Chief executive officers (CEOs) are often rewarded for aspects of their firms’ performance that are outside their control but which are influenced by luck, either bad or good. Such ‘paying for luck’ may seem like a bad idea, but new research in the August 2018 issue of the Economic Journal provides a rationale for its use: aspects of a firm’s current performance that depend on luck may help to predict the future success of the employment relationship between the CEO and the shareholders.
The study by Jed DeVaro, Jin?Hyuk Kim and Nick Vikander finds support for this rationale from looking at the compensation of a broad sample of American CEOs.
Their research has policy implications for caps on CEO pay like those implemented during the 2008 financial crisis in which firms received taxpayer-financed bailouts. The caps forced firms looking to retain good CEOs to change the compensation packages they offered by rewarding CEOs in dimensions of compensation that were not capped.
The research predicts that the damage caused by caps may be particularly high in industries where luck is highly persistent, so that paying for luck is important.
The authors note that in recent decades, CEO pay has become more closely linked to measures of firm performance such as the share price. This may push the CEO to please the shareholders by managing the firm in ways that make the performance measure as high as possible.
But performance measures sometimes change for reasons unrelated to CEO decisions. This effectively means that CEOs who make great decisions may suffer and CEOs who make poor decisions may benefit – because of either bad or good luck.
Why do firms reward CEOs for performance influenced by luck? Firms are sometimes able to renege on their promises to pay performance bonuses. But while they are saving money, failing to pay a promised bonus has the disadvantage of angering the CEO, who will be likely to resign.
The more successful a firm expects the employment relationship with its CEO to be in the future, the more it wants the CEO to stay – so the more likely it will be to keep its promises.
Aspects of current firm performance that are beyond the CEO’s control can help to predict the future success of the employment relationship, as long as this ‘luck’ is persistent. In other words, good performance today, even if it is due to luck, makes good performance in the future more likely – and similarly for poor performance.
The implication is that good luck makes it more valuable for the firm to retain the CEO, leading it to pay larger performance bonuses rather than renege on its promises. When luck is more persistent, it reveals more about the likely success of the employment relationship in the future, and has a larger impact on CEO compensation.
Analysing a large sample of American CEOs in publicly traded firms drawn from the ExecuComp and Compustat databases, the researchers construct a persistent measure of luck for each firm. Their results show that this measure is positively correlated with CEO performance pay.
The study also shows that the positive correlation is stronger for firms where the luck measure is more persistent. These results would not be anticipated if all employment relationships were governed by formal contracts that prohibit reneging on bonuses. So this empirical work suggests the presence of more informal contracting relationships between the CEO and the firm, which allows the possibility of reneging on pay.
'Non-Performance Pay and Relational Contracting: Evidence from CEO Compensation’ by Jed DeVaro, Jin?Hyuk Kim and Nick Vikander is published in the August 2018 issue of the Economic Journal.