5 49.8 216.5
Annual Growth Rate (%) 4.1 8.5 15.4 14.1 9.4 9.9 9.6 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.
2006
agents engaging in multiple tasks.38 More re-
cently, 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 unantici-
pated effects of financial incentives on economic
outcomes have been documented in diverse con-
texts such as classroom teaching, real estate mar-
kets, vehicle inspection markets, and the behavior
of physicians.40 In the corporate context, David
Yermack demonstrates that CEOs opportunisti-
cally time the award of option grants around earn-
ings announcements in order to increase their
compensation.41 Other studies find that private
information is used by executives to engineer ab-
normally large option exercises and hence the
payouts from those options. In addition, studies
show that firms with more incentives are associ-
ated with greater earnings manipulation.42 Recent
studies show that the likelihood of a firm being
the target of fraud allegations is positively corre-
lated with option incentives.43 In short, options
and incentive pay may motivate managerial be-
havior 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
T
he empirical evidence suggests fundamental
shifts in compensation and incentives. Incen-
tive 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 expla-
nations, 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 principal-
agent theory. A standard agency model shows that
Conyon 33
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 incen-
tives and the variation in firm performance. This
relationship is the incentive-risk trade-off. How-
ever, studies often show a positive relation be-
tween incentives and firm risk (see below). In
addition, Prendergasts46 review of the empirical
literature shows that the trade-off between incen-
tives and risk is tenuous. He develops a contract
model that reconciles the theory with the empir-
ical evidence, showing incentives are provided in
more risky environments when authority is dele-
gated to the agent. In addition, the standard
agency model predicts greater expected compen-
sation when incentives are greater. This increase
is required to compensate the CEO for the impo-
sition of greater risk and the increased effort in-
duced by higher incentives. Suppose that efficient
contracting requires an increase in CEO incen-
tives over time. This would lead to an increase in
risk borne by the CEO. Given that both incen-
tives 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 com-
pensation. Himmelberg and Hubbard48 argue that
the supply of highly skilled CEOs who are capable
of running large complex firms is relatively inelas-
tic; therefore, shocks to aggregate demand in-
crease both the value of the firm as well as the
marginal value of the CEOs labor services to the
firm. They show that, in equilibrium, such shocks
lead to greater executive compensation. Murphy
34 Academy of Management Perspectives
and Zabojnik49 present a theoretical model ex-
plaining 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 manage-
ment of human capital) is valuable and transfer-
able across companies, whereas specific manage-
rial 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 hir-
ing 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 capi-
tal. Labor market competition for talent, espe-
cially 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 premi-
umand this premium has increased during the
1990s.
The third explanation for changes in U.S. ex-
ecutive compensation is the growth of more dili-
gent boards. Recently, there has been an increase
in theoretical research on boards of directors.50 In
the context of CEO, pay one might initially be-
lieve 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. Be-
cause the percentage of outsiders on compensa-
tion 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 dili-
gence) to work harder in equilibrium. Because of
February
this response, the CEOs equilibrium utility will
have decreased; thus, he will demand more com-
pensation 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 execu-
tive compensation is a shift in corporate strategy
brought about by technology and other environ-
mental shocks. As firms adapt to or change with
their environment, different compensation con-
tracts may become necessary. Dow and Raposo52
develop a contracting model demonstrating the
link between corporate strategy and CEO com-
pensation, predicting greater executive compensa-
tion in highly changeable environments. Dra-
matic corporate change has abounded in the
United States since the 1980s. Major U.S. indus-
tries were deregulated, and fundamental techno-
logical developments led to pressure for U.S. firms
to reconsider their corporate strategies and fo-
cus.53 These developments acted as important cat-
alysts behind the merger, restructuring, and take-
over 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 firms
strategy, and that different strategies require dif-
ferent 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 incen-
tives 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 strate-
gic change is possible and CEOs are better in-
formed about strategy than the shareholders, such
a contract may be optimal for shareholders. The
model helps interpret the 1990s as a period of
2006
great corporate change where firms committed to
high CEO compensation.
Inderst and Mueller56 also link strategy to com-
pensation by addressing how to induce a CEO to
reveal information to shareholders. They articu-
late that the firm should alter its corporate strat-
egy 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 firms business environ-
ment (the state of nature). In low states of
nature, the firms expected future profits under the
continuation strategy are low, meaning
change is optimal. In high states of nature, con-
tinuation is optimal. In practice, the CEO typi-
cally knows the ideal strategy before others. Be-
cause 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 sever-
ance pay. The role of severance pay is to encour-
age the CEO to reveal information that might cost
the CEO his job. When deciding between con-
tinuation and change strategies, the CEOs
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 sev-
erance 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. More-
over, 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 re-
lated. Smith and Watts57 argue that the existence
and prevalence of growth opportunities (or the
firms investment opportunity set) make it diffi-
cult for owners to know the correct value maxi-
mizing strategies. In addition, they are uncertain
Conyon 35
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 environ-
ments require greater incentives, because share-
holder-monitoring costs increase. Rather than en-
during the greater monitoring costs to determine if
the CEO has taken the right actions, shareholders
instead use equity incentives to motivate manag-
ers. 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 per-
ceived 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 op-
tions with favorable accounting treatment will be
preferred to better incentive plans with less favor-
able accounting treatment.
The final explanation for the growth in exec-
utive compensation is the managerial power hy-
pothesis. Bebchuk and Fried62 develop a model
where CEOs control the pay-setting process, sug-
gesting managerial power and rent extraction are
occurring. For example, research has indeed dem-
onstrated 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 direc-
tors serve on too many other boards, making them
too busy to be effective monitors. Finally, it is
36 Academy of Management Perspectives
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 be-
came less weak because boards increasingly added
independent directors and strengthening gover-
nance 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 re-
moved 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 rela-
tive performance evaluation. Bebchuk and Fried
argue that, since option contracts lack explicit
relative performance evaluation, executives re-
ceive 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
executives own performance. This means that, in
rising markets, the value of a CEOs options in-
creases even if firm performance is worse than the
market.
Using indexed options would be one way to
explicitly introduce relative performance evalua-
tion into the contract66 and provide incentives at
lower cost. However, the lack of indexed options
and the near ubiquity of so-called fixed price op-
tions, 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-
February
mance (or reduced-windfall options) is incom-
plete. 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 compen-
sation contracts rare, studies also find little evi-
dence of relative performance evaluation in the
estimated relationship between pay and perfor-
mance.68 However, this may not be due to man-
agerial power. For instance, more complicated
agency models suggest the value of a CEOs hu-
man 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 corre-
lated with the CEOs outside opportunities. In
addition, recent empirical evidence shows that
this hypothesis has validity.70
The managerial power theory advanced by Beb-
chuk 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 ac-
ceptance by shareholders of equity-based compen-
sation. This enabled the compensation plan de-
signers (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. Manag-
ers 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
C
ontract theory shows that pay can ameliorate
the agency problem by providing incentives
that motivate managers to optimize the long-
term value or earnings potential of the firm. How-
ever, if the CEO controls the contracting process
then, as Bebchuk and Fried have argued, compen-
sation can be part of the problem rather than the
2006 Conyon
solution. It is impossible to evaluate whether pay
outcomes are optimal without better understand-
ing 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 com-
pensate 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 ex-
plicit employment contracts. These contracts
specify the CEOs salary, bonus, and incentive
(option) package. The employment contracts typ-
ically have a fixed duration. They are not so-
called employment-at-will contracts, but are
typically 2-to-3 year renewable. The contracts usu-
ally contain information about termination proce-
dures, and provisions and non-compete and arbitra-
tion clauses. Schwab and Thomas73 show that
employment contracts generally do not contain re-
strictions on the CEOs ability to hedge stock op-
tions. In addition, the employment contract con-
tains information about perquisites (such as
company car, country club membership, pension
advice, company aircraft, and spouse travel). Gil-
lan et al. show that less than half of S&P 500
CEOs have explicit contracts; the rest have im-
plicit 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 informa-
tion asymmetries between the parties.
We showed earlier that boards and compensa-
tion 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 di-
rectly address whether perquisites represent man-
agerial 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.
37
As such, perquisites are not managerial excess, but
instead form part of the complex contracting be-
tween the CEO and the board. In contrast, Yer-
mack75 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 provi-
sion of pension and perquisite arrangements in
firms promises to be an important topic for future
research.
Compensation Committees and Executive Pay
A
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 compen-
sation 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 moni-
toring authority to a separate supervisor (e.g., a
compensation committee) who evaluates the
agent (e.g., CEO). Whether the supervisor will
work in the principals best interest, or instead
collude with the agent, is dependent on whether
the supervisors interests are more tightly related
with those of shareholders (principal) or manage-
ment (agent). The value of the three-tier agency
model is that it focuses attention on the supervi-
sors 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 in-
centives. 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
38 Academy of Management Perspectives February

other firms serving on the compensation commit-
tee 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 compo-
sition 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 incen-
tives. Anderson and Bizjak80 and Vafeas81 find no
evidence that CEO incentives are lower when
affiliated directors are on the compensation com-
mittee. 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 be-
tween 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 affilia-
tion, demographic characteristics, and other infor-
mation. Table 4 shows board and compensation
committee composition by year. The IRRC clas-
sifies 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 percent-
age of independent directors has been increasing
annually, coinciding with a decrease in the num-
ber of employees and linked affiliated directors on
the board. Boards, then, are becoming more inde-
pendent 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 in-
dependent 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 1998 1999 2000 2001 2002 2003
Director Type Employee (%) 22.3 21.9 21.8 21.3 19.7 18.4
Director Type Linked/affiliated (%) 17.4 17.3 16.6 15.7 13.9 12.8
Director Type Independent (%) 60.3 60.8 61.6 63.0 66.4 68.8
Total 17,048 17,420 16,675 16,669 13,499 13,792

Directors on the Compensation 1998 1999 2000 2001 2002 2003

Committee by Director Type
Director Type Employee (%) 1.4 1.7 1.4 1.3 0.7 0.4
Director Type Linked/affiliated (%) 12.8 12.8 11.9 11.5 9.4 7.7
Director Type Independent (%) 85.8 85.6 86.7 87.2 90.0 91.9
Total number of directors on 6,238 6,375 6,088 6,165 5,085 5,188
Compensation Committee
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.
2006 Conyon 39

are more likely to set contracts that are more
favorable to CEOs relative to shareholders. For
example, one might predict that CEO compensa-
tion would be greater and that the CEO would
receive fewer incentives when the compensation
committee contains affiliated directors. Such em-
pirical evidence would be consistent with the
managerial power perspective. To test this we
performed some simple fixed-effects pay regres-
sions. We defined an independent binary variable
equal to one if the compensation committee con-
tains any affiliated directors and zero, otherwise.
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 incen-
tives and firm size.91
Conclusions

The measure is consistent with previous re-
search.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 co-
efficient of interest (affiliated compensation com-
mittee) is negative and insignificant in both re-
gressions, indicating no effect on total CEO
compensation or incentives. The results are con-
sistent with the findings of Anderson and Bijack86
and Daily et al.,87 who also find no relation be-
tween 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 posi-
tively to dollar equity incentives. This is because
E
xecutive compensation is a controversial and
complex subject that continues to attract the
attention of the media, policymakers, and aca-
demics. Contract theory predicts that sharehold-
ers 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 opportunis-
tically. 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-

Table 5
Compensation Committee Structure and CEO Pay
Log Log
Dependent variable log(total compensation) (CEO compensation) (CEO incentives)
Affiliated compensation committee (1) 0.008 0.022
(0.031) (0.026)
Log(market value) 0.34** 0.83**
(0.029) (0.24)
Stock returns (103) 1.32** 4.77**
(0.52) (0.43)
Time effects Yes Yes
Firm fixed effects Yes Yes
Observations 7024 6994
R2 0.74 0.90
** 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).
40 Academy of Management Perspectives
pened to CEO pay between 1993 and 2003. It
shows that total compensation increased signifi-
cantly 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 in-
crease, 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 in-
centives 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 con-
tracts and appropriate pay). The analysis in this
paper illustrates that U.S. boards and compensa-
tion 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 con-
tracts to align the interests of owners with man-
agers. One test of whether the corporate gover-
nance system is working appropriately, including
executive compensation arrangements, is to eval-
uate 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 per-
formed well, both on an absolute basis and relative
to other countries over about two decades. Impor-
tantly, the economy has been robust even after
the scandals were revealed. This is not to deny
that improvements in governance arrangements
February
may be beneficial. Furnishing CEOs with appro-
priate 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.
Acknowledgements
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.
Endnotes
1
Jensen, M.& Murphy, K.J. 1990. Performance pay and top
management incentives. Journal of Political Economy, 98:
225264.
2
Bebchuk, L. & Fried, J. 2003. Executive compensation as
an agency problem. Journal of Economic Perspectives,
17(3): 7192; Bebchuk, L. & Fried, J. 2004. Pay without
performance: The unfulfilled promise of executive compen-
sation. Harvard University Press.
3
Bebchuk, L. & Fried, J. 2004. Pay without performance: The
unfulfilled promise of executive compensation. Harvard Uni-
versity 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 with-
out principals. American Economic Review, 90:203208;
Bertrand, M. & Mullainathan, S. 2001. Are CEOs re-
warded for luck? The one without principals are. Quar-
5
terly Journal of Economics, 116: 901932.
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 ineffi-
cient pay without performance? A review of Pay without
Performance: The unfulfilled promise of executive compen-
sation. Vanderbilt Law and Economics Research Paper No.
05-05; U of Penn, Inst for Law & Econ Research Paper
05-13. http://ssrn.com/abstract648648.
6
For an impressive technical account of contract and in-
centive 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 compen-
sation contracts can traced to: Mirrlees, J. 1976. Optimal
structure of incentives and authority within an organi-
zation. Bell Journal of Economics, 7: 105131; Holmstrom,
B. 1979. Moral hazard and observability. Bell Journal of
Economics, 10: 74 91; Holmstrom, B. 1982. Moral haz-
ard in teams. Bell Journal of Economics, 13: 324 40;
2006
Holmstrom, B. & Milgrom, P. 1987. Aggregation and
linearity in the provision of intertemporal incentives.
Econometrica, 55: 30328.
7
Jensen, M., Murphy, K.J., & Wruck, E. 2004.
Remuneration: where weve 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/abstract561305.
8
Core, J., Guay, W., & Larcker, D. 2003. Executive equity
compensation and incentives: a survey. FRBNY Eco-
nomic 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. http://ssrn.com/abstract
648648.
10
As in Hermalin, B. 2004. Trends in corporate gover-
nance, Journal of Finance (forthcoming).
11
Bebchuk &. Fried, 2004, supra note 2.
12
Some information on perquisites and deferred compensa-
tion is not fully disclosed (see Bebchuk & Fried, 2004).
13
Murphy, K. 1999. Executive compensation, in Ashen-
felter, 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: 151184; 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. Sup-
pose 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 12 %; 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 (Black-
Scholes) value of about $37.
17
See Lambert, R., Larcker, D., & Verrichia, R. 1991.
Portfolio considerations in valuing executive compensa-
tion. 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 ex-
ecutives. These include Hall & Murphy (2002), supra
note 16; Henderson, V. 2005. The impact of the market
portfolio on the valuation, incentives, and optimality of
Conyon 41
executive stock options. Quantitative Finance, 5: 113;
Ingersoll, J. 2002. The subjective and objective evalua-
tion of incentive stock options. Journal of Business, Yale
ICF Working Paper No. 02-07. http://ssrn.com/
abstract303940; Cai, J. & Vijh, A. 2005. Executive
stock and option valuation in a two state-variable frame-
work. 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://
ssrn.com/abstract353422. 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 pen-
sions 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. http://ssrn.com/abstract529822;
Bebchuk, L. & Jackson. 2005. Putting executive pen-
sions on the radar screen (March). Harvard Law and
Economics Discussion Paper No. 507. http://ssrn.com/
abstract694766. 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. http://ssrn.com/abstract694766.
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 exec-
utive 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 perfor-
mance but rather less linkage between pay and perfor-
mance than firms could have easily accomplished and
than investors appreciate. Also, they recognize incen-
tives 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 compen-
sation 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 Econom-
ics, 113: 653 691; Murphy, 1999; Core et al., 2004, supra
note 5.
42 Academy of Management Perspectives
28
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 deriv-
ative 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 (forth-
coming).
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 prin-
cipal-agent analyses: Incentive contracts, asset owner-
ship and job design. Journal of Law, Economics and Or-
ganization 7: 24 52.
39
See Gibbons, R. 2005. Incentives between firms (and
within). Management Science, 51: 217.
40
See Jacob, B. & S. Levitt, S. 2003. Rotten apples: An
investigation of the prevalence and predictors of teacher
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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,
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See Denis, D., Hanouna, P., & Sarin, A. 2005. Is there a
dark side to incentive compensation, Journal of Corporate
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Bebchuk A& Grinstein also review alternative explana-
tions for the growth in CEO pay albeit from the mana-
gerial power perspective. See Bebchuk, 2005, supra note
24.
45
An often-used agency model involves the principal offer-
ing the agent a linear contract (Holmstrom & Milgrom,
1987, supra note 6). The first order condition for optimal
incentives (b) is: b*P(e)/[1 r 2 c(e)], where
P(e) is the CEOs 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 execu-
tives (b/r 0), and when there is more uncontrollable
noise in firm value (b/2 0). Expected CEO com-
pensation 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
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47
This issue is further explored by Conyon, M., Core, J., &
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Murphy, K. & Zabojnik, J. 2003. Managerial capital and
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(working paper).
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Jensen, M. 1993. The modern industrial revolution, exit
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Bebchuk & Fried (2004, supra note 2) and Bebchuk &
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Rapapport, A. 1999. New thinking on how to link exec-
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Firms are now expensing options due to changes in ac-
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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 majority-
owned 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 mate-
rial in the firms 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 pro-
fessional 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.
44 Academy of Management Perspectives February

87
Daily et al., 1998, supra note 79. shares owned are negatively correlated with firm size
88
Smith & Watts, 1992, supra note 57. because the value of providing incentives for effort does
89
Baker, G. & Hall, B. 1998. CEO incentives and firm size. not increase with size as fast as the cost of risk bearing by
Journal of Labor Economics. NBER Working Paper Series, the executive. See Schaefer, S. 1998. The dependence of
No. 6868. pay-performance sensitivity on the size of the firm, Re-
90
Core, J. & Guay, W. 1999. The use of equity grants to view of Economics and Statistics, 80: 436 443.
92
manage optimal equity incentives. Journal of Accounting Holmstrom, B. & Kaplan, S. 2003. The state of S&P 500
and Economics, 28: 151184. corporate governance: Whats right and whats wrong?
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See Core et al., 2003, supra note 8. In contrast, Schaefer European Corporate Governance Institute Finance
argues that incentives measured as a fraction of common Working Paper No. 23/2003.