The Ratchet Effect of Transparency in Executive Compensation

Abstract

How does the mandated disclosure of executive compensation affect the dynamics of compensation within a peer group of firms? We argue in this paper that, under plausible conditions, it will trigger a ratchet effect in the mean level of executive pay within the peer group and is accompanied, hand in hand, by a compression effect in the distribution of executive pay. Specifically, the mean executive pay rises while the variance slumps, in successive increments that taper off over time. These effects occur when participants – i.e., managers and firms – have rational expectations and develop forecasts for the distribution of executive pay within the peer group that take into account the wage setting process at each individual firm. When participants ignore such process and develop forecasts that naively extrapolate from disclosed compensation data, the ratchet and compression effects continue to occur and become more powerful and long lasting.