CEO Compensation MIT

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Table of Contents,Introduction, Section 1 The level and structure of CEO compensation. 1 1 The level of CEO compensation,1 2 The main components of CEO pay. 1 3 Other forms of pay,1 4 Brief summary, Section 2 The sensitivity of CEO wealth to firm performance. 2 1 Quantifying managerial incentives, 2 2 What is the right measure of the wealth performance relationship. 2 3 Are incentives set optimally,2 4 Brief summary.
Section 3 Explaining CEO compensation Rent extraction or competitive pay. 3 1 Theoretical explanations for the rise in CEO pay. 3 2 The empirical evidence, 3 2 1 Evidence for and against the managerial power hypothesis. 3 2 2 Evidence for and against competitive pay,3 3 Brief summary. Section 4 The effect of compensation on CEO behavior and firm value. 4 1 The relation between CEO incentives and firm value. 4 2 The relation between CEO incentives and firm behavior. 4 3 Incentive compensation and manipulation,4 4 Brief summary. Conclusion,Introduction, Executive compensation is a complex and contentious subject The high level of CEO pay in the. U S has spurred an intense debate about the nature of the pay setting process and the outcomes. it produces Some argue that large executive pay packages are the result of powerful managers. setting their own pay and extracting rents from firms Others interpret the same evidence as the. result of optimal contracting in a competitive market for managerial talent This survey. summarizes the research on CEO compensation and assesses the evidence for and against these. explanations, Our review suggests that both managerial power and competitive market forces are important.
determinants of CEO pay but that neither approach alone is fully consistent with the available. evidence The evolution of CEO compensation since WWII can be broadly divided into two distinct. periods Prior to the 1970s we observe low levels of pay little dispersion across top managers. and moderate pay performance sensitivities From the mid 1970s to the early 2000s. compensation levels grow dramatically differences in pay across managers and firms widen and. equity incentives tie managers wealth closer to firm performance None of the existing theories. offers a fully convincing explanation for the apparent regime change that occurred during the. 1970s and all theories have trouble explaining some of the cross sectional and time series. patterns in the data, Many of the theoretical studies we review explore how various characteristics of real world. compensation contracts can be consistent with either rent extraction or optimal contracting. While obviously useful demonstrating that a given compensation feature can arise in an optimal. contracting or rent extraction framework provides little evidence that the feature is in fact used. for efficiency reasons or to extract rents Partly as a result there is no consensus on the relative. importance of rent extraction and optimal contracting in determining the pay of the typical CEO. To help answer this question models of CEO pay will have to produce testable predictions that. differ between the two approaches, We expect that the renewed interest in theoretical work on CEO pay and the emergence of new. data will deliver both the predictions and the testing opportunities needed to resolve this debate. Promising recent contributions have examined the effects of exogenous changes in the. contracting environment on CEO compensation firm behavior and firm performance For. example industry deregulations have been linked to higher CEO compensation suggesting that. increased demand for CEO talent raises pay levels On the other hand declines in CEO. compensation following regulations that strengthen board oversight suggest rent extraction. The literature on CEO compensation is vast and this survey makes no attempt to be. comprehensive Instead we emphasize recent contributions and especially contributions made. since the comprehensive review by Murphy 1999 Our focus is on empirical work more than. theory on U S rather than foreign evidence and on public instead of private firms The large. segments of the literature we ignore have been ably covered in other surveys starting with Rosen. 1992 and followed by among others Finkelstein Hambrick 1996 Abowd Kaplan 1999. Murphy 1999 Core Guay Larcker 2003 Aggarwal 2008 Bertrand 2009 and Edmans. Gabaix 2009, The paper is organized as follows Section 1 describes the evidence on the level and structure of. CEO compensation Section 2 examines the relationship between CEO pay and firm performance. and discusses the merits of different pay for performance measures Section 3 summarizes and. critiques explanations for the rise in CEO pay Section 4 discusses the effects of CEO pay on firm. behavior and value The final section concludes, Section 1 The level and structure of CEO compensation. 1 1 The level of CEO compensation, The increase in CEO pay over the last 30 years and in particular its rapid acceleration in the.
1990s has been widely documented and analyzed Figure 1 provides a longer run perspective on. the evolution of annual compensation for the three highest paid executives in large U S firms. from 1936 to 2005 The data is from Frydman Saks 2010 who identify the 50 largest public. firms in 1940 1960 and 1990 for a total of 101 firms and collect information on executive. compensation in these firms for all available years from 1936 to 2005 Total compensation is the. sum of the executive s salary current bonuses and payouts from long term incentive plans paid. in cash or stock and the Black Scholes value of stock option grants 1. Figure 1 reveals a J shaped pattern in executive compensation over the 1936 2005 period. Following a sharp decline during World War II and a further slow decline in the late 1940s the. real value of top executive pay increased slowly from the early 1950s to the mid 1970s averaging. about 0 8 growth per year The rapid growth in executive pay only started in the mid 1970s and. continued almost until the end of the sample in 2005 The increase in compensation was most. dramatic in the 1990s with annual growth rates that reached more than 10 by the end of the. decade Figure 1 also shows that CEO pay grew more rapidly than the pay of other top executives. Black Scholes values are likely to overstate both the cost of option compensation to the firm and its value. to the executive Lambert et al 1991 Carpenter 1998 Meulbroek 2001 Hall Murphy 2002 Ingersoll. 2006 Klein Maug 2009 Carpenter et al 2010, during the past 30 years but not before The median ratio of CEO compensation to that of the. other highest paid executives was stable at about 1 4 prior to 1980 but has since then risen to. almost 2 6 by 2000 05, The surge in executive pay in the last 30 years has been replicated in larger cross sections by. many other studies 2 Table 1 zooms in on the evolution of compensation levels from 1992 to 2008. for CEOs and other top executives in S P 500 firms in a sample of mid cap firms and in a sample. of small cap firms Executive compensation has increased for firms of all sizes For CEOs of S P. 500 firms the median level of pay climbed rapidly from 2 3m in 1992 to a peak of 7 2m in 2001. CEO pay did not resume its rise after 2001 and median pay in the S P 500 has remained stable at. levels between 6m and 7m throughout the 2000s, Beyond the overall rise in pay Table 1 reveals three important facts First changes in CEO pay are. amplified when focusing on average instead of median compensation because the distribution of. compensation has become more skewed over time For example median CEO pay in the S P 500. grew by 213 percent from 1992 to its peak in 2001 while the increase in average pay was a much. steeper 310 percent Focusing on medians is therefore important if the goal is to analyze the. experience of a typical CEO Second comparing executive pay in large cap mid cap and small cap. firms reveals interesting differences Although executive pay has increased across the board the. growth has been much steeper in larger firms As a result the compensation premium for. managing a larger firm has increased Finally the growth in pay has been larger for CEOs than for. other top executives raising the compensation premium for CEOs. 1 2 The main components of CEO pay, See for example Jensen Murphy 1990a Hall Liebman 1998 Murphy 1999 and Bebchuk. Grinstein 2005, Despite substantial heterogeneity in pay practices across firms most CEO compensation packages.
contain five basic components salary annual bonus payouts from long term incentive plans. restricted option grants and restricted stock grants In addition CEOs often receive contributions. to defined benefit pension plans various perquisites and in case of their departure severance. payments The relative importance of these compensation elements has changed considerably. Panel A of Figure 2 illustrates the importance of the major pay components for CEOs of large firms. from 1936 to 2005 using again the Frydman Saks 2010 data From 1936 to the 1950s CEO. compensation was composed mainly of salaries and annual bonuses As today bonuses were. typically non discretionary tied to one or more measures of annual accounting performance and. paid in either cash or stock Payments from long term incentive plans which are bonus plans. based on multi year performance started to make a noticeable impact on CEO pay in the 1960s. These long term rewards are often paid out over several years again with payment in either cash. The most striking pattern in Figure 2 is the surge in stock option compensation starting in the. early 1980s The purpose of option compensation is to tie remuneration directly to share prices. and thus give executives an incentive to increase shareholder value The use of stock options was. negligible until 1950 when a tax reform permitted certain option payoffs to be taxed at the much. lower capital gains rate rather than as labor income Although many firms responded by. instituting stock option plans the frequency of option grants remained too small to have much of. an impact on median pay levels until the late 1970s. During the 1980s and especially the 1990s stock options surged to become the largest. component of top executive pay Panel B of Figure 2 illustrates this development for S P 500. CEOs from 1992 to 2008 3 Option compensation comprised only 20 of CEO pay in 1992 but rose. to a staggering 49 in 2000 Thus a significant portion of the overall rise in CEO pay is driven by. the increase in option compensation and any theory that attempts to explain the growth in CEO. pay needs to account for this important change in the structure of pay as well The growth in. stock option use did not occur at the expense of other components of pay median salaries rose. from 0 8 to 0 9 million and short and long term bonuses from 0 6 to 1 million over the same. period After the stock market decline of 2000 01 stock options seem to have lost some of their. luster both in relative and absolute terms and restricted stock grants have replaced them as the. most popular form of equity compensation by 2006, Explaining the stark changes in the structure of compensation since the 1980s remains an open. challenge It is possible that the explosion in option use was prompted by tax policies that made. performance based pay advantageous and by accounting rules that downplayed the cost of. option compensation to the firm Murphy 2002 Hall Murphy 2003 Moreover it is likely that. both the prior decline in the stock market and the advent of option expensing in 2004 have. contributed to the declining popularity of stock options in recent years 4 This intriguing shift away. from options has not yet attracted much attention in the academic literature and further. research is needed to determine its causes and consequences. 1 3 Other forms of pay, The evolution was similar for other top executives in S P 500 firms and for S P MidCap and S P SmallCap. Hall Murphy 2003 and Bergman Jenter 2007 argue that managers are more willing to accept. options after stock market booms, Three important components of CEO compensation that have received less attention in the. literature are perquisites pensions and severance pay Obtaining comprehensive information on. these forms of pay has been difficult until recent years Because of the insufficient disclosure. perquisites pensions and severance pay have often been labeled stealth compensation that. may allow executives to surreptitiously extract rents Jensen Meckling 1976 Jensen 1986. Bebchuk Fried 2004 However these forms of pay may also arise as the result of optimal. contracting For example perks may be optimal if the cost of acquiring goods and services that. the manager desires is lower for the firm Fama 1980 or if they aid managerial productivity and. thereby increase shareholder value Rajan Wulf 2006 Defined benefit pensions can be justified. as a form of inside debt that mitigates risk shifting problems by aligning executives incentives. with those of lenders Sundaram Yermack 2007 Edmans Liu 2010 5. The evidence on the size of perquisites is limited and empirical work on their effects and. determinants has found mixed results Perks encompass a wide variety of goods and services. provided to the executive including the personal use of company aircraft club memberships and. loans at below market rates Consistent with the rent extraction hypothesis shareholders react. negatively when firms first disclose the personal use of company aircraft by the CEO Yermack. CEO Compensation Carola Frydman1 Dirk Jenter2 1Sloan School of Management Massachusetts Institute of Technology Cambridge Massachusetts 02142 email frydman mit edu 2Graduate School of Business Stanford University Stanford California 94305 email djenter stanford edu Key Words

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