Ceo Pay and the Rise of Relative Performance Contracts: A Question of Governance?

Abstract

We exploit the large rise in relative performance awards in the UK over the last two decades to investigate whether these contracts improve the alignment between CEO pay and performance. We first document that corporate governance appears to be stronger when institutional ownership is greater. Then, using hand-collected data from annual reports on explicit contracts, we show that (1) CEO pay still responds more to increases in the firms’ stock performance than to decreases and, importantly, this asymmetry is stronger when corporate governance is weak as measured by low institutional ownership; (2) “pay-for-luck” persists as remuneration increases with random positive shocks, even when the CEO has equity awards that explicitly condition on firm performance relative to peer firms in the same sector. A major reason why relative performance contracts do not eliminate pay for luck is that CEOs who fail to meet the terms of their past performance awards are able to obtain more generous new equity rewards in the future in weakly governed firms. We show the mechanism operates both through the quantum of shares and the structure of new contracts. These findings suggest that reforms to the formal structure of CEO pay contracts are unlikely to align incentives in the absence of strong corporate governance.

The Dynamics of Bargaining Power in a Principal-Agent Model

“…An additional assumption behind this proposed law of motion is that the principal is more generous with the rewards than astringent with the punishments for increments in the next-period agent's bargaining power are equal to ε whereas reductions in the next-period agent's bargaining power are lower than ε. This assumption is based on asymmetrical responses that have been observed in CEO pay in the face of good versus bad outcomes, see for instance Gopalan et al (2010) and Bell et al (2021).…”