Optimal CEO Compensation Research Articles

Search for Optimal CEO Compensation: Theory and Empirical Evidence

Much of the agency literature focuses on effort-inducing while little attention is paid to the participation constraint. Intuitively, it is important to jointly address both for CEOs. This paper achieves this by developing a dynamic search equilibrium model that allows for quitting if a CEO is not satisfied with the incentive contract. The reservation utility is endogenized in equilibrium since the value of the CEO’s outside option depends on other firms’ contracts. As a result, the equilibrium incentive contract exhibits some new and important features that can explain two long-standing puzzles related to the executive compensation practice. First, the equilibrium pay-to-performance sensitivity negatively depends on the expected aggregate state and a firm’s systematic risk, and positively on the firm’s specific risk. The separate effects of firms’ systematic and specific risks enable us to reconcile the mixed evidence on the relationship between pay-to-performance sensitivity and a firm’s risk. Second, the equilibrium salary and total pay depend on the firm’s size, which, in turn, increases with the expected aggregate state. This result provides a plausible explanation to the steadily increased compensation paid to executives in the past three decades. These theoretical predictions are broadly supported by our empirical results. Hence, we conclude that the participation constraint is an important determinant for the executive compensation policy.

Executive options with inflated equity prices

Purpose – The purpose of this paper is to solve the optimal managerial compensation problem when shareholders are either naïvely optimistic or rational. Design/methodology/approach – The paper uses applied game theory to derive the optimal CEO compensation package with over optimistic shareholders. Findings – The results suggest that boards of directors should decrease option grants to CEOs when equity is likely to be irrationally overvalued at the date when the CEO's options vest. Research limitations/implications – The implications of the model are consistent with the available empirical evidence. In addition, the model generates new testable predictions about managerial stock price manipulation, the number of options granted, and the magnitude of the options’ strike prices that have not yet been formally tested. Originality/value – This is the only paper to derive closed-form solutions to optimal CEO compensation when shareholders are naïvely optimistic.

Optimal CEO Compensation with Search: Theory and Empirical Evidence

ABSTRACTWe integrate an agency problem into search theory to study executive compensation in a market equilibrium. A CEO can choose to stay or quit and search after privately observing an idiosyncratic shock to the firm. The market equilibrium endogenizes CEOs’ and firms’ outside options and captures contracting externalities. We show that the optimal pay‐to‐performance ratio is less than one even when the CEO is risk neutral. Moreover, the equilibrium pay‐to‐performance sensitivity depends positively on a firm's idiosyncratic risk and negatively on the systematic risk. Our empirical tests using executive compensation data confirm these results.

Sticks or Carrots? Optimal CEO Compensation when Managers Are Loss Averse

ABSTRACTThis paper analyzes optimal executive compensation contracts when managers are loss averse. We calibrate a stylized principal‐agent model to the observed contracts of 595 CEOs and show that this model can explain observed option holdings and high base salaries remarkably well for a range of parameterizations. We also derive and calibrate the general shape of the optimal contract that is increasing and convex for medium and high outcomes and that drops discontinuously to the lowest possible payout for low outcomes. Finally, we identify the critical features of the loss‐aversion model that render optimal contracts convex.

CEO Replacement Under Private Information

This article examines the optimal CEO compensation and replacement policy when the CEO is privately informed about the firm’s continuation value under his leadership. Ex ante moral hazard implies that the CEO must receive ex post quasi rents, which endogenously biases him toward continuation. Our model shows that to induce “bad” CEOs to quit, it may be best to make continuation costly (through steep incentive pay) rather than simply rewarding quitting (through severance pay). Incentive pay makes continuation attractive for “good” CEOs, who can expect high future on-the-job pay, but unattractive for “bad” CEOs, who may instead prefer to take their outside option payoff. Our model generates novel empirical implications that jointly relate CEO compensation and turnover to corporate governance, firm size, cash-flow risk, and the informativeness of performance measurement. (JEL G34)

Optimal CEO Compensation with Search: Theory and Empirical Evidence

We integrate an agency problem into search theory to study executive compensation in a market equilibrium. A CEO can choose to stay or quit and search after privately observing an idiosyncratic shock to the firm. The market equilibrium endogenizes CEOs’ and firms’ outside options and captures contracting externalities. We show that the optimal pay-to-performance ratio is less than one even when the CEO is risk neutral. Moreover, the equilibrium pay-toperformance sensitivity depends positively on a firm’s idiosyncratic risk, and negatively on the systematic risk. Our empirical tests using executive compensation data confirm these results.

Search for Optimal CEO Compensation: Theory and Empirical Evidence

Search for Optimal CEO Compensation: Theory and Empirical Evidence

On the Design of CEO Compensation Contracts

The empirical literature testing hypotheses on the casual relation between the CEO compensation policies and other factors mainly relies on the predictions by the classical principal-agent theory, which are mostly descriptive and vague. In this paper we develop a theory of optimal CEO compensation design in continuous-time that incorporates several important factors of practical relevance into analysis. Our model is tractable and has a closed-form nonlinear solution. It provides a uni ed framework that links the CEO compensation schemes to three dimensions that are perceived to be mostly relevant in practice: 1) the rm's accounting return; 2) the rm's stock return and 3) relative performance measures such as market indexes. We show that the design of the optimal CEO compensation can be decomposed into two steps. First, an aggregate performance index (API), which is a certain linear combination of the three signals, is constructed. Second, the optimal compensation is shown to be a nonlinear function of the API. Testable implications are derived and their relevance to empirical literature is discussed in details.

Optimal CEO Compensation: Some Equivalence Results

I study optimal managerial contracts in two contracting environments. When the investment return is contractible, an optimal contract combines a base salary, golden parachute, and bonus. When the return is not contractible, two types of optimal contracts are studied: a contract with restricted stock and a contract with stock options. These three types of contracts are equivalent: they implement the same outcome and lead to the same expected payoff for the manager, implying that the choice of contractual form is irrelevant in the environment I study. I suggest directions of research for the relevance of different contractual forms.

Price versus Non-Price Performance Measures in Optimal CEO Compensation Contracts

We empirically examine standard agency predictions about how performance measures are optimally weighted to provide CEO incentives. Consistent with prior empirical research, we document that the relative weight on price and non-price performance measures in CEO cash pay is a decreasing function of the relative variances. Agency theory speaks to the weights in total compensation (annual total pay and changes in the CEO's equity portfolio value), however, and we document that very little of CEOs' total incentives come from cash pay. We also document that variation in the relative weight on price and non-price performance measures in CEO total compensation is an increasing function of the relative variances. The conflicting results using total compensation indicate that existing findings on cash pay cannot be interpreted as evidence supporting standard agency predictions. Based on our results, we suggest approaches for future research on performance measure use in CEO total compensation.

Price vs. Non-Price Performance Measures in Optimal CEO Compensation Contracts

We empirically examine standard agency predictions about how performance measures are optimally weighted to provide CEO incentives. Consistent with prior empirical research, we document that the relative weight on price and non-price performance measures in CEO cash pay is a decreasing function of the relative variances. Agency theory speaks to the weights in total compensation (annual total pay and changes in the CEO's equity portfolio value), however, and we document that very little of CEOs' total incentives comes from cash pay. We also document that variation in the relative weight on price and non-price performance measures in CEO total compensation is an increasing function of the relative variances. The conflicting results using total compensation indicate that existing findings on cash pay cannot be interpreted as evidence supporting standard agency predictions. Based on our results, we suggest approaches for future research on performance measure use in CEO total compensation.

Palace Coup, Inside Rival, Investment, and the Optimal CEO Compensation Scheme

In this paper, I claim that threat of palace coup by an inside rival can be used as an effective disciplinary method on the Chief Executive Officer. I set up the moral hazard model with hidden information with respect to the idiosyncratic intrinsic risk associated with the CEO?s investment choice. Then, I analyze the relationship among the investment choice, the role of palace coup, the rent-seeking by the CEO, the optimal CEO compensation scheme, and the changing direction of reservation wage for the CEO position and the second position. I find that, under information asymmetry about the intrinsic risk of the investment between the board of directors and the CEO, the optimal compensation scheme is to retain a fixed risk-free compensation and a fixed risk-sharing compensation, rather than adjusting them according to the investment variation. With that consistent fixed wage policy, in equilibrium, a reckless investment can be deterred. By widening the gap in the reservation wage between CEO position and second position, board of directors gives a greater incentive to the inside rivals to launch a palace coup. Then, the board of directors can effectively prevent the CEO from rent-seeking with a reckless investment and from bribing rents to the inside rival within the management team. These results well explain the current phenomena of the soaring CEO compensation and the widening gap of the compensation between the CEO and the second man, which are explained by the extant theory with limit.