How Important Are Dismissals in CEO Incentives?: Evidence From a Dynamic Agency Model

Abstract

I estimate a dynamic agency model to quantify the importance of dismissals in CEO incentives -vis-a-vis pecuniary compensation. The model features endogenous dynamics in deferred and flow compensation, as well as exogenous departures, and endogenous dismissals after poor firm performance. Thus, the model functions as a classification device for CEO turnover events that exploits information from all the departures in the data. I estimate the model via the Simulated Method of Moments, using data for CEOs in U.S. public firms appointed from 1993 to 2013. The estimated CEO dismissal rate is 1.2 percent, and the CEO replacement cost represents 3.4 percent of firm assets, 64 million in 2015 U.S. dollars for the median firm. Poor governance, proxied by director independence, increases the replacement costs for big firms. The relationship reverses in small firms, so board independence must also capture better hiring policies or career concerns of directors. The results confirm that CEO dismissals are infrequent. However, changes in the cost of replacements that generate small increases in the underlying dismissal rate lead to substantial reductions in the size of incentive compensation.