Do CEOs Set Their Own Pay? The Ones Without Principals Do

Abstract

We empirically examine two competing views of CEO pay. In the contracting view, pay is used to solve an agency problem: the compensation committee optimally chooses pay contracts which give the CEO incentives to maximize shareholder wealth. In the skimming view, pay is the result of an agency problem: CEOs have managed to capture the pay process so that they set their own pay, constrained somewhat by the availability of cash or by a fear of drawing shareholders' attention. To distinguish these views, we first examine how CEO pay responds to luck, observable shocks to performance beyond the CEO's control. Using several measures of luck, such as changes in oil price for the oil industry, we find substantial pay for luck. Pay responds about as much to a "lucky" dollar as to a general dollar. Most importantly, we find that better governed firms pay their CEOs less for luck. Our second test examines how much CEOs are charged for the options they are granted. Since options never appear on balance sheets, they might offer an appealing way to skim. Here again we find a crucial role for governance: CEOs in better governed firms are charged more for the options they are given. These results suggest that both views of CEO pay matter. In poorly governed firms, the skimming view fits better (pay for luck and little charge for options) while in well governed firms, the contracting view fits better (filtering out of luck and charging for options).

Why does capital structure choice vary with macroeconomic conditions?

“…32 Aggarwal and Samwick (1999) develop a model where strategic interactions among firms can explain the lack of relative performance-based incentives. Bertrand and Mullainathan (2000) argue that boards may want their CEOs to respond to aggregate shocks for two reasons. First, in the context of the oil industry, the board may want the CEO to "keep his eyes open" for an oil shock.…”

“…Resolving the tension between the manager's incentives to misreport or liquidate his firm and his desire to share risk results in a constrained-optimal capital structure. 9 At the macroeconomic level, the fraction of wealth held by managers varies over the business cycle and is the driving force in the model. Consider a two period economy where households can only save by investing with managers that face lax leverage constraints.…”

Stock options for undiversified executives

“…In this case, the net cost to the company of the option grant is nC(P) -V(n). Bertrand and Mullainathan (2000) report evidence suggesting that the appropriate cost assumption depends on the effectiveness of the company's corporate governance: options are an add-on in firms with weak governance, but are (at least partially) offset by decreases in cash compensation in firms with stronger governance. In order to capture both extremes, as well as intermediate cases, we define net cost as nC(P) -αV(n), where 0>α>1, and solve numerically for 4MAX X ∂V (n,X,P) ∂P subject to nC(X,P) -αV(n,X,P) = k.…”

Executive Compensation, Incentives, and Risk

“…4 Executive stock options have been recommended for incentive compensation 3 Corporate executives are generally not permitted to sell their stock and option grants for a specified period of time, the "vesting period", and are also contractually precluded from hedging the risk by short-selling company stock. 4 The approach taken in this paper is normative, without taking a stance on whether corporate boards or compensation commitees try to design optimal compensation contracts. See Core and Guay (1999) for evidence that firms use annual stock and option grants to achieve desired levels of incentives for their executives.…”