Pay-performance Sensitivity Research Articles

Why Do Firms Use Compensation Peer Benchmarking?

We develop a cost-benefit tradeoff model to explain corporate boards’ decision whether to use compensation peer benchmarking. Peer benchmarking helps a board retain a talented but risk-averse CEO, but it weakens CEO incentives to exert effort. Consistent with high retention needs, benchmarking firms have more peer citations, operate in general business domains with more similar firms, and their CEOs are at the most marketable age. Benchmarking firms also tend to be younger and have more volatile stock returns and earnings and higher leverage, where CEO performance is riskier. Consistent with high incentive costs, CEO pay-performance sensitivities are lower and CEO pay growth is higher at benchmarking firms. To mitigate such costs, benchmarking firms award their CEOs more equity annually and are more likely to dismiss them for poor performance. When retention needs are low, peer benchmarking is associated with lower firm value. Retention needs can also explain peer selection decisions.

On the relation between managerial power and CEO pay

We study how friendly boards design the structure of optimal compensation contracts in favor of powerful CEOs. Our study yields unexpected results. First, powerful managers receive higher pay and a contract with a higher pay-performance sensitivity (PPS) if firm performance is low and vice versa. Moreover, we identify conditions where expected pay and expected PPS are both increasing in the friendliness of the board. Second, we show that friendly boards provide managers with higher salaries, more shares, but less options. Third, friendly boards offering contracts with a higher PPS also make more intensive use of relative performance evaluation (RPE). Overall, our results suggest that frequently used indicators of poor (or sound) compensation practices should be interpreted with care. Extending the scope of our model beyond executive pay, we show that powerful managers underinvest in capital but have less incentives to manage earnings.

Venture Capital Contracting with Ambiguity Sharing and Effort Complementarity Effect

In this paper, we established a continuous-time agency model in which an ambiguity-averse venture capitalist (VC) employs an ambiguity-neutral entrepreneur (EN) to manage an innovative project. We analyzed the connection between ambiguity sharing and incentives under double moral hazard. Applying a stochastic dynamic programming approach, we solved the VC’s maximization problem and obtained the Hamilton–Jacobi–Bellman (HJB) equation under a special form of the value function. We showed that the optimal pay-performance sensitivity was a fixed point of a nonlinear equation. The model ambiguity on the probability measure induced a tradeoff between ambiguity sharing and the incentive compensation that improved the EN’s pay-performance sensitivity level. Besides, we simulated the model and showed that when two efforts were complementary, the VC’s effort did not monotonically decrease with respect to the pay-performance sensitivity, while the EN’s effort did not monotonically increase in the pay-performance sensitivity level. More importantly, we found that as efforts tended to be more complementary, the optimal pay-performance sensitivity tended to approach those that maximized the efforts exerted by the EN and the VC.

The effects of accounting conservatism on executive compensation

PurposeThe purpose of this paper is to identify means of better associating executive remuneration with managerial decision making and firm performance.Design/methodology/approachThe authors evaluate the influence of conditional accounting conservatism on CEO compensation. The authors focus particularly on the ex ante pay-for-performance sensitivity (PPS) of CEO stock option grants. The empirical method used is panel data regression.FindingsThe authors find that accounting conservatism is positively related to the PPS of CEO option-based compensation. The effects of accounting conservatism on the PPS of options are more significant for firms with relatively weaker corporate governance and for the period before the introduction of FAS 123R. The findings suggest that directors reward CEOs for adopting accounting conservatism, both in general terms and incrementally, and that rewards are channelled through incentive-linked compensation. The results are also consistent with the view that accounting conservatism compliments other mechanisms, such as corporate governance, in reducing information asymmetry and agency problems between managers and shareholders and other stakeholders.Originality/valueThis paper provides a number of important contributions to the literature. It is the first to identify a relationship between accounting conservatism and option-based CEO compensation, which has important potential contracting and enforcement implications due to the incomplete nature of option contracts and the reward and risk attributes of CEOs. This paper is also the first to analyse the association between conditional accounting conservatism and CEO compensation at the firm–year level, by employing the firm–year conservatism score approach proposed by Khan and Watts (2009). This provides for greater insight regarding the interaction between accounting conservatism and other firm-specific elements than is otherwise obtainable from an overall firm or year interpretations derived from the traditional Basu (1997) asymmetric timeliness model approach. Furthermore, this paper also provides a comparison of the relative association of accounting conservatism on both explicit and implicit forms of CEO compensation for the same firm sample. This allows for the assessment of whether accounting conservatism relates differently to incentive-based CEO remuneration relative to ex post CEO compensation outcomes.

Corporate awards and executive compensation: empirical evidence from Chinese A-Share listed companies

ABSTRACT From the perspective of non-financial performance, this study investigates the effect of corporate awards on executive compensation. We find that as a measure of non-financial performance, corporate awards help increase executive compensation by demonstrating the company’s status in the industry through the efforts of executives. In addition, corporate awards play an important role in supplementing the financial performance of a firm to improve executives’ pay-performance sensitivity. Our empirical evidence also reveals that corporate awards are included as a subjective indicator to evaluate the non-financial performance of state-owned enterprises (SOEs) in China: the increase in compensation and the stickiness of this compensation for financial performance based on corporate awards in SOEs are both stronger than in non-SOEs. Moreover, when managers cannot fully obtain other forms of incentives (such as perk consumption or equity incentives), the effect of corporate awards on managers’ monetary remuneration is more significant.

Effects of Compensation Contracts Disclosure on Executive Behavior

This study investigates how the disclosure of management compensation contracts affects executive behavior by modeling a situation in which both the principal-agent relationship and market interactions are important. We find that making the disclosure of these contracts mandatory creates proprietary costs for the firm. Additionally, we also analyze the effect of market competition and find that a manager works less in a more competitive environment when compensation contracts are undisclosed, whereas when disclosed, managers could either work harder or less diligently. Our work provides some interesting implications for empirical research. For example, we show that mandatory disclosure of compensation contracts increases both pay-performance sensitivity and managers’ total compensation.

Impact of Internal Governance on a CEO’s Investment Cycle

This paper examines the impact of internal governance on a CEO’s investment cycle. Extant literature defines internal governance as the mechanism by which senior executives help discipline the CEO to maximize shareholder value. Weisbach (1995) finds that a year or two before the CEO retires, the firm experiences a decrease in total investment. Pan, Wang and Weisbach (2016) find evidence of a CEO’s investment cycle, in which investment increases over a CEO’s tenure, whereas disinvestment decreases. These papers suggest that older CEOs incur agency costs as they try to extract rents as their investment horizon declines. We confirm their results, and additionally find that good internal governance helps reduce older CEOs under-investing before their exit. For younger CEOs we do not find any relationship between internal governance and investment. This suggests that older CEOs who face good internal governance under-invest less. We also find that new incoming CEOs divest these projects profitably. These results are robust to: normal CEO retirements (exclude performance-related turnover), sudden CEO deaths, and controlling for measures of board size, proportion of outsiders on the board, CEO’s pay-performance sensitivity, CEO pay slice, CEO power, firm complexity and if the CEO was an outsider or not.

What Matters More in Board Independence? Form or Substance?

Prior studies show uncertain associations between board independence and firm performance. We propose a novel measure of board independence and argue that influential CEO-directors (ICDs), those with higher compensation than the appointing firm’s CEO, are more independent of appointing firm’s top management. Controlling for conventional measures of board independence, we show that ICDs are effective monitors who help appointing firms by improving CEO pay-performance sensitivities. Through improved managerial incentives, ICDs have a significantly positive impact on long-term firm performance. In contrast, uninfluential CEO-directors are ineffective monitors whom presence on the board is either inconsequential or even detrimental to the firm.

Optimal Information Design and Incentive Contracts with Performance Measure Manipulation

We study how a firm owner motivates a manager to create value by optimally designing an information system and a compensation contract based on a manipulable performance measure. In equilibrium, the firm either implements a perfect or an uninformative system. The information system and the pay-performance sensitivity (PPS) of the compensation contract can be substitutes in a sense that the firm optimally combines a perfect information system with a low PPS or an uninformative system with a high PPS. Because the information design is endogenous, firms facing relatively high manipulation threat may offer financial incentives that are higher-powered than the ones offered by their peers facing lower manipulation threat. If the manager is in charge of implementing the information system, he chooses a perfect one unless the firm uses the information for internal control. The firm may prefer to commit to an internal control level before observing any information.

Does Independent Advice to the Board Affect CEO Compensation?

AbstractThis article investigates the role external advice plays in the board’s determination of chief executive officer (CEO) compensation. We show that CEO incentive pay increases with the degree of compensation consultant independence using a quasi-natural experiment provided by the creation of an independent consultant after separation from an affiliated consultant. Specifically, switching to an independent consultant significantly increases the pay–performance sensitivity and relative performance evaluation of CEO contracts. Despite the benefits of independent advice, independent consultants may not be hired due to the influence of powerful CEOs or because boards already possess adequate expertise.

The Value of Precontract Information About an Agent's Ability in the Presence of Moral Hazard and Adverse Selection

ABSTRACTWe analyze the expected value of information about an agent's type in the presence of moral hazard and adverse selection. Information about the agent's type enables the principal to sort/screen agents of different types. The value of the information decreases in the variability of output and the agent's risk aversion, two factors that are typically associated with the severity of the moral hazard problem. However, the value of the information about agent type first increases but ultimately decreases in the severity of adverse selection. The decrease comes about because the means available to the principal to induce effort—namely, the pay–performance sensitivity—must also be used to sort/screen agents, and these two goals conflict. This decline in value occurs despite the monotonically increasing importance of the information in determining the principal's expected profits. Further, we show that the peak value of information occurs at a predictable level of adverse selection. These results imply that over some range, the importance of the information will be increasing, and the value of the information will be simultaneously decreasing, in the severity of adverse selection.

Rational Apathy: The Curse of Shareholder Empowerment in Uncontested Board Elections

In contrast to popular belief, this paper shows that there does not exist an unambiguous positive relationship between an unbiased shareholder’s voting power and the quality of corporate governance. I utilize a 2010 NYSE policy change that increased shareholders’ voting power in uncontested board elections, and, to establish the causality, I take advantage of the exogenous election cycles for director elections. I find that an increase in individual shareholder’s voting power will worsen some measures of corporate governance (CEO’s pay-performance sensitivity and probability of removing poison pills). I show that this is due to shareholders’ decreased participation in both the sponsorship of governance proposals and active voting in annual meetings. I argue that the negative relationship between shareholders’ voting power and their participation is due to a free-rider problem in the collective action.

Non-CEO top managers’ monitoring power and CEO pay-performance sensitivity in state-owned enterprises: Evidence from Chinese state-owned listed firms

Few studies have focused on the role of non-CEO top manager inside directors in corporate governance, especially in the context of emerging countries. Despite their tendency to be subject to CEOs, non-CEO top manager inside directors can counterbalance CEOs in specific situations. Using panel data on state-owned listed companies in China, we conduct an empirical study of how non-CEO top manager inside directors influence CEO pay-performance sensitivity under serious agency conflicts. We find that the proportion of non-CEO top manager inside directors is significantly negatively correlated with CEO pay-performance sensitivity in state-owned enterprises, whereas the shareholding proportion of the controlling shareholders weakens this relationship. Furthermore, we find that non-CEO top manager inside directors significantly increase executives’ on-the-job consumption. Our conclusions are robust to endogeneity testing and alternative specifications.

Compensation consultants’ reputation, non-compensation consulting services and CEO pay

ABSTRACTIn this study, we draw on the reputation and product quality literature to examine whether compensation consultants with higher reputation have incentives to provide higher-quality services in terms of CEO pay level and pay performance sensitivity (PPS). Using 1,827 US firm-year observations for 2009 and 2010, we find that consulting firms with a higher reputation, proxied by consultant size, are associated with lower compensation and higher PPS. We also find that the PPS for consultants that also provide non-compensation-related services (NCS) is significantly positive for consultants with a higher reputation, consistent with the reputation protection explanation, and significantly negative for the other consultants with a lower reputation consistent with the conflict of interest argument.

The Value of Pre-contract Information about an Agent's Ability in the Presence of Moral Hazard and Adverse Selection

We analyze the expected value of information about an agent's type in the presence of moral hazard and adverse selection. Information about the agent's type enables the principal to sort/screen agents of different types. The value of the information decreases in the variability of output and the agent's risk aversion, two factors that are typically associated with the severity of the moral hazard problem. However, the value of the information about agent type first increases but ultimately decreases in the severity of adverse selection. The decrease comes about because the means available to the principal to induce effort — namely, the pay-performance sensitivity — must also be used to sort/screen agents, and these two goals conflict. This decline in value occurs despite the monotonically increasing importance of the information in determining the principal's expected profits. Further, we show that the peak value of information occurs at a predictable level of adverse selection. These results imply that over some range, the importance of the information will be increasing, while the value of the information will be simultaneously decreasing, in the severity of adverse selection.

Does Independent Advice to the Board Affect CEO Compensation?

This paper investigates the role external advice plays in the board’s determination of CEO compensation. Specifically, I examine whether the Pay-Performance Sensitivity and the Relative Performance Evaluation component of a CEO’s contract increase with the degree of compensation consultant independence. I use a unique sample of Canadian firms which allows me to directly measure the impact of non-compensation related consulting fees on compensation advice. For identification, I exploit a 'quasi-natural experiment' provided by the creation of an independent consultant as a spin-off from an affiliated consultant. Switching to an independent consultant is associated with relative increases of 22% in Pay-Performance Sensitivity and 28% in Relative Performance Evaluation of CEO contracts. Despite the benefits of independent advice, independent consultants may not be hired due to higher fees, the influence of powerful CEOs, or because boards already possess adequate expertise.

The effect of financial reporting quality on CEO compensation structure: Evidence from accounting comparability

This study examines the effect of accounting comparability on the design of CEO compensation structure. After controlling for firm-specific attributes, we find that accounting comparability is positively associated with CEO equity-based compensation intensity and pay-performance sensitivity. This suggests that the improved comparability increases the usefulness of equity-based compensation and a firm is willing to offer more equity-based compensation contracts to CEOs and increase their pay-performance sensitivity. Further, we find that the impact of comparability on the CEO’s compensation contract increases with information asymmetry, which is consistent with the notion that accounting comparability is a quality of financial reporting that facilitates the use of equity-based compensation in a poor information environment. Our analysis also reveals that the effect of accounting comparability on CEO compensation structure is greater when a firm’s corporate governance is strong, consistent with the complementary relation between comparability and the exiting corporate governance in determining CEO compensation schemes. Overall, our evidence suggests that firms utilize more equity-based compensation as a proportion of total compensation under greater accounting comparability and enhance the alignment between equity-based compensation and firm performance.

Effect of Employees’ Pay-performance Sensitivity on Future Firm Performance: Evidence from State-owned Listed Enterprises in China over 2007-2015

Taking a balanced panel data consisting of 4365 firm-year observations drawn from the listed state-owned enterprises in Shanghai and Shenzhen Stock Exchange over 2007-2015 as the research sample, the paper examines the effect of the employees’ pay-performance sensitivity (PPS) on the future firm performance from the two competing perspectives of “incentive effect” and “risk-aversion effect”, adopting the method of multiple regression analysis based on OLS and applying the SPSS23 as the data processing tool. Theoretical analysis and empirical results demonstrate that there is a positive link between the employees’ PPS and the future firm performance. To improve the employees’ PPS can stimulate the engagement of the employees, improve their working quality, enrich their workplace innovative behavior, and further lead to higher future firm performance. Meanwhile, the positive effect of the employees’ PPS on the future firm performance is, on average, lower than that of the top executives’ PPS on the future firm performance. Implications of the findings are provided in the end.

Idiosyncratic risk, managerial discretion and capital structure

This paper develops an integrated dynamic model to examine the impact of managerial compensation packages, namely, cash salary and ownership stake, and reservation income on the credit spreads and capital structure choice of a risk-averse manager who faces incomplete markets and costly effort. Our model predicts an inverted U-shaped relationship between credit spreads (market leverage) and managerial ownership stake, which reconciles empirical findings that are inconsistent with previous theories. Moreover, in contrast to the predictions of previous models, we find that credit spreads decrease with the manager's cash salary, whereas they increase with the manager's reservation income. Finally, we also demonstrate that the relationship between pay-performance sensitivity (PPS) and the firm's market leverage is dependent on the manager's ownership stake and cash salary; this prediction provides novel empirical tests.

Does executive directors from controlling shareholders improve corporate governance?

PurposeThe existence of controlling shareholders creates a remarkable difference between the corporate governance structures of Chinese firms and those of western firms. Despite the increasing importance of controlling shareholders, it remains disputable whether they are playing the “tunneling” roles or the “governance” roles. Therefore, more research is needed on what roles controlling shareholders are playing and how they play their roles. Previous empirical studies document a common phenomenon that directors play dual roles both on the board and in the top management team. Because of information asymmetry, the board of directors may not be able to perform its supervisory and strategic decision-making functions. Therefore, this paper aims to investigate whether controlling shareholders participate in firm management by appointing the executive directors and examine the economic consequences of controlling shareholder involvement.Design/methodology/approachIn the empirical tests, the authors use the split share structure reform in China as a natural experiment. Using the data from Chinese listed firms between 2001 and 2015 and difference-in-differences analysis, the authors examine the impact of the split share structure reform on the executive directors of controlling shareholders and the governance effect of controlling shareholders’ appointing executive directors to the management.FindingsThe authors find that controlling shareholders get involved in firm management by appointing executive directors to strengthen the supervision and incentives of managers. The authors also find that firms exhibit a lower level of earnings management and enhance and higher pay-performance sensitivity after controlling shareholders appoint executive directors to the top management team.Originality/valueAs the natural experiment of the split share structure reform enables us to mitigate endogeneity, the authors investigate the channels through, which controlling shareholders get involved in firm management from the unique perspective of executive director appointment. The study expands the literature on corporate governance and board functions. The findings provide new insights to the effect of controlling shareholder governance and casts light on a new way for controlling shareholders of Chinese firms to participate in firm management – by appointing executive directors.