Promotion Incentives, CEO Appointments and Firm Performance

Abstract

Executive remuneration is often criticised as being excessive and not clearly linked to firm performance. This study further examines the link between pay and performance by examining the impact of promotion-based tournament incentives. Our hypotheses draw on tournament theory of labour economics which argues that the ‘gap’ between the remuneration of CEO and other senior executives creates a tournament-style competition for promotion amongst ambitious senior executives. The efforts of these highly motivated executives have a positive influence on overall firm performance. Whilst tournament theory is well studied in the US and UK (Conyon et al. 2001; Kale et al. 2009; Gong et al. 2011), Australian evidence is sparse. Our empirical analysis therefore seeks to better understand the determinants of tournament incentives, particularly surrounding the appointment of a new CEO. Further, we test whether firm performance is influenced by the magnitude of tournament incentives. Our results suggest that tournament incentives play a significant role in enhancing firm performance, but that this positive impact is somewhat reduced after a change in CEO. We also find that closer alignment of CEO pay (through equity compensation) is positively associated with firm performance. In regards to the determinants of tournament incentives we find that tournament incentives are lowest after a change in CEO. This study therefore contributes to the topical debate on executive compensation by providing evidence on the effectiveness of tournament incentives and their relationship to firm performance in the Australian environment. It is one of the first to examine whether tournament incentives play any role in the pay-for-performance relationship in Australia and findings are likely to be of interest to researchers, policy makers, corporations and their shareholders, given the increased current focus on executive compensation and the lack of clear alignment with firm performance.