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CEOCompensation

CarolaFrydman1

Dirk

Jenter2

1Sloan School of Management, Massachusetts Institute of Technology,

Cambridge,Massachusetts02142;email:frydman@mit.edu

2Graduate SchoolofBusiness, StanfordUniversity, Stanford,California94305;

email:djenter@stanford.edu

KeyWords

Executivecompensation,managerialincentives,incentivecompensation,equity

compensation,optioncompensation,corporategovernance

Abstract

ThispapersurveystherecentliteratureonCEOcompensation. Therapidrisein

CEOpay

over

the

last

30

years

has

sparked

an

intense

debate

about

the

nature

of thepaysettingprocess. Manyviewthehigh levelofCEOcompensationas

the resultofpowerfulmanagers setting theirownpay. Others interprethigh

payastheresultofoptimalcontractinginacompetitivemarketformanagerial

talent. WedescribeanddiscusstheempiricalevidenceontheevolutionofCEO

payandontherelationshipbetweenpayandfirmperformancesincethe1930s.

Ourreviewsuggeststhatbothmanagerialpowerandcompetitivemarketforces

are important determinants of CEO pay, but that neither approach is fully

consistentwiththeavailableevidence. Webrieflydiscusspromisingdirections

forfutureresearch.

mailto:frydman@mit.edumailto:frydman@mit.edumailto:djenter@stanford.edumailto:djenter@stanford.edumailto:djenter@stanford.edumailto:frydman@mit.edu

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TableofContents:

Introduction

Section1:ThelevelandstructureofCEOcompensation

1.1

The

level

of

CEO

compensation

1.2ThemaincomponentsofCEOpay

1.3Otherformsofpay

1.4Briefsummary

Section2:ThesensitivityofCEOwealthtofirmperformance

2.1Quantifyingmanagerialincentives

2.2Whatistherightmeasureofthewealthperformancerelationship?

2.3Areincentivessetoptimally?

2.4Briefsummary

Section3:ExplainingCEOcompensation:Rentextractionorcompetitivepay?

3.1TheoreticalexplanationsfortheriseinCEOpay

3.2Theempiricalevidence

3.2.1Evidenceforandagainstthemanagerialpowerhypothesis

3.2.2Evidenceforandagainstcompetitivepay

3.3Briefsummary

Section4:

The

effect

of

compensation

on

CEO

behavior

and

firm

value

4.1:TherelationbetweenCEOincentivesandfirmvalue

4.2TherelationbetweenCEOincentivesandfirmbehavior

4.3Incentivecompensationandmanipulation

4.4Briefsummary

Conclusion

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Introduction

Executivecompensation isacomplexandcontentioussubject.Thehigh levelofCEOpay in the

U.S.hasspurredanintensedebateaboutthenatureofthepaysettingprocessandtheoutcomes

itproduces.Somearguethat largeexecutivepaypackagesaretheresultofpowerfulmanagers

settingtheirownpayandextractingrentsfromfirms.Othersinterpretthesameevidenceasthe

result of optimal contracting in a competitive market for managerial talent. This survey

summarizestheresearchonCEOcompensationandassessestheevidenceforandagainstthese

explanations.

Our review suggests thatbothmanagerialpowerand competitivemarket forcesare important

determinantsofCEOpay,but thatneitherapproachalone is fullyconsistentwith theavailable

evidence.TheevolutionofCEOcompensationsinceWWIIcanbebroadlydividedintotwodistinct

periods.Priortothe1970s,weobserve low levelsofpay, littledispersionacrosstopmanagers,

and moderate payperformance sensitivities. From the mid1970s to the early 2000s,

compensationlevelsgrowdramatically,differencesinpayacrossmanagersandfirmswiden,and

equity incentivestiemanagerswealthclosertofirmperformance.Noneoftheexistingtheories

offers a fully convincing explanation for the apparent regime change thatoccurredduring the

1970s, and all theories have trouble explaining some of the crosssectional and timeseries

patternsinthedata.

Many of the theoretical studies we review explore how various characteristics of realworld

compensation contracts can be consistent with either rent extraction or optimal contracting.

Whileobviouslyuseful,demonstratingthatagivencompensationfeaturecanariseinanoptimal

contracting(orrentextraction)frameworkprovideslittleevidencethatthefeatureisinfactused

forefficiencyreasons(ortoextractrents).Partlyasaresult,thereisnoconsensusontherelative

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importanceofrentextractionandoptimalcontractingindeterminingthepayofthetypicalCEO.

Tohelpanswerthisquestion,modelsofCEOpaywillhavetoproduce testablepredictionsthat

differbetweenthetwoapproaches.

WeexpectthattherenewedinterestintheoreticalworkonCEOpayandtheemergenceofnew

datawilldeliverboththepredictionsandthetestingopportunitiesneededtoresolvethisdebate.

Promising recent contributions have examined the effects of exogenous changes in the

contracting environment on CEO compensation, firm behavior, and firm performance. For

example, industryderegulationshavebeen linked tohigherCEOcompensation,suggestingthat

increased demand for CEO talent raises pay levels. On the other hand, declines in CEO

compensationfollowingregulationsthatstrengthenboardoversightsuggestrentextraction.

The literature on CEO compensation is vast, and this survey makes no attempt to be

comprehensive. Instead,weemphasize recentcontributions,andespeciallycontributionsmade

since the comprehensive reviewbyMurphy (1999).Our focus isonempiricalworkmore than

theory,on

U.S.

rather

than

foreign

evidence,

and

on

public

instead

of

private

firms.

The

large

segmentsoftheliteratureweignorehavebeenablycoveredinothersurveys,startingwithRosen

(1992)and followedby,amongothers,Finkelstein&Hambrick (1996),Abowd&Kaplan (1999),

Murphy (1999),Core,Guay&Larcker (2003),Aggarwal (2008),Bertrand (2009),andEdmans&

Gabaix(2009).

Thepaper

is

organized

as

follows.

Section

1describes

the

evidence

on

the

level

and

structure

of

CEOcompensation.Section2examinestherelationshipbetweenCEOpayandfirmperformance

anddiscusses themeritsofdifferentpayforperformancemeasures.Section3summarizesand

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critiquesexplanationsfortherise inCEOpay.Section4discussestheeffectsofCEOpayonfirm

behaviorandvalue.Thefinalsectionconcludes.

Section1:ThelevelandstructureofCEOcompensation

1.1ThelevelofCEOcompensation

The increase in CEOpay over the last 30 years, and in particular its rapid acceleration in the

1990s,hasbeenwidelydocumentedandanalyzed.Figure1providesalongerrunperspectiveon

theevolution

of

annual

compensation

for

the

three

highest

paid

executives

in

large

U.S.

firms

from1936to2005.Thedata is fromFrydman&Saks (2010),who identify the50 largestpublic

firms in 1940, 1960, and 1990 (for a total of 101 firms) and collect information on executive

compensationinthesefirmsforallavailableyearsfrom1936to2005.Totalcompensationisthe

sumoftheexecutivessalary,currentbonusesandpayoutsfrom longtermincentiveplans(paid

incashorstock),andtheBlackScholesvalueofstockoptiongrants.1

Figure 1 reveals a Jshaped pattern in executive compensation over the 1936 2005 period.

FollowingasharpdeclineduringWorldWar IIanda furtherslowdecline in the late1940s,the

realvalueoftopexecutivepayincreasedslowlyfromtheearly1950stothemid1970s(averaging

about0.8%growthperyear).Therapidgrowthinexecutivepayonlystartedinthemid1970sand

continuedalmostuntiltheendofthesample in2005. The increase incompensationwasmost

dramaticin

the

1990s,

with

annual

growth

rates

that

reached

more

than

10%

by

the

end

of

the

decade.Figure1alsoshowsthatCEOpaygrewmorerapidlythanthepayofothertopexecutives

1BlackScholesvaluesarelikelytooverstateboththecostofoptioncompensationtothefirmanditsvalue

to the executive (Lambert et al.1991,Carpenter1998,Meulbroek2001,Hall&Murphy2002, Ingersoll

2006,Klein&Maug2009,Carpenteretal.2010).

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during thepast30years,butnotbefore.ThemedianratioofCEOcompensationto thatof the

otherhighestpaidexecutiveswas stableatabout1.4prior to1980buthas since then risen to

almost2.6by200005.

The surge inexecutivepay in the last30 yearshasbeen replicated in larger crosssectionsby

manyotherstudies.2Table1zoomsinontheevolutionofcompensationlevelsfrom1992to2008

forCEOsandothertopexecutivesinS&P500firms,inasampleofmidcapfirms,andinasample

ofsmallcap firms.Executivecompensationhas increased for firmsofallsizes.ForCEOsofS&P

500firms,themedianlevelofpayclimbedrapidlyfrom$2.3min1992toapeakof$7.2min2001.

CEOpaydidnotresumeitsriseafter2001,andmedianpayintheS&P500hasremainedstableat

levelsbetween$6mand$7mthroughoutthe2000s.

Beyondtheoverallriseinpay,Table1revealsthreeimportantfacts.First,changesinCEOpayare

amplifiedwhenfocusingonaverageinsteadofmediancompensation,becausethedistributionof

compensationhasbecomemoreskewedovertime.Forexample,medianCEOpayintheS&P500

grewby

213

percent

from

1992

to

its

peak

in

2001,

while

the

increase

in

average

pay

was

amuch

steeper 310 percent. Focusingonmedians is therefore important if the goal is to analyze the

experienceofatypicalCEO.Second,comparingexecutivepayinlargecap,midcap,andsmallcap

firmsrevealsinterestingdifferences.Althoughexecutivepayhasincreasedacrosstheboard,the

growth has been much steeper in larger firms. As a result, the compensation premium for

managingalargerfirmhasincreased.Finally,thegrowthinpayhasbeenlargerforCEOsthanfor

othertopexecutives,raisingthecompensationpremiumforCEOs.

1.2ThemaincomponentsofCEOpay

2 See, for example, Jensen&Murphy (1990a),Hall& Liebman (1998),Murphy (1999), and Bebchuk&

Grinstein(2005).

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Despitesubstantialheterogeneityinpaypracticesacrossfirms,mostCEOcompensationpackages

contain five basic components: salary, annual bonus, payouts from longterm incentive plans,

restrictedoptiongrants,andrestrictedstockgrants.Inaddition,CEOsoftenreceivecontributions

todefinedbenefitpensionplans,variousperquisites,and, incaseoftheirdeparture,severance

payments. The relative importanceof these compensation elementshas changed considerably

overtime.

PanelAofFigure2illustratestheimportanceofthemajorpaycomponentsforCEOsoflargefirms

from1936 to2005,usingagain theFrydman&Saks (2010)data.From1936 tothe1950s,CEO

compensationwas composedmainly of salaries and annual bonuses. As today, bonuseswere

typicallynondiscretionary,tiedtooneormoremeasuresofannualaccountingperformance,and

paid in either cashor stock. Payments from longterm incentive plans,which arebonusplans

basedonmultiyearperformance,startedtomakeanoticeableimpactonCEOpayinthe1960s.

Theselongtermrewardsareoftenpaidoutoverseveralyears,againwithpaymentineithercash

orstock.

Themost strikingpattern inFigure2 is the surge in stockoption compensation starting in the

early1980s.Thepurposeofoptioncompensation istotieremunerationdirectlytoshareprices

andthusgiveexecutivesanincentivetoincreaseshareholdervalue.Theuseofstockoptionswas

negligibleuntil1950,whenataxreformpermittedcertainoptionpayoffstobetaxedatthemuch

lower capital gains rate rather than as labor income. Although many firms responded by

institutingstockoptionplans,thefrequencyofoptiongrantsremainedtoosmalltohavemuchof

animpactonmedianpaylevelsuntilthelate1970s.

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During the 1980s and especially the 1990s, stock options surged to become the largest

componentof topexecutivepay.PanelBof Figure2 illustrates thisdevelopment for S&P500

CEOsfrom1992to2008.3Optioncompensationcomprisedonly20%ofCEOpayin1992butrose

toastaggering49%in2000.Thus,asignificantportionoftheoverallriseinCEOpayisdrivenby

theincreaseinoptioncompensation,andanytheorythatattemptstoexplainthegrowthinCEO

payneeds toaccount for this important change in the structureofpay aswell.Thegrowth in

stockoptionusedidnotoccurattheexpenseofothercomponentsofpay;mediansalariesrose

from$0.8to$0.9million,andshort andlongtermbonusesfrom$0.6to$1millionoverthesame

period.Afterthestockmarketdeclineof200001,stockoptionsseemtohavelostsomeoftheir

luster,bothinrelativeandabsoluteterms,andrestrictedstockgrantshavereplacedthemasthe

mostpopularformofequitycompensationby2006.

Explainingthestarkchanges inthestructureofcompensationsincethe1980sremainsanopen

challenge.It ispossiblethattheexplosioninoptionusewaspromptedbytaxpoliciesthatmade

performancebased pay advantageous, and by accounting rules that downplayed the cost of

optioncompensationtothefirm(Murphy2002,Hall&Murphy2003).Moreover, itis likelythat

both the prior decline in the stockmarket and the advent of option expensing in 2004 have

contributedtothedecliningpopularityofstockoptionsinrecentyears.4 Thisintriguingshiftaway

from options has not yet attracted much attention in the academic literature, and further

researchisneededtodetermineitscausesandconsequences.

1.3Otherformsofpay

3TheevolutionwassimilarforothertopexecutivesinS&P500firmsandforS&PMidCapandS&PSmallCap

firms.4Hall&Murphy (2003) and Bergman& Jenter (2007) argue thatmanagers aremorewilling to accept

optionsafterstockmarketbooms.

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Three important components of CEO compensation that have received less attention in the

literatureareperquisites,pensions,andseverancepay.Obtainingcomprehensiveinformationon

these formsofpayhasbeendifficultuntil recent years.Becauseof the insufficientdisclosure,

perquisites,pensions and severancepayhaveoftenbeen labeled stealth compensation that

may allow executives to surreptitiously extract rents (Jensen &Meckling 1976, Jensen 1986,

Bebchuk& Fried 2004).However, these forms of paymay also arise as the result of optimal

contracting.Forexample,perksmaybeoptimal if thecostofacquiringgoodsandservices that

themanagerdesiresislowerforthefirm(Fama1980),oriftheyaidmanagerialproductivityand

therebyincreaseshareholdervalue(Rajan&Wulf2006).Definedbenefitpensionscanbejustified

asaformofinsidedebtthatmitigatesriskshiftingproblemsbyaligningexecutives incentives

withthoseoflenders(Sundaram&Yermack2007,Edmans&Liu2010).5

The evidence on the size of perquisites is limited, and empirical work on their effects and

determinants has foundmixed results. Perks encompass awide varietyof goods and services

providedtotheexecutive,includingthepersonaluseofcompanyaircraft,clubmemberships,and

loansatbelowmarket rates.Consistentwith the rentextractionhypothesis,shareholders react

negativelywhen firms firstdisclose thepersonaluseofcompanyaircraftby theCEO (Yermack

2006a).Averagedisclosedperquisites increasedby190%followingan improvement intheSECs

disclosurerulesinDecember2006,suggestingthatfirmspreviouslyfoundwaystoobfuscatethe

reporting of perks (Grinstein et al. 2009). Perks appear to be amore general signal ofweak

corporate

governance,

as

reductions

in

firm

value

upon

the

revelation

of

perks

substantially

exceed their actual cost (Yermack 2006a, Grinstein et al. 2009). Thus, the available evidence

indicates thatat leastsomeperkconsumption isa reflectionofmanagerialexcessand reduces

5 Defined benefit pensions are inside debt becausemost executive pensions are unsecured, unfunded

claimsagainstthefirm. Thus,executiveswouldstandinlinewithotherunsecuredcreditorsinbankruptcy

(Sundaram&Yermack2007).

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shareholdervalue.Ontheotherhand,Rajan&Wulf(2006)provideevidencethatperksareused

consistentlywith theirproductivityenhancementhypothesis,e.g., tohelp themostproductive

employees save time. The extent to which perks are justified by the efficient mechanisms

proposedbyFama(1980)orRajan&Wulf(2006)remainsanopenquestion.

Theempiricalevidenceonpensionsisevensparserthanforperquisites.PriortoDecember2006,

SECdisclosurerulesdidnotrequirefirmstoreporttheactuarialvaluesofexecutivepensions.In

their absence, Sundaram and Yermack (2007) use their own calculations and estimate annual

increasesinpensionvaluestobeabout10%oftotalpayforFortune500CEOs.Similarly,Bebchuk

& Jackson (2005) find largepension claims ina small sampleofS&P500CEOs.Conditionalon

having a pension plan, themedian actuarial value at retirement is around $15million,which

corresponds to roughly 35% of the CEOs total compensation throughout her tenure. These

findings suggest that ignoringpensions can result ina significantunderestimationof totalCEO

pay.

Alack

of

readily

available

data

has

also

hampered

the

study

of

severance

pay.

Researchers

have

collected information fromemploymentcontracts, separationagreements,andothercorporate

filingsforusuallysmallsamplesoffirms.Yermack(2006b)findsthatgoldenhandshakes(that is,

separationpay that isawarded to retiringor firedCEOs)arecommon,butusuallymoderate in

value.Rusticus(2006)showsthatexanteseparationagreementssignedwhenCEOsarehiredare

also common, and equivalent to two years of cash compensation for the typical CEO. Finally,

manyCEOsreceiveasubstantialspecialseverancepayment,calledagoldenparachute,ifthey

losetheirjobduetotheirfirmbeingacquired.Thestockmarkettendstoreactpositivelytothe

adoptionofgoldenparachuteprovisions(Lambert&Larcker1985),andsuchprovisionsbecame

widespreadduringthe1980sand90s(Hartzelletal.2004).Aswithperksandpensions,research

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hasnotyetconclusivelydeterminedwhetherseverancepayisaformofrentextractionorpartof

anoptimalcontract.6

1.4Brief

summary

Boththe leveland thecompositionofCEOpayhavechangeddramaticallyovertime.Thepost

WWIIera canbedivided intoat least twodistinctperiods.Prior to the1970s,weobserve low

levels of pay, little dispersion across top managers, and only moderate levels of equity

compensation.Fromthemid1970stotheendofthe1990s,allcompensationcomponentsgrow

dramatically,anddifferencesinpayacrossexecutivesandfirmswiden.Byfarthelargestincrease

comesintheformofstockoptions,whichbecomethesinglelargestcomponentofCEOpayinthe

1990s. Finally, averageCEOpaydeclined from 2000 to 2008, and restricted stock grantshave

replacedstockoptionsasthemostpopularformofequitycompensation.Itisarguablytooearly

tojudgewhetherthepost2001periodconstitutesathirdregimeinCEOcompensation,orjusta

temporaryanomalycausedbythetechnologybustof200001andthefinancialcrisisof2008.

Section2:ThesensitivityofCEOwealthtofirmperformance

Theprincipalagentproblembetween shareholders and executiveshasbeen a central concern

ever since the separation of corporate ownership from corporate control at the turn of the

twentieth century (Berle &Means 1932). Ifmanagers are selfinterested and if shareholders

cannotperfectly

monitor

them

(or

do

not

know

the

best

course

of

action),

executives

are

likely

to

pursue their ownwellbeing at the expense of shareholder value. Anecdotal and quantitative

evidenceonexecutivesperquisiteconsumption,empirebuilding,andpreferenceforaquite life

6 See Almazan & Suarez (2003), Manso (2009), and Inderst & Mueller (2009) for models of optimal

severancepay.

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suggeststhattheprincipalagentproblem ispotentiallyhighlydetrimentaltofirmvalues(Jensen

&Meckling1976,Jensen1986,Morcketal.1990,Bertrand&Mullainathan2003).

Executivecompensation

can

be

used

to

partly

alleviate

the

agency

problem

by

aligning

managers

interestswith thoseof shareholders (Jensen&Meckling1976). Inprinciple,anexecutivespay

shouldbebasedonthemostinformativeindicator(s)forwhethertheexecutivehastakenactions

thatmaximize shareholder value (Holmstrm1979,1982). In reality,because shareholders are

unlikelytoknowwhichactionsarevaluemaximizing,incentivecontractsareoftendirectlybased

ontheprincipalsultimateobjective,i.e.,shareholdervalue.7Byeffectivelygrantingtheexecutive

anownershipstakeinherfirm,equitylinkedcompensationcreatesincentivestotakeactionsthat

benefitshareholders.Theoptimalcontractbalancestheprovisionof incentivesagainstexposing

riskaversemanagerstotoomuchvolatility intheirpay.Thedatareviewed inthissectionshow

thatthesensitivityofCEOwealthtofirmperformancesurgedinthe1990s,mostlyduetorapidly

growingoptionholdings.Atthesametime,mostCEOsfractionalequityownershipremainslow,

whichsuggeststhatmoralhazardproblemsremainrelevant.

2.1Quantifyingmanagerialincentives

Measuring the incentiveeffectsofCEO compensationhasbeen a centralgoalof the literature

since at least the 1950s. Early studies focused on identifying the measure of firm scale or

performance (e.g., sales,profits,ormarket capitalization) thatbest explainsdifferences in the

level of pay across firms (Roberts 1956, Lewellen&Huntsman 1970). The next generation of

studiestriedtoquantifymanagerialincentivesbyrelatingchangesinexecutivepaytostockprice

performance (Murphy 1985, Coughlan & Schmidt 1985). Although these studies found the

7Inpractice,CEOcompensationislinkedtobothstockpricesandaccountingperformance.Becausestock

pricesareanoisymeasureofCEOperformance,itcanbeoptimaltosupplementthemwithothervariables

thatinformaboutCEOactions(Holmstrm1979,Lambert&Larker1987,Baker1992).

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predictedpositive relationshipbetweenexecutive compensation and shareholder returns, they

systematicallyunderestimatedthe levelof incentivesbyfocusingoncurrentpay(Benston1985,

Murphy1985).Mostexecutiveshaveconsiderablestockandoptionholdings in theiremployer,

which directly tie their wealth to their employers stock price performance. For the typical

executive, thedirectwealthchangescausedbystockpricemovementsareseveraltimes larger

thanthecorrespondingchangesintheirannualpay.

Acomprehensivemeasureof incentivesshouldtakeallpossible linksbetweenfirmperformance

andCEOwealth intoaccount.These links includetheeffectsofcurrentperformanceoncurrent

and future compensation,on the valuesof stock andoptionholdings,on changes innonfirm

wealth,andontheprobabilitythattheCEOisdismissed.Jensen&Murphy(1990a)arethefirstto

integratemost of these effects in a study of large publiclytradedU.S. firms for the 197486

period.TheyfindanincreaseinCEOwealthofonly$3.25forevery$1,000increaseinfirmvalue,

andconcludethatcorporateAmericapaysitsCEOslikebureaucrats(Jensen&Murphy1990b).

Table2reproduces

the

Jensen

&

Murphy

result

using

data

from

1936

to

2005

for

the

top

3

executivesinlargeU.S.firms. TocalculatetheJensenMurphymeasureofincentives(thedollar

changeinwealthforadollarchangeinfirmvalue,orsimplythefractionalequityownership),we

follow the literatureanduse twoapproximations:First,we consideronly changes inexecutive

wealth thataredrivenby revaluationsofstockandoptionholdings.Thischannelhasswamped

the incentives provided by annual changes in pay formost of the twentieth century (Hall &

Liebman 1998, Frydman & Saks 2010). Second, we follow Core & Guay (2002a) and use an

approximationtomeasurethesensitivityofexecutivesoptionportfoliostothestockprice.

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Column1showsthatthefractionalequityownershipofthemedianexecutivedeclinedsharplyin

the 1940s, recovered in thenext two decades, and shrank again in the 1970s. Although this

measureof incentiveshas increasedrapidlysincethe1980s, its levelhasyettorecover itspre

WorldWarIIvalue.Figure3zoomsinonthemorerecentevolutionofmedianCEOincentivesin

S&P 500 firms from 1992 to 2005. Consistent with the longrun sample, the JensenMurphy

fractional ownership statistic has steadily increased: in 1992, a typical S&P 500 CEO receives

about$3.70fora$1,000increaseinfirmvalue;by2005,hergainwouldbealmost$6.40.

In contrast to Jensen & Murphy (1990a), Hall & Liebman (1998) dispute the view that CEO

incentivesarewidelyinefficientontwogrounds.First,theincreaseinstockoptioncompensation

since the1980shas substantially strengthened the linkbetweenCEOwealthandperformance.

Second,theyarguethatthechangesinwealthcausedbytypicalchangesinfirmvalueareinfact

large. Even though executives fractional equity holdings are small, the dollar values of their

equitystakesarenot.Asaresult,thetypicalexecutivestandstogainmillionsfromimprovingfirm

performance.Hall&Liebmanpropose thedollarchange inwealth forapercentagechange in

firmvalue,i.e.,thevalueofequityatstake,asmeasureofCEO incentives.Column2ofTable2

reportsthemedianequityatstakestatisticforthetop3executivesinlargeU.S.firmsfrom1936

to2005.WhileHallLiebmansequityatstakefollowsasimilarpatternofupsanddownsasthe

JensenMurphymeasureovertime,itpaintsaverydifferentpictureofthestrengthofincentives

towardstheendofthesampleperiod.Basedonequityatstake,incentiveshavebeenhigherthan

their

1930s

level

in

every

decade

since

the

1960s,

reaching

a

peak

in

the

2000

05

period

at

12

timestheir level inthe193640period. Thesharpest increase in incentivesoccurredduringthe

1990sand2000s. ForS&P500firms,Figure3showsthatthevalueofequityatstakeforatypical

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CEO increasedmore than fourfold, from $144,000 per 1% increase in firm value in 1992 to

$683,000in2005.

Thejuxtaposition

of

the

Jensen

Murphy

(1990a)

and

Hall

Liebman

(1998)

findings

highlights

that

alternativemeasures of payperformance sensitivities can lead to very different views on the

magnitudeof incentives.Thedivergence in the levelof these two incentivemeasures in recent

years ismostly due to the growth in firm values over time: Executives tend to own smaller

percentage (and largerdollar) stakes in larger firms,with the result that firm growth leads to

lowerfractionalownershipincentivesbuthigherequityatstakeincentives(Garen1994,Schaefer

1998,Baker&Hall2004,Edmansetal.2009).8Nevertheless,bothmeasuresrosefromthe1970s

to the 2000s despite further increases in firm size, mostly due to rapidly increasing option

holdings. By 200005, themedian largefirm executive holds stock optionsworth $7.2million,

significantlylargerthanherstockholdingsof$5million,andalmost30timesheroptionholdings

in197079(columns3and4ofTable2).

Tosummarize,

executives

monetary

gains

from

atypical

improvement

in

firm

value

were

sizeable

formostofthetwentiethcenturyand increasedrapidly inthe lastthreedecades.Ontheother

hand,executivesfractionalequityownershiphasalwaysbeenlow,andisevenlowertodaythan

in the1930s.Becauseof theseconflicting signalsaboutexecutives incentives,weexamine the

meritsofthedifferentincentivemeasuresinmoredetailnext.

2.2What

is

the

right

measure

of

the

wealth

performance

relationship?

8Controllingforfirmsize leadstoan increasingpattern inboth incentivemeasuresovertime(Hadlock&

Lumer1997,Frydman&Saks2010).

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The rightmeasureofCEO incentiveshasbeen the subjectof a longdebate in the academic

literature.9 In recent theoreticalwork, Baker&Hall (2004) show that the correctmeasure of

incentives depends on howCEO behavior affects firm value. In amodified agencymodel that

allowsthemarginalproductofCEOactionstovarywiththevalue(orsize)ofthefirm,thelevelof

CEOincentivesdependsonthetypeofCEOactivityconsidered.TheJensenMurphystatisticisthe

rightmeasureofincentivesforactivitieswhosedollarimpactisthesameregardlessofthesizeof

the firm, such as acquiring an unnecessary corporate jet or overpaying for an acquisition.

Conversely,thevalueofequityatstakeistherightmeasureofincentivesforactionswhoseeffect

scaleswith firm size, such as a corporate reorganization. Since CEOs engage in both types of

activities,bothmeasuresof incentivesare importantand shouldbe lookedat independently.10

ThehighvaluesofequityatstakeandthelowfractionalownershiplevelsinFigure3suggestthat

todaysCEOsarewellmotivatedtooptimallyreorganizetheirfirm,butmaystillfinditoptimalto

wastemoneyoncorporatejets.

2.3Areincentivessetoptimally?

9 See, among others, Jensen&Murphy (1990a), Joskow& Rose (1994),Garen (1994), Hall& Liebman

(1998),Murphy(1999),Baker&Hall(2004),andEdmansetal.(2009).Measuringoptionincentivesasthe

sensitivityofwealthtoperformanceisproblematicforriskaverseCEOs.Optionstendtopayoffinstatesin

whichmarginalutilityisalreadylow,whichmeansthattheactualincentivescreatedforagivensensitivity

aremuchsmallerforoptionsthanforstock(Jenter2002).10

Athird incentivemeasure istheelasticityofCEOwealthtoperformance(i.e.,thepercentagechange in

wealthfor

aone

percent

improvement

in

firm

value).

This

statistic

has

the

attractive

feature

of

not

being

sensitivetochangesinfirmsize(Murphy1985,Rosen1992),andisthecorrectmeasureofincentiveswhen

theeffortchoiceof theCEOhasamultiplicativeeffectonbothCEOutilityand firmvalue (Edmansetal.

2009).WithCEOsnonfirmwealthunobservable,theelasticityhasthedisadvantageofbeingmechanically

closetoonewhenonlyconsideringtherevaluationsofstockandstockoptionholdingsassourcesofchange

inCEOwealth. Intheextreme,thismeasureiszeroforanexecutivewithnoequityholdings,andequalto

one (or theoptiondelta) if theexecutiveholdsat leastone share (oneoption). Inpractice, researchers

resorttoapproximationstothiselasticitybyscalingtheabsolutechangeinwealthbyannualpay(Edmans

etal.2009)orbythesumofpayandtheequityportfolioheld(Hall&Liebman1998,Frydman&Saks2010).

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Determining whether observed compensation contracts optimally address the moral hazard

problembetweenshareholdersandCEOsisdifficult.11Theoptimalincentivestrengthdependson

parameters that areunobservable, such as themarginalproduct of CEO effort, the CEOs risk

aversion,theCEOscostofeffort,andtheCEOsoutsidewealth.Thesefreevariablesmakeiteasy

to develop versions of the principalagent model that are consistent with a wide range of

empiricalpatterns.Forexample,Garen(1994)andHaubrich(1994)showthatthe lowfractional

ownershipstakeslamentedbyJensen&Murphy(1990a)areconsistentwithoptimalcontracting

if CEOs are sufficiently risk averse. Given the flexibility of the agencymodel,most empirical

studiesfocusinsteadontestingpredictionsaboutcrosssectionaldeterminantsofCEOincentives

oraboutthemodelscomparativestatics.

In the basic principalagent model, the optimal level of incentives declines with the cost of

managerialeffort,thenoisetosignalratiooftheperformancemeasure,andtheexecutivesrisk

aversion.Consistentwiththesecomparativestatics,thevariation inCEO incentivesacross firms

appearstobepartlyexplainedbythevarianceinstockreturns,arguablyaproxyforthenoisein

the outcomemeasure (Garen 1994, Aggarwal& Samwick 1999a, Himmelberg et al. 1999, Jin

2002,Garvey&Milbourn2003).12 Also,wealthierCEOs,whoarelikelytobelessriskaverse,have

higherpoweredincentives(Garen1994,Becker2006).

EmpiricalevidenceonotherpredicteddeterminantsofCEOincentivesisinconclusive.Lambert&

Larcker (1987) argue that compensation should be more closely tied to stock prices when

accountingperformanceisrelativelynoisier.Eventhoughthereisconsistentevidenceforsalaries

11 The determination is made more difficult by the fact that executive pay may be linked to firm

performanceforotherreasons, includingsortingofexecutives(Lazear2004)andefficientbargainingover

profits(Blanchfloweretal.1996).12

In contrast, Core & Guay (2002b) find a positive correlation between stockprice variance and pay

performancesensitivity,contrarytothepredictionsofthebasicmodel.

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andbonuses(Lambert&Larcker1987)andoptionpay(Yermack1995,Bryanetal.2000),Core,

Guay&Verrecchia (2003) find theopposite result for totalCEOpay.Gibbons&Murphy (1992)

predictthatincentivesshouldbestrongestforCEOsclosetoretirementtosubstitutefordeclining

careerconcerns,andfindconsistentevidenceforcashcompensation.Yermack(1995)andBryan

etal.(2000),ontheotherhand,findnoevidencethatCEOsnearretirementreceiveorholdmore

stockoptions.John& John (1993)predictanegative relationbetweenexecutive incentivesand

leverageasfirmstrytoavoidagencycostsofdebt,butYermack(1995)findsnoempiricalrelation

betweenstockoptiongrantsand leverage.Finally,somestudiesreportevidenceconsistentwith

theconjecturethat incentives,andespeciallyequity incentives,shouldbestronger infirmswith

greatergrowthopportunities (Smith&Watts1992,Gaver&Gaver1995),whileothers reporta

negativecorrelationbetweenthesetwovariables(Bizjaketal.1993,Yermack1995).

Finally, a central prediction of the principalagent model is the use of relative performance

evaluation forCEOs.Holmstrm (1982)andDiamond&Verrecchia (1982)argue that contracts

shouldfilteroutanysystematic(e.g.,marketorindustry)componentsinmeasuredperformance,

as executives cannot affect these components but suffer from bearing the associated risk.

Consistentwiththisprescription,bonusplansfrequentlylinktheirpayoutstotheperformanceof

thefirmrelativetoanindustrybenchmark.However,theoverallevidencefortheeffectiveuseof

relativeperformanceevaluationisweak.13Thereasonisthatwealthperformancesensitivitiesare

drivenby revaluationsof (nonindexed) stockandoptionholdings.14Asa result,CEOwealth is

strongly

and

seemingly

unnecessarily

affected

by

aggregate

performance

shocks.

Several

recent

13See,amongothers,Murphy(1985),Coughlan&Schmidt(1985),Antle&Smith(1986),Gibbons&Murphy

(1990),Janakiramanetal.(1992),Garen(1994),Aggarwal&Samwick(1999a,b),andMurphy(1999).14

Recentevidenceshowsthatsomefirmslinkthevestingofoptionandstockawardstofirmperformance

relativetoapeergroup(Bettisetal.2010a).

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papers,however,haveproposed theories thatexplain the lackofbenchmarkingasanefficient

contractingoutcome.15

2.4Brief

summary

Since Jensen&Murphy (1990a),ourunderstandingof the linkbetween firmperformance and

CEOcompensationhas improvedsubstantially.The longrunevidenceshowsthatcompensation

arrangementshaveserved totiethewealthofmanagersto firmperformanceandperhaps to

alignmanagerswith shareholders interestsformost of the twentieth century.Much of the

effectofperformanceonCEOwealthworks through revaluationsofstockandoptionholdings,

ratherthanthroughchangesinannualpay.ThesensitivityofCEOwealthtoperformancesurged

in the 1990s, mostly due to rapidly growing option portfolios. In contrast, the typical CEOs

fractionalequityownership remains low, suggestinga continuedneed fordirectmonitoringby

boardsandinvestors.

Section3:

Explaining

CEO

compensation:

Rent

extraction

or

competitive

pay?

The rapid rise in CEO pay over the past 30 years has sparked a lively debate about the

determinantsofexecutivecompensation.Atoneendofthespectrum,thehighlevelsofCEOpay

areseenastheresultofexecutivesabilitytosettheirownpayandextractrentsfromthefirms

theymanage.Attheotherendofthespectrum,CEOpayisviewedastheefficientoutcomeofa

labormarket

in

which

firms

optimally

compete

for

managerial

talent.

Many

other

explanations

for

theriseinCEOpayhaveemergedinrecentyears,andthedebateistooextensivetodoitjustice

15 Aggarwal& Samwick (1999b), Himmelberg& Hubbard (2000), and Gopalan et al. (2009) argue that

benchmarkingmaynotbeoptimal,andJin(2002),Jenter(2002),andGarvey&Milbourn(2003)thatitmay

beunnecessary.

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inthisreview.Instead,wedividethetheoriesintothosethatviewrisingcompensationasarent

extractionproblem,andthosethatview itastheefficientoutcomeofamarketmechanism.We

briefly summarize themain theoretical arguments for these two views and then discuss the

empiricalevidence.

3.1TheoreticalexplanationsfortheriseinCEOpay

The rentextractionviewposits thatweak corporategovernanceandacquiescentboardsallow

CEOs to (at least partly) determine their own pay, resulting in inefficiently high levels of

compensation. This theory, summarized as the managerial power hypothesis by Bebchuk&

Fried(2004),alsopredictsthatmuchoftherentextractionoccursthroughformsofpaythatare

less observable or more difficult to value, such as stock options, perquisites, pensions, and

severancepay.Whilethisargument is intuitive,recenttheoreticalworkexploreshow inefficient

compensationcanbesustainedinmarketequilibrium.Kuhnen&Zwiebel(2009)modelCEOswho

settheirownpay,withbothobservableandunobservablecomponents,subjecttotheconstraint

that too much rent extraction will get them ousted. Rent extraction survives in equilibrium

because firing is costly and because a replacement CEO can also extract rents. Others have

explored how CEO compensation is determined if there are both firmswith strong andweak

governanceintheeconomy.Acharya&Volpin(2010)andDicks(2010)showthatfirmswithweak

governance (and therefore higher compensation) impose a negative externality on better

governedfirmsthroughthecompetitionformanagers,inducing inefficientlyhighlevelsofpayin

all

firms.

Incontrast to themanagerialpowerhypothesis,agrowing literatureargues that thegrowth in

CEOpay is theefficient resultof increasingdemand forCEOeffortorscarcemanagerial talent.

Onesetof theories in thisveinattributes the rise inCEOpay to increasing firm sizesand scale

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effects.IfhigherCEOtalentismorevaluableinlargerfirms,thenlargerfirmsshouldofferhigher

levelsofpay andbematchedwithmore ableCEOsby an efficient labormarket (Rosen1981,

1982).SmallincrementsinCEOtalentcanimplylargeincrementsinfirmvalueandcompensation

duetothescaleofoperationsundertheCEOscontrol(Himmelberg&Hubbard2000).Gabaix&

Landier(2008)andTervi(2008)developthisideafurtherbysolvingcompetitiveandfrictionless

assignmentmodels forCEOsunder the assumption thatmanagerial talenthas amultiplicative

effectonfirmoutput.Inthisframework,andusingspecificassumptionsaboutthedistributionof

CEOtalent,Gabaix&LandiershowthatCEOpayshouldmoveoneforonewithchanges inthe

sizeof the typical firm.Thus, theyargue thatthesixfold increase inaverageCEOpaybetween

1980and2003canbefullyexplainedbythesixfoldincreaseinaveragemarketcapitalizationover

thatperiod.

Asecondsetoftheoriesproposesthatchangesinfirmscharacteristics,technologies,andproduct

marketsoverthe last30yearshave increasedtheeffectofCEOeffortandtalentonfirmvalue,

andthereforealsotheoptimallevelsofincentivesandpay.Forexample,anincreaseinfirmsize

raisestheoptimal levelofCEOeffort,andthus incentives, ifthemarginalproductofCEOeffort

increases with the size of the firm (Himmelberg & Hubbard 2000, Baker & Hall 2004).

Alternatively, the productivity ofmanagerial effort and talentmay have increased because of

more intensecompetitionduetoderegulationorentryby foreignfirms (Hubbard&Palia1995,

Cuat&Guadalupe2009a,b),becauseofimprovementsinthecommunicationstechnologiesused

by

managers

(Garicano

&

Rossi

Hansberg

2006),

or

because

of

higher

volatility

in

the

business

environment(Dow&Raposo2005,Campbelletal.2001).Finally,moralhazardproblemsmaybe

moresevereinlargerfirms,resultinginstrongerincentivesforCEOsasfirmsgrow(Gayle&Miller

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2009). Independently of their cause, higherpowered incentives have to be accompanied by

higherlevelsofexpectedpaytocompensatemanagersforthegreaterriskintheircompensation.

Athird

market

based

explanation

for

the

growth

in

CEO

pay

is

ashift

in

the

type

of

skills

demanded by firms from firmspecific to generalmanagerial skills. Such a shift intensifies the

competition for talent, improves the outside options of executives, and allows managers to

capturealargerfractionoftheirfirmsrents(Murphy&Zbojnk2004,2007,Frydman2007).This

theorypredictsanincreaseinthelevelofCEOpay,risinginequalityamongexecutiveswithinand

acrossfirms,andahigherfractionofCEOshiredfromoutsidethefirm.

Finally,a fourthmarketbasedexplanationproposes that thegrowth inCEOpay istheresultof

stricter corporate governance and improved monitoring of CEOs by boards and large

shareholders.Hermalin(2005)showsthat,ifCEOjobstabilityisnegativelyaffectedbyanincrease

inmonitoring intensity,firmsoptimallyrespondby increasingthe levelofCEOpay.Accordingto

this theory, theobserved rise inpayshouldbeaccompaniedbymoreCEO turnover,astronger

linkbetween

CEO

turnover

and

firm

performance,

and

more

external

CEO

hires.

However,

an

economywide strengthening of governancemay not lead to higher pay in equilibrium if the

change also causes CEOs outside opportunities to become less appealing (Edmans & Gabaix

2010).

3.2Theempiricalevidence

Manyof

the

theories

described

above

have

been

developed

to

explain

the

rise

in

CEO

compensationandtheuseofequitylinkedpaysincethe1970s.Itisthereforenotsurprisingthat

manyofthemdoagoodjobfittingsomeofthemajorstylizedfactsandcrosssectionalpatterns.

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However,asweargueinthissection,thesetheorieshavetroubleexplainingCEOcompensationin

earlierdecades,aswellasrecentcrosssectionalpatternstheywerenotdesignedtomatch.

3.2.1Evidence

for

and

against

the

managerial

power

hypothesis

ThemanagerialpowerviewofCEOcompensationissupportedbyseveralpiecesofanecdotaland

systematicevidence.Forexample, thewidespreaduseof stealth compensation isdifficult to

explain ifcompensationweresimply theefficientoutcomeofanoptimalcontract.Even though

perks, pensions, and severance pay can be part of optimal compensation, hiding these

compensationelementsfromshareholdersissuggestiveofrentextraction(Bebchuk&Fried2004,

Kuhnen&Zwiebel2009).Similarly, thewidespreadpracticeofexecutiveshedgingexposures to

theirown firm, againwithminimal disclosure, isdifficult tojustify (Bettis et al. 2001, 2010b).

RentextractionisalsosuggestedbytheobservationthatCEOsarefrequentlyrewardedforlucky

eventsthatarenotundertheircontrol(suchasanimprovingeconomy)butnotequallypenalized

forunluckyevents (Bertrand&Mullainathan2001,Garvey&Milbourn2006).16Finally,CEOpay

increasesfollowingexogenousreductionsintakeoverthreats(Bertrand&Mullainathan1998)and

decreases following regulatory changes that strengthen board oversight (Chhaochharia &

Grinstein2009).

A furthersuggestivepieceofevidence forthemanagerialpowerhypothesis istherevelationof

widespread options backdating and spring loading. Yermack (1997) observes that stock prices

tend to rise subsequent tooption grants, suggesting thatpowerfulCEOs are awardedoptions

rightbeforethereleaseofpositivenews(socalledspringloading).Recentevidenceshowsthat

spring loading alone isnot sufficient toexplain the stockpricepatterns aroundoption grants.

16 Jenter&Kanaan (2008) show thatCEOsaremore likely tobe firedafterbad industryorbadmarket

performance,whichindicatesthatsomeCEOsarepenalizedforbadluck.

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Instead,many grantsmusthavehad their grantdates chosenexpost tominimize the strike

priceofatthemoneyoptionsandmaximizetheirvaluetoexecutives(Lie2005,Heron&Lie2007,

Narayanan & Seyhun 2008). Such backdating of options appears to have been widespread,

affectingabout30%offirmsfrom1996to2005 (Heron&Lie2009),andwasmoreprevalent in

firmswithweak boards and strong chief executives (Bebchuk et al. 2010). However, option

backdatingmayalsoariseduetoboardsdesiretoavoidaccountingchargesandearningsdilution.

ItremainstobeshownthatbackdatingwasinfactassociatedwithrentextractionbyCEOs.

Apotentcriticismof themanagerialpowerhypothesis is that it isunable toexplain the steady

increaseinCEOcompensationsincethe1970s.Thereisscantevidencethatcorporategovernance

has weakened over the last 30 years; instead, most indicators show that governance has

considerably strengthenedover thisperiod (Holmstrm&Kaplan2001,Hermalin2005,Kaplan

2008).Moreover,awardingpaybyallowingmanagerstoextractsomerentscanbeoptimal if

monitoring iscostly.Inequilibrium,rentextractionmaybecompensatedforthroughreductions

inother formsofpay, thusnot leading tohigher total compensation.Consequently,observing

that a CEO receives forms of pay usually associatedwith rent extraction does not necessarily

implythattheCEOscompensationexceedsthecompetitivelevel.

Indefenseofthemanagerialpowerhypothesis,itispossiblethatthedesireorabilityofmanagers

toextractrents(and increasetheirtotalpay)onlyemergedassocialnormsagainstunequalpay

weakened.Piketty&Saez(2003)arguethatsuchashift insocialnormshelpsexplaintherise in

CEOpayandthewideningincomeinequalityinthepastthreedecades,andLevy&Temin(2007)

relate this change in norms to the dismantling of institutions and government policies that

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preventedextremepayoutcomesfromWorldWarIItothe1970s.17Alternatively,theincreasing

popularityofstockoptions,coupledwithboardslimitedunderstandingofoptionvaluation,may

haveallowedmanagers tocamouflage their rentextractionasefficient incentivecompensation

(Hall&Murphy2003,Bebchuk&Fried2004).

3.2.2Evidenceforandagainstcompetitivepay

Marketbased andoptimal contractingexplanations for the rise inCEOpayhave also received

considerable empirical support. For example, the stock market tends to react positively to

announcementsofcompensationplansthatintroducelongtermincentivepayorlinkpaytostock

prices(Larcker1983,Morgan&Poulsen2001).Consistentwithacompetitivelabormarket,CEOs

of higher ability (identified through better performance) tend to receive higher compensation

(Graham et al. 2009). Moreover, changes in product markets appear to have increased the

demand for managerial talent and raised CEO pay. Hubbard & Palia (1995) and Cuat &

Guadalupe (2009a) document higher pay levels and payperformance sensitivities following

industry deregulations, and Cuat & Guadalupe (2009b) show that pay levels and incentives

increase when firms face more import penetration. While these exogenous changes in the

contractingenvironmenthavethepredictedeffectsonmanagerialpay,theestimatedmagnitudes

aremodest,leavingalargefractionofthesharpriseinCEOpayunexplained.

The idea that firmsdemand forCEO skillshas shifted from firmspecific togeneralmanagerial

human capitalhas theadvantageofpredictingnotonlyan increase in compensation,butalso

changes in pay dispersion and managerial mobility that are consistent with the empirical

evidence.Asdescribed inSection1,thepastthreedecadeshaveseenamarked increase inthe

17However,FrydmanandMolloy (2010)suggest thatchanges in thehigh tax ratesprevalentduring this

periodhadatmostmodestshortruneffectsonexecutivepay.

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differences in executive paybetween large and small firms, andbetween CEOs andother top

executives.Over the sameperiod, the ratioofnewCEOs appointed fromoutside the firmhas

risensharply,topexecutiveshavebecomemoremobileacrosssectors,theirbusinessexperiences

havebecomemorediverse,andthefractionofCEOswithanMBAhasrisen(Murphy&Zbojnk

2007,Frydman2007,Schoar2008).However,thesechangesinmanagersbackgroundsandskills

appeartohaveoccurredslowlyovertime(Frydman2007),andthemagnitudeandtimingofthe

changesmaynotbelargeorquickenoughtoexplaintherapidaccelerationinCEOcompensation

sincethe1980s.

As detailed in Section 3.1,Hermalin (2005) argues that risingCEOpay is the result of stricter

monitoringofCEOsbyboards and large shareholders.Thisview isbroadly consistentwith the

empiricalevidence.Thefractionofoutsidedirectorsonboardsandthelevelofinstitutionalstock

ownershiphaveincreasedsincethe1970s(Husonetal.2001),whileCEOturnovershavebecome

morefrequent(Kaplan&Minton2008)andcloselylinkedtofirmperformance(Jenter&Lewellen

2010).Whilethesetrendsaresuggestive,thereisnodirectevidencethatchangesingovernance

causedthesurge inCEOpay,orthataddedpressureonCEOscanaccountforthemagnitudeof

thepayincrease.

Finally,theoriesbasedontheinteractionoffirmscalewiththedemandforCEOtalentfindtheir

strongestempiricalsupportinthecorrelatedincreasesinfirmvalueandCEOpaysincethe1970s.

Gabaix&Landier(2008)calibratetheircompetitivemodelofCEOtalentassignmentandfindthat

thegrowth inthesizeofthetypicalfirm(measuredbythemarketvalueofthemedianS&P500

firm)canexplaintheentiregrowthinCEOcompensationfrom1980tothepresent.However,this

resulthasbeen criticized in several studies.Frydman&Saks (2010) show that the relationship

betweenfirmsizeandCEOpayishighlysensitivetothetimeperiodchosen,asthiscorrelationis

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almostnonexistent from the1940s to theearly1970s.Moreover, thepost1970s relationship

maynotberobusttodifferentsampleselectionchoices(Nagel2010).Finally,sinceboththesize

ofthetypicalfirmandCEOcompensationhavetrendedupwardssincethe1970s,itisdifficultto

determinewhethertherelationshipbetweenthesetwovariablesiscausal.

A seconddifficulty formodels of frictionless CEO assignment is the empirical scarcityof CEOs

movingbetweenfirms.ThemodelsofGabaix&Landier(2008)andTervi(2008)predictthat,at

anypointintime,amoretalentedCEOshouldrunalargerfirm.Consequently,anychangesinthe

sizerankoffirmsshouldleadtoCEOsswitchingfirms.Inreality,CEOsstayatonefirmforseveral

yearsandrarelymovedirectlyfromoneCEOpositiontothenext.Althoughitisstraightforwardto

augmentacompetitiveassignmentmodelwitha fixedcostofCEO replacement, the fixed cost

would need to exceed the effects of differences in CEO talent. A large fixed cost of CEO

replacementcreateslargematchspecificrentsthatapowerfulCEOcouldcapture,fundamentally

changingtheexplanationforhighlevelsofCEOpaytoonerelatedtomanagerialpower(Bebchuk

&Fried2004,Kuhnen&Zwiebel2009).

3.3Briefsummary

Ourreadingoftheevidencesuggeststhatbothmanagerialpowerandcompetitivemarketforces

are importantdeterminantsofCEOpay,andthatneitherapproachalone isfullyconsistentwith

theavailableevidence.Ontheonehand,severalcompensationpractices,aswellasspecificcases

ofoutrageousandhighlypublicizedpaypackages, indicatethat(at leastsome)CEOsareableto

extractrentsfromtheirfirms.Ontheotherhand,efficientcontractingexplanationsarearguably

more successful at explaining differences in pay practices across firms and at explaining the

evolution of CEO pay since the 1970s. However, none of theories provides a fully convincing

explanationfortheapparentregimechangeinCEOcompensationthatoccurredduringthe1970s.

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Moreover,bothapproachesfailtoexplaintheexplosivegrowthofoptionsinthe1990sandtheir

recent decline in favor of restricted stock, which may be in part a response to changes in

accountingpractices. While it ispossible thatacombinationof theproposedexplanationscan

explain the changes in CEO pay in recent decades, the relative importance of the different

theoriesremainsanopenquestion.

Section4:TheeffectofcompensationonCEObehaviorandfirmvalue

Thedebate

about

the

nature

of

the

pay

setting

process

and

the

recent

financial

crisis

have

createdrenewedinterestintheeffectsofcompensationonCEObehaviorandfirmperformance.

Most concerns aboutmanagerial paywould be alleviated if high levels of CEO pay and high

wealthperformance sensitivities led to better performance and higher firm values. However,

providingconvincingevidenceontheeffectsofexecutivepayisextraordinarilydifficult.

Themain

problem

with

measuring

the

effects

of

compensation

is

one

of

identification.

Compensation arrangements are the endogenousoutcomeof a complexprocess involving the

CEO,thecompensationcommittee,thefullboardofdirectors,compensationconsultants,andthe

managerial labormarket.As a result, compensation arrangements are correlatedwith a large

numberofobservable andunobservable firm andCEO characteristics.Thismakes itextremely

difficult to interpret any observed correlation between executive pay and firm outcomes as

evidenceof

acausal

relationship.

For

example,

CEO

pay

and

firm

performance

may

be

correlated

becausecompensationaffectsperformance,becausefirmperformanceaffectspay,orbecausean

unobservedfirmorCEOcharacteristicaffectsbothvariables.

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4.1:TherelationbetweenCEOincentivesandfirmvalue

The relationbetweenmanagerial incentivesand firmvalue isoneof the fundamental issues in

compensationresearch.Moststudies focusonwhethermanagerialequity incentivesaffect firm

value,oftenmeasuredasTobinsQ. Inan influential study,Morcketal. (1988)document that

firmvalueincreaseswithmanagerialownershipifmanagersownbetween0and5%ofthefirms

equity,decreasesifmanagersownbetween5and25%,andincreasesagain(weakly)forholdings

above25%.Oneinterpretationoftheirfindingsisthattheinitialpositiveeffectreflectsimproving

incentives,andthesubsequentnegativeeffect increasingmanagerialentrenchmentandactions

adversetominorityshareholders.Usingtwo largercrosssectionsoffirms,McConnell&Servaes

(1990) find that firm value increases until the equity ownership by managers and directors

exceeds40to50%ofsharesoutstanding.

Subsequentstudieshaveexaminedhowdifferentaspectsofexecutivesequity incentivesrelate

tofirmvalue,withmixedresults.Forexample,Mehran(1995) findsthat firmvalue ispositively

relatedtomanagersfractionalstockownershipandtothefractionofequitybasedpay.Habib&

Ljungqvist (2005) observe a positive association of firm valuewith CEO stock holdings, but a

negativeonewithoptionholdings.Manyotherstudiesfailtofindanyrelationshipbetweenfirm

value and executives equity stakes (e.g., Agrawal & Knoeber 1996, Himmelberg et al. 1999,

Demsetz&Villalonga2001).Sinceequityholdingsaremanagersandboardsdecision,noneof

thesecorrelationscanbeinterpretedascausal.

Several studies use instrumental variables to address the endogeneity of managers equity

incentives (e.g.,Hermalin&Weisbach1991,Himmelbergetal.1999,Palia2001).However, as

pointed out by Himmelberg et al., valid instruments formanagerial ownership are extremely

difficulttoobtain,becauseallknowndeterminantsofownershiparealso likelydeterminantsof

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Tobins Q.18 Because of the lack of credible instruments, this literature has been unable to

convincinglyidentifythecausaleffectsofmanagerialincentivesonfirmvalue.

4.2The

relation

between

CEO

incentives

and

firm

behavior

Incentive compensation should motivate managers to make sound business decisions that

increaseshareholdervalue.Toassesswhetherexistingcompensationarrangementsachievethis

goal,alargeliteraturestudiestherelationshipbetweenexecutivecompensationandcompanies

investmentdecisionsandfinancialpolicies.

Manyof

the

early

studies

in

this

literature

focus

on

accounting

based

long

term

incentive

plans.

Theintroductionofsuchplanshasbeenlinkedto,amongothers,increasesincapitalinvestment

(Larcker1983)andimprovementsinprofitability(Kumar&Sopariwala1992).Morerecentstudies

shifttheirfocustomanagersstockandoptionholdings.Equity incentiveshavebeenconnected

to awide varietyofoutcomes, includingbetteroperatingperformance (Core& Larcker2002),

moreandbetteracquisitions(Dattaetal.2001,Cai&Vijh2007),largerrestructuringsandlayoffs

(Dial&

Murphy

1995,

Brookman

et

al.

2007),

and

more

voluntary

liquidations

(Mehran

et

al.

1998).Executivestockoptions,whichareusuallynotdividendprotected,havealsobeenlinkedto

lowerdividends(Lambertetal.1989)andtoashiftfromdividendstosharerepurchases(Fenn&

Liang2001).Finally,asizeable literaturestudiestherelationshipbetweenmanagerial incentives

andcorporaterisktaking.Theresultssuggestthatstrongerequityincentivesareassociatedwith

18Somepaperstrytoaccountfortheendogeneityofmanagerialownershipbyestimatingasimultaneous

equation system.However, thisapproach requiresat leastasmanyexogenous variablesasendogenous

variablesinthemodel,leavingthechallengesinfindingvalidinstrumentsunsolved.

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less risk taking,whileconvexity inexecutivesportfoliosdue tooptions iscorrelatedwithmore

risktaking.19

4.3Incentive

compensation

and

manipulation

Any form of incentive compensation entails the danger that managers may manipulate the

performance measure.20 Consistent with this prediction, several studies link earningsbased

bonusplanstoearningsmanagement,especiallyifrealizedearningsareclosetofloorsandcapsin

the bonus schedule (Healy 1985,Holthausen et al. 1995). Firms also seem tomanipulate the

disclosure of information around CEO option awards, delaying the release of good news and

accelerating the disclosure of bad news (Aboody & Kasznik 2000). Finally, a series of recent

studies document a positive correlation between CEOs equity incentives and earnings

manipulation(Cheng&Warfield2005,Bergstresser&Philippon2006,Burns&Kedia2006,Efendi

etal.2007,Peng&Rell2008,Johnsonetal.2009).However,thereisdisagreementaboutwhich

partofCEOsequity incentives is the culprit,with some studies linkingmanipulation tooption

(butnot stock) incentives, andothers linkingmanipulation to stockholdings (butnotoptions).

Moreover,theevidenceforaconnectionbetweenequityincentivesandaccountingirregularities

isnotunanimous.Ericksonetal. (2006) find thatexecutivesequity incentivesareunrelated to

accusationsofaccounting fraudby theSEC,whileArmstrongetal. (2009) find thatCEOequity

incentives have, if anything, a modestly negative effect on restatements, SEC enforcement

releases,andclassactionlawsuits.

4.4Briefsummary

19See,forexample,Tufano(1996),Guay(1999),Rajgopal&Shevlin (2002),Lewellen(2006),andColeset

al.(2006).20

See Bolton et al. (2006), Goldman & Slezak (2006), and Benmelech et al. (2010) for models of

performancemanipulation.

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The literature provides ample evidence that CEO compensation and portfolio incentives are

correlatedwithawidevarietyofcorporatebehaviors, from investmentand financialpoliciesto

risk takingandmanipulation.Arguably, thewidespreaduseof incentive compensationand the

largecrosssectionaldifferencesinmanagerialcontractswouldmakelittlesenseifcompensation

hadnoeffectonCEObehavior.However,becausecompensationarrangementsareendogenous

and correlatedwithmanyunobservables,measuring their causal effects onbehavior and firm

value isextremelydifficult and remainsoneof themost important challenges for researchon

executivepay.

Conclusion

Theexecutivecompensation literaturehasexperiencedtremendousgrowth inrecentyears,and

sohasourunderstandingofpaypractices.Yet,many importantquestions remainunanswered.

For example, the causes of the apparent regime change in CEO compensation that occurred

duringthe

1970s

remain

largely

unknown.

The

relative

importance

of

rent

extraction

and

optimal

contractingindeterminingpayforthetypicalCEOisstilltobedetermined,andevenlessisknown

about the causal effects of CEO pay on behavior and firm value. Finding answers to these

questionswill requirea combinationofnew theorypredictions, the creativeuseofexogenous

changes inthecontractingenvironment,andnewdatafromothercountries,priordecades,and

differenttypesoffirms.Theprogressmadebyrecentstudiesonallthesedimensionsiscausefor

optimismandsuggeststhatanswersmaynotbefaroff.

DisclosureStatement

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Theauthorsarenotawareofany affiliations,memberships, funding,or financialholdings that

mightbeperceivedasaffectingtheobjectivityofthisreview.

Acknowledgments

We thank Jeffrey Coles, Alex Edmans, Eitan Goldman, ToddMilbourn, Kevin J.Murphy, Stew

Myers,DavidYermack, and Jeff Zwiebel forhelpfuldiscussions and suggestions, and Francisco

GuedesSantosandYesolHuhforassistanceinpreparingthismanuscript.

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Figure1:MedianCompensationofCEOsandOtherTopOfficersfrom1936to2005Figure1shows themedian levelofcompensation inasampleofthe threehighestpaidofficers in the

largest50firms in1940,1960and1990(foratotalof101firms).Firmsareselectedaccordingtototal

salesin1960and1990,andaccordingtomarketvaluein1940.Compensationdataishandcollectedfor

allavailableyearsfrom1936to1992;theS&PExecuCompdatabase isusedtoextendthedatato2005

(Frydman&Saks2010).Totalcompensationiscomposedofsalary,bonuses,longtermbonuspayments

(includinggrants

of

restricted

stock),

and

stock

option

grants

(valued

using

Black

Scholes).

The

CEO

is

identifiedasthepresidentofthecompanyinfirmswheretheCEOtitleisnotused.Othertopofficers

includeanyexecutivesamongthe3highestpaidwhoarenottheCEO.Alldollarvaluesare in inflation

adjusted2000dollars.

0.30.40.50.60.70.80.9

11.11.21.31.41.51.61.71.8

1.92

2.12.22.32.42.5

1940 1950 1960 1970 1980 1990 2000

CEOs Other top executives

Executivecompensationin2000d

ollars(logscale)

2

4

6

8

10

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Figure2:TheStructureofCEOCompensation

PanelA:ThestructureofCEOcompensationfrom1936to2005Thediagram shows themedian leveland theaveragecompositionofCEOpay in the50 largest firms in

1940,1960,and1990(foratotalof101firms).Compensationdataishandcollectedfromproxystatements

forallavailableyearsfrom1936to1992;theS&PExecuCompdatabaseisusedtoextendthedatato2005

(Frydman&

Saks

2010).

The

figure

depicts

total

compensation

and

the

three

main

components

that

can

be

separatelytrackedoverthesampleperiod:salariesandcurrentbonuses,payoutsfromlongtermincentive

plans(includingthevalueofrestrictedstock),andthegrantdatevaluesofoptiongrants(calculatedusing

BlackScholes).ThecomponentpercentagesarecalculatedbycomputingthepercentagesforaverageCEO

payineachperiodandthenapplyingthemtomedianCEOpay,asinMurphy(1999).Alldollarvaluesarein

inflationadjusted2000dollars.Notethattheverticalaxisisonalogscale.

0.00

0.50

1.00

1.50

2.00

2.50

1936-39 1940-45 1946-49 1950-59 1960-69 1970-79 1980-89 1990-99 2000-05

Salary &

Bonus

LTIP &

Stock

Options

74% 53% 40%

19%15%

37%

$0.9m $1.0m $1.0m

$1.2m

$1.8m

$4.1m

$9.2m

23%

32%

7%

84%87%93%99%

$1.1m

99%

$4,000

$8,000

$6,000

$2,000

$1,000

$10,000

$1.1m

100%

11%

CEO

compensationin2000dollars(log

scale)

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PanelB:ThestructureofCEOcompensationfrom1992to2008ThediagramshowsthemedianlevelandtheaveragecompositionofCEOpayinS&P500firmsfrom1992

to2008andisbasedonExecuCompdata.ExecuCompcollectscompensationdatafromp