Performance pay sensitivity: Do top management incentives align with shareholder value creation?

Abstract

Arising from the principal-agent consideration, Jensen and Murphy (1990b) studied the pay-performance sensitivity (including pay, options, stockholdings, and dismissal) for chief executive officers (CEOs) in the 1980s. They found that CEO wealth changes $3.25 for every $1,000 change in shareholder wealth. In this study, we revisit the issue of the linkage between CEO pay and performance but with the difference that we only include observable measures in the pay-performance sensitivity estimate. Our data on executive compensation stems from the ExecuComp database on S&P 1500 firms, and the performance data from the Center for Research in Security Prices (CRSP) database (total: 23,737 firm-year observations). We find that CEO wealth changes $5.34 for every $1,000 change in shareholder wealth. Almost all of this sensitivity is attributed to compensation through stock options and the CEO’s inside stockholdings. Today, the incentives generated by stock options have increased thirteen times, and the total pay-performance sensitivity has almost doubled in value, compared to when Jensen and Murphy (1990b) estimated the pay-performance sensitivity in the 1980s for the first time. Despite the increased pay performance sensitivity, we hypothesize that internal and external political forces negatively affect the CEO’s performance incentives. Compensation constraints reduce the pay performance sensitivity and hereby the incentives for the CEO to maximize shareholder wealth. Further research on how CEO wealth varies with absolute and relative corporate performance is required to determine if the CEO’s incentives are consistent with shareholder wealth maximization.