CEO Compensation and Relative Company Performance Evaluation

Abstract

This study examines how firm performance influences CEO pay in U.K. public listed companies. Specifically, it explores evidence of relative performance evaluation, following the recommendation in the U.K. Combined Code on Corporate Governance to link executive pay to relative firm performance. Using a panel of CEOs drawn from 204 of the largest, nonfinancial U.K. companies, between 2003 and 2007, we provide new and convincing evidence that shows basic pay and annual bonus is determined relative to annual FTSE 350 market performance and long-term incentive payouts are determined relative to 3-year FTSE 350 industry sector performance. Our results provide robust evidence that is consistent with the principal-agent framework of executive pay and firm performance. We demonstrate that it is crucial for research to distinguish between the different elements of pay and the different performance conditions that attach to those elements in order to establish a comprehensive understanding of the pay-for-performance relationship. The study provides confirmation that remuneration committees consider own firm performance relative to peer group performance in setting up CEO compensation contracts. We conclude that changes introduced to improve corporate governance practice in the field of executive pay are working to the benefit of shareholders.