Use Of Relative Performance Evaluation Research Articles

Do Growth-Option Firms Use Less Relative Performance Evaluation?

ABSTRACTThe use of relative performance evaluation (RPE) in compensation contracts for CEOs at growth-option (GO) firms that operate in more volatile environments can provide insurance against common exogenous shocks and thus reduce the amount of risk that CEOs face. However, the implementation of RPE for high-GO firms can be impaired by these firms' inability to find a peer group that captures common risk exposure. This paper studies GO firms' reliance on RPE and finds that the use of RPE in CEO compensation contracts varies negatively with a firm's level of growth options. The tests use three proxies for growth options: the market-to-book value of assets, research and development expenses scaled by assets, and a factor obtained from a principal component analysis. The results are robust to controlling for the impact of other firm characteristics on pay-for-performance sensitivities.Data Availability: All data are obtained from publicly available sources.

Performance effects of setting targets and pay–performance relations before or after operations

This study investigates both theoretically and experimentally whether and how ex post use of relative performance evaluation (RPE) information in determining performance target levels and profit sharing ratio (PSR) levels affects employer profit performance. Our findings show that employers use RPE information, i.e. peer performance, to adjust performance target levels and PSR levels to reflect economic conditions. More importantly, we find that ex post use of RPE information, i.e. peer performance, improves profit performance. However, ex post adjustment of target levels and PSR levels based on peer performance have different performance implications. Specifically, we find that ex post target contracts improve employer residual profit over ex ante target contracts, while ex post PSR contracts do not improve employer residual profit over ex ante PSR contracts. Our supplemental analyses suggest that this difference is likely because employees are more sensitive to prior period compensation determined by ex post PSRs than ex post targets. Compared to ex post targets that are likely perceived to be fair based on peer performance, ex post PSRs based on the peer performance can be used opportunistically by employers and/or are perceived so by employees, which leads to future repercussions manifested in lower employee effort and employer residual profit.

Competition and Corporate Fraud Waves

Our paper examines the effect of product market competition on firms’ incentives to misreport financial information to investors. We examine three specific channels through which product market competition can affect the information environment in an industry and individual firms’ incentives to misreport information. We show that the lack of product market sensitivity to individual firm information tends to encourage fraud commission. The use of relative performance evaluation (i.e., industry benchmarking) in managerial retention decisions also encourages fraud. The lack of information collection about individual firms tends to decrease the probability of fraud detection and increase the probability of fraud commission. All three channels are more likely to be present in more competitive industries, implying that fraud propensity is on average higher in those industries. We show that fraud can help explain the predictable busts in competitive industries. Post-boom poor performance in competitive industries is largely concentrated in firms that are likely to have committed fraud during the booms. The underlying reason is twofold. First, fraud propensity is more cyclical in more competitive industries. Second, the consequence of fraud in competitive industries is particularly bad following booms. Our results suggest that the dynamic of fraud can amplify the cyclical fluctuations in the real economy, particularly in competitive industries.

SFAS 123R and the CEO Contracting Use of Relative Performance Evaluation

This paper examines how changes in CEO risk-taking incentives are associated with changes in the use of relative performance evaluation (RPE) in CEO contracts. Using a shock to the accounting for executive stock options (SFAS 123R), I confirm that risk-taking incentives and option grants declined following SFAS 123R using a within-firm design, but not a within-CEO-firm-design. Decreased risk-taking incentives lead executives to invest in projects with lower systematic risk and can result in reduced incentives to hedge exposure to systematic risk in CEO compensation contracts via RPE. However, CEO relative risk-aversion increases with decreases in risk-taking incentives, potentially increasing incentives to protect CEO wealth from systematic performance via RPE. Testing these competing predictions, I find modest evidence consistent with reduced RPE surrounding SFAS 123R, suggesting that when CEO risk-taking incentives are reduced, so are incentives to shield CEO pay from systematic performance.

Endogenous Social Comparisons and the Internal Organization of Firms

Should workers of a firm be organizationally integrated to realize benefits from benchmarking? Or should they be separated to preclude horizontal social comparisons? This paper highlights a trade-off that arises if social comparisons in firms are endogenous. We analyze a principal multi-agent model in which the principal trades off the reduction of agents' risk exposures by use of relative performance evaluation and the thereby induced social comparisons for which agents must be compensated. Contrary to standard theoretical predictions, relative performance evaluation is optimal only if the performance measures are sufficiently correlated relative to the agents' regard for others.

Endogenous Social Comparisons and the Internal Organization of Firms

Should workers of a firm be organizationally integrated to realize benefits from benchmarking? Or should they be separated to preclude horizontal social comparisons? This paper highlights a trade‐off that arises if social comparisons in firms are endogenous. We analyze a principal multi‐agent model in which the principal trades off the reduction of agents' risk exposures by use of relative performance evaluation and the thereby induced social comparisons for which agents must be compensated. Contrary to standard theoretical predictions, relative performance evaluation is optimal only if the performance measures are sufficiently correlated relative to the agents' regard for others. Copyright © 2011 John Wiley & Sons, Ltd.

Do Growth-Option Firms Use Less Relative Performance Evaluation?

The use of relative performance evaluation (RPE) in compensation contracts for CEOs at growth-option (GO) firms that operate in more volatile environments can provide insurance against common exogenous shocks and thus reduce the amount of risk that CEOs face. However, the implementation of RPE for high GO firms can be impaired by these firms’ inability to find a peer group that captures common risk exposure. This paper studies GO firms’ reliance on RPE and finds that the use of RPE in CEO compensation contracts varies negatively with a firm’s level of growth options. The tests use three proxies for growth options: the market-to-book value of assets, research and development expenses scaled by assets, and a factor obtained from a principal component analysis. The results are robust to controlling for the impact of other firm characteristics on pay-for-performance sensitivities.

Relative Performance Evaluation in CEO Compensation: Evidence from the 2006 Disclosure Rules

In December 2006, the Securities and Exchange Commission issued new rules that require the disclosure of the use of relative performance evaluation (RPE) in CEO compensation contracts. We find that about a third of the sample firms use RPE in the CEO compensation contract. On average, RPE users tie about half of the estimated value of the awards to RPE. Firms tie a larger fraction of their awards to RPE when they face less uncertainty regarding the right performance benchmark. We find little evidence to support hypotheses based on product market competition, CEO hedging constraints, or managerial power.

The Influence of Social Identity on the Performance Effects of Relative Performance Evaluation

This study examines performance effects from the use of relative performance evaluation (RPE) as a sorting mechanism for promotion decisions within the organizational labor market. Organizations routinely use RPE to reduce common uncertainty and increase contracting efficiency. However, owing to the discrete and persistent increase in compensation that occurs when an individual is promoted, incentive effects of RPE are likely to be most pronounced when RPE is used as the basis for promotion decisions. We use proprietary archival and survey data from a large internal audit organization and find that RPE increases performance to a greater extent for junior auditors who have higher opportunities for promotion relative to senior auditors who have fewer opportunities for promotion. Indeed, we find that RPE is negatively associated with performance for senior auditors. These results suggest that RPE is not only less effective at higher levels of the organization, but may also be dysfunctional.

Relative performance evaluation and pension investment management: A challenge for ESG investing

Abstract The fund management industry is the primary investment arm of the pension funds that control a significant portion of global capital market assets. Pension assets are frequently cited as vehicles for the use of “environmental, social and governance” (ESG) factors in investing for broader, extra-financial aims. Yet, compensation practices in the pension investment management industry remain focused on relative performance. This study examines the use of relative performance evaluation (RPE) as a form of compensation and control, including its historical emergence, using a genealogical history that attempts to provide some critique of its current day usage. In doing so, it follows the call by Norman Macintosh to both examine the social embeddedness of accounting, and to engage in reflexive accounting histories. The study argues that continued focus on relative results may pose challenges to incorporating ESG factors, and that further study of the RPE technique is needed, particularly with the increased focus on ESG at the policy level.

Accounting Integration and Comparability: Evidence from Relative Performance Evaluation Around IFRS Adoption

We study a sample of Continental European firms for changes in the sensitivity of their CEO turnover to their foreign peers’ accounting performance around the mandatory adoption of International Financial Reporting Standards (IFRS). We find a post-adoption increase in the use of Relative Performance Evaluation (RPE) based on foreign peers’ accounting information, consistent with greater financial reporting comparability associated with mandatory IFRS adoption. These findings cannot be explained by changes in foreign ownership or changes in foreign operations around mandatory IFRS adoption. Furthermore, we find stronger results for firms in more competitive industries and when peers are from highly correlated economies, consistent with the economic theory of RPE.

Relative Performance Evaluation and Related Peer Groups in Executive Compensation Contracts

ABSTRACT: This study examines the explicit use of relative performance evaluation (RPE) in executive compensation contracts and the selection of RPE peers. Using S&P 1500 firms’ first proxy disclosures under the SEC’s 2006 executive compensation disclosure rules, we find that about 25 percent of our sample firms explicitly use RPE in setting executive compensation. We demonstrate that a lack of knowledge of both actual peer-group composition and the link between RPE-based performance targets and future peer performance significantly hinder the traditional implicit test from detecting RPE use. We also find that firms consider both costs and benefits of RPE as an incentive mechanism when deciding to use RPE. Finally, both efficient contracting and rent extraction considerations influence RPE peer selection, with the relative importance of these competing considerations depending on RPE firms’ performance.

Relative Performance Evaluation and Related Peer Groups in Executive Compensation Contracts

This study examines the explicit use of relative performance evaluation (RPE) in executive compensation contracts and the selection of RPE peers. Using S&P 1500 firms’ first proxy disclosures under the SEC’s 2006 executive compensation disclosure rules, we find that 25.44 percent of our sample firms explicitly use RPE in setting executive compensation. We demonstrate that a lack of knowledge of both actual peer group composition and the link between RPE-based performance targets and future peer performance significantly hinder the traditional implicit test from detecting RPE use. We also find that firms consider both costs and benefits of RPE as an incentive mechanism when deciding to use RPE. Finally, both efficient contracting and rent extraction considerations influence RPE peer selection and the relative importance of these competing considerations depends on RPE firms’ performance.

The Impact of Individual and Collective Performance on Ministerial Tenure

Government ministers in Parliamentary democracies are career politicians for whom public service is an important source of motivation. The length of their tenure is controlled by the Prime Minister. We test a simple Principal-Agent model of parliamentary government in which the Prime Minister evaluates her ministers according to information available to her that is related to their performance. We study the effects of individual and collective ministerial performance on the length of time a minister serves in British government over the period 1945–97. We use the number of resignation calls for a minister as an individual performance indicator and the cumulative number of such calls as an indicator of government performance. A minister’s hazard rate increases sharply after the first individual call for resignation and is decreasing in the cumulative number of resignation calls. These results are consistent with the Principal-Agent model and with the use of relative performance evaluation by the Prime Mini...

EXPLAINING THE UTILIZATION OF RELATIVE PERFORMANCE EVALUATION IN LOCAL GOVERNMENT: A MULTI‐THEORETICAL STUDY USING DATA FROM SWEDEN

One of the more lasting imprints that New Public Management (NPM) has made in the public sector is an increase in the popularity of performance measurement. In Sweden, performance measurement has gained popularity in the public sector, not least at the local government level with the use of relative performance evaluation (RPE). Because utilization of RPE is a decentralized and optional mode of governance, a somewhat heterogeneous practice has evolved. The aim of this paper is to examine the causes of this differentiated practice. We jointly examine economic, political and institutional/cultural explanations in order to account for the utilization of RPE. The empirical material consists of archival data and a questionnaire sent to all Swedish municipalities in late 2005. We show that RPE adoption and use partly has different antecedents and that the institutional/cultural perspective appears to have greater explanatory power than economic and political, not least as a consequence of the potential to explain decoupling and the importance of change facilitating capabilities. The investigation contributes specifically to the literature on the utilization of RPE in local governments and more generally to the literature on why and to what extent management accounting practices are utilized.

Relative performance evaluation in board cash compensation: UK empirical evidence

This paper presents an empirical examination of whether evidence of the implicit use of relative performance evaluation (RPE) can be found in the cash compensation of boards of directors for 169 UK non-financial listed companies that existed for all of the period from 1971 to 1998. We perform two types of analyses. Initially, we estimate individual firm time series regressions of the change in board cash compensation against measures of firm and peer group performance. The measures of firm performance we use are annual cash stock market returns and pre-tax accounting earnings. Peer group measures of performance are industry value-weighted average cash stock market returns and industry value-weighted average pre-tax accounting earnings. Subsequently, we analyse the data as a balanced panel. We provide evidence that board cash compensation is positively related to accounting earnings and negatively associated with peer group pre-tax accounting earnings. Some evidence suggests that board cash compensation is related to firm stock market returns but none suggests it is related to peer group market returns. This result implies the presence of RPE based on accounting earnings in the design of UK board compensation, with the cash compensation of boards of directors implicitly (partially) protected from industry uncertainties.

The Effect of Relative Performance Evaluation on the Joint Choice of Risk and Effort

The use of Relative Performance Evaluation (RPE) is widely observed across academic and corporate settings. While the use of RPE is commonly justified by the theoretical prediction that it can increase employee risk-taking and effort beyond that of an incentive plan that rewards based only on individual performance, there is no empirical evidence documenting the effect of RPE on individuals’ joint choice of risk and effort. Prior research has been either unable to untangle the effect of RPE on effort and risk-taking or have focused on only one or the other. Using an experiment, this paper examines if the impact of RPE is different in a setting whereby employees’ performance is jointly affected by their concurrent risk and effort choices versus a setting whereby employees’ risk and effort choices are independent and evaluated separately. The results of this experiment show the impact of RPE to be different in the joint setting. I also find that RPE can potentially encourage more extreme risk-taking behavior. In addition, I do not find on average that RPE is more effective than an individual performance based incentive plan in motivating higher effort and lower risk-aversion in the joint setting.

Infectious Ethics: How Upright Employees Can Ease Concerns of Tacit Collusion

The recent spate of corporate scandals in the United States has led to a newfound emphasis on developing a culture of ethics within organizations. Many hope the leadership of a few can help persuade ethical behavior by others. This article suggests that direct interpersonal influences need not necessarily be present for individuals to spur such a culture. In this article, incentive contracts make use of relative performance evaluation, which gives rise to concerns of tacit collusion among employees. Ethical employees stand to alter the behavior of others, since their mere presence limits the number and size of potential collusive coalitions. As a result, the firm finds it much easier to motivate not only those who themselves are ethical but also those who act entirely in self-interest. (JEL J33, M14, M52)

Strategic Information Spillover to Be Imitated: Incentive to Make Use of Relative Performance Evaluation

In this article, we deal with the topic of intentional information spillover using a model in which both informational- and payoff-externalities are present and the timing of agents' actions is endogenous. In this model, three players, who are heterogeneous in the quality of their information, compete with one another in a common task. According to the results, the weakly-informed players may voluntarily relinquish an option to wait, although no cost is imposed for a delay of action. When acting without a delay, they reveal their information with the hope that others will imitate them. This type of information spillover is due to their incentive, which is to make use of the relative performance evaluation structure under which a bad reputation can be shared if others are also wrong.

Choice of relative performance evaluation for strategic reasons

This paper presents a new perspective for the use of relative performance evaluation. It argues that firms may want to evaluate their CEOs relative to their competitors for strategic reasons. It considers a competitive industry and with the help of a multiple agency model arrives at a set of hypotheses regarding the weights on firm performance and industry performance. These hypotheses do not have an analogue in a traditional single agency model framework. The empirical hypotheses relating the compensation contract parameters to the cost and market structures of the industry are tested with cash compensation data from 272 firms over a period of 18 years. Some of the empirical hypotheses find support from the data. Finally the paper also investigates whether the data supports alternate hypotheses arrived at by considering competing explanation for the use of RPE based on Holmstrom’s informativeness criterion.