Performance Pay and Top-Management Incentives

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Performance Pay and Top-Management Incentives

• By
• Michael Jensen, and Kevin Murphy

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Purpose

• To estimate the magnitude of the incentives
  provided by each of the following mechanisms.

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Incentive Generating Mechanisms

• Performance- based bonuses
• Performance- based salary revisions
• Stock Options
• Performance- based dismissal decisions

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• Agency Theory Suggests
• Compensation policy should be designed to give
  the manager the incentives to select and
  implement actions that increase the shareholders
  wealth.
• Paying CEOs on basis of increased shareholder
  wealth is the objective of the owners.

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CEO Compensation

• Deferred Compensation
• Stock Options
• Profit- Sharing Arrangements
• Stock Grants
• Savings plans
• Long-term performance plans
• Other fringe benefits

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Equation (1)

• CEO cash compensation and firm performance as
  measured by a change in shareholder wealth.
• ?(CEO salary bonus)t a b(?shareholder
  wealth)t
• This equation assumes that current stock price
  performance affects current compensation.
• But that decision could be made before final
  earnings data is in.

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• This equation assumes that current stock price
  performance affects current compensation.
• But that decision could be made before final
  earnings data is in.

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Equation (2)

• Allows current pay revisions to be based on past
  as well as current performance.
• ?(CEO salary bonus)t a
  b(?shareholders wealth)t b2(?shareholders
  wealth)t-1
• This regression may have better results than
  equation (1) but you cant tell if it represents
  a real lag of rewards on performance and how much
  represents simple measuring errors caused by lags
  in reporting.

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Equation (3)

• The relation between total compensation and firm
  performance based on the Forbes total
  compensation data, excluding both stock option
  grants and the gains from exercising stock
  options.
• The dependent variable in equation (3)
  represents the change in the current cash flows
  accruing to the CEO, the independent variables
  represent the discounted present value of the
  change in all future cash flows accruing to the
  shareholders.

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Equation (4)

• Assumptions
• Real interest rate 3
• CEO receives this increment until the age of 70.
• Changes in salary and bonuses are permanent
• ?(CEO wealth)t total pay PV(?salarybonus)t

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Incentives Generated by Stock Options

• The Forbes definition of total pay excludes
  stock options although they clearly provide value
  increasing incentives for CEOs
• The value of options held at the end of year ?
  is calculated as
• Black-Scholes 1973 Valuation Formula
• SNt Ste-dTF(Zt) Pte-rt F(Zt-dT½)
• We assume that options are exercised at the
  highest stock price observed during the year.

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• For a more complete measure of CEO wealth changes
  they used a proxy from Murphys 1985 sample of 73
  Fortune 500 manufacturing firms during a 15 year
  period 1969-1983.
• Sample of 154 CEOs

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Table 3

• Summarizes fractional stock ownership data for a
  much larger sample of CEOs.
• 746 CEOs in the Forbes 1987 Executive
  Compensation Survey held an average of 2.4 of
  firms common stock.

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Incentives generated by threat of dismissal.

• The threat of dismissal for poor performance
  produces value-increasing incentives to the
  extent that managers are earning more than their
  opportunity cost.

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Table 4

• ln(prob of TO/ 1-prob TO) a b1(net market
  return)b2 (lagged net market return)
• Net market return fiscal year shareholders
  return- value weighted return of all NYSE
  firms

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TABLE 5

• Dismissal Probability is P ex/(1ex)
• x -2.08- .6363-.4181
• CEOs are more likely to be fired at a younger
  age.

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Conclusions

• The empirical relation between pay of top
  management firm performance is positive and
  statistically significant, but is small for an
  occupation where incentive pay is expected to
  play an important role.
• The results are inconsistent with the
  implications of the formal agency models of
  optimal contracting.

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Alternative Hypotheses

• CEO may be an unimportant input in the production
  process.
• CEO actions may be easily monitored and evaluated
  by the board of directors.
• Political forces that implicitly regulate
  executive compensation by constraining the types
  of contracts that can be written between managers
  and shareholders
• Equilibrium in the managerial labor market
  prohibits large penalties for poor performance
  and as result the dependence of pay on
  performance is decreased.