PERFORMANCE PAY AND TOP-MANAGEMENT INCENTIVES

Our estimates of the pay-performance relation (including pay, options, stockholdings, and dismissal) for chief executive officers indicate that CEO wealth changes $3.25 for every $1,000 change in shareholder wealth. Although the incentives generated by stock ownership are large relative to pay and dismissal incentives, most CEOs hold trivial fractions of their firms’ stock, and ownership levels have declined over the past 50 years. We hypothesize that public and private political forces impose constraints that reduce the payperformance sensitivity. Declines in both the pay-performance relation and the level of CEO pay since the 1930s are consistent with this hypothesis.  The conflict of interest between shareholders of a publicly owned corporation and the corporation’s chief executive officer (CEO) is a classic example of a principal-agent problem. If shareholders had complete information regarding the CEO’s activities and the firm’s investment opportunities, they could design a contract specifying and enforcing the managerial action to be taken in each state of the world. Managerial actions and investment opportunities are not, however, perfectly observable by shareholders; indeed, shareholders do not often know what actions the CEO can take or which of these actions will increase shareholder wealth. In these situations, agency theory predicts that * We have benefitted from the assistance of Stephanie Jensen, Natalie Jensen, Mary Rojek, and Mike Stevenson and from the comments of Sherwin Rosen (the editor), George Baker, Carliss Baldwin, Ray Ball, Gary Becker, Joseph Bower, James Brickley, Jeffrey Coles, Harry DeAngelo, Robert Gibbons, Gailen Hite, Clifford Holderness, Robert Kaplan, Steven Kaplan, Edward Lazear, Richard Leftwich, John Long, Jay Lorsch, John McArthur, Paul MacAvoy, Kenneth McLaughlin, Kenneth Merchant, Andrall Pearson, Ronald Schmidt, G. William Schwert, Robert Simons, Jerold Warner, Ross Watts, and Jerold Zimmerman. This research is supported by the Division of Research, Harvard Business School; the Managerial Economics Research Center, University of Rochester; and the John M. Olin Foundation. Kevin J. Murphy and Michael C. Jensen 2 compensation policy will be designed to give the manager incentives to select and implement actions that increase shareholder wealth. Shareholders want CEOs to take particular actions—for example, deciding which issue to work on, which project to pursue, and which to drop—whenever the expected return on the action exceeds the expected costs. But the CEO compares only his private gain and cost from pursuing a particular activity. If one abstracts from the effects of CEO risk aversion, compensation policy that ties the CEO’s welfare to shareholder wealth helps align the private and social costs and benefits of alternative actions and thus provides incentives for CEOs to take appropriate actions. Shareholder wealth is affected by many factors in addition to the CEO, including actions of other executives and employees, demand and supply conditions, and public policy. It is appropriate, however, to pay CEOs on the basis of shareholder wealth since that is the objective of shareholders. There are many mechanisms through which compensation policy can provide value-increasing incentives, including performance-based bonuses and salary revisions, stock options, and performance-based dismissal decisions. The purpose of this paper is to estimate the magnitude of the incentives provided by each of these mechanisms. Our estimates imply that each $1,000 change in shareholder wealth corresponds to an average increase in this year’s and next year’s salary and bonus of about two cents. We also estimate the CEO wealth consequences associated with salary revisions, outstanding stock options, and performance-related dismissals; our upper-bound estimate of the total change in the CEO’s wealth from these sources that are under direct control of the board of directors is about 75¢ per $1,000 change in shareholder wealth. Stock ownership is another way an executive’s wealth varies with the value of the firm. In our sample CEOs hold a median of about 0.25 percent of their firms’ common stock, including exercisable stock options and shares held by family members or connected trusts. Thus the value of the stock owned by the median CEO changes by $2.50 whenever the value of the firm changes by $1,000. Therefore, our final allKevin J. Murphy and Michael C. Jensen 3 inclusive estimate of the pay-performance sensitivity—including compensation, dismissal, and stockholdings—is about $3.25 per $1,000 change in shareholder wealth. In large firms CEOs tend to own less stock and have less compensation-based incentives than CEOs in smaller firms. In particular, our all-inclusive estimate of the pay-performance sensitivity for CEOs in firms in the top half of our sample (ranked by market value) is $1.85 per $1,000, compared to $8.05 per $1,000 for CEOs in firms in the bottom half of our sample. We believe that our results are inconsistent with the implications of formal agency models of optimal contracting. The empirical relation between the pay of top-level executives and firm performance, while positive and statistically significant, is small for an occupation in which incentive pay is expected to play an important role. In addition, our estimates suggest that dismissals are not an important source of managerial incentives since the increases in dismissal probability due to poor performance and the penalties associated with dismissal are both small. Executive inside stock ownership can provide incentives, but these holdings are not generally controlled by the corporate board, and the majority of top executives have small personal stockholdings. Our results are consistent with several alternative hypotheses; CEOs may be unimportant inputs in the production process, for example, or their actions may be easily monitored and evaluated by corporate boards. We offer an additional hypothesis relating to the role of political forces in the contracting process that implicitly regulate executive compensation by constraining the type of contracts that can be written between management and shareholders. These political forces, operating both in the political sector and within organizations, appear to be important but are difficult to document because they operate in informal and indirect ways. Public disapproval of high rewards seems to have truncated the upper tail of the earnings distribution of corporate executives. Equilibrium in the managerial labor market then prohibits large penalties for poor performance, and as a result the dependence of pay on performance is decreased. Our Kevin J. Murphy and Michael C. Jensen 4 findings that the pay-performance relation, the raw variability of pay changes, and inflation-adjusted pay levels have declined substantially since the 1930s are consistent with such implicit regulation. I. Estimates of the Pay-Performance Sensitivity We define the pay-performance sensitivity, b, as the dollar change in the CEO’s wealth associated with a dollar change in the wealth of shareholders. We interpret higher b’s as indicating a closer alignment of interests between the CEO and his shareholders. Suppose, for example, that a CEO is considering a nonproductive but costly “pet project” that he values at $100,000 but that will diminish the value of his firm’s equity by $10 million. The CEO will avoid this project if his pay-performance sensitivity exceeds b = .01 (through some combination of incentive compensation, options, stock ownership, or probability of being fired for poor stock price performance) but will adopt the project if b < .01. Incentives Generated by Cash Compensation The pay-performance sensitivity is estimated by following all 2,213 CEOs listed in the Executive Compensation Surveys published in Forbes from 1974 to 1986. These surveys include executives serving in 1,295 corporations, for a total of 10,400 CEO-years of data. We match these compensation data to fiscal year corporate performance data obtained from the data files of the Compustat and the Center for Research in Security Prices (CRSP). After observations with missing data are eliminated, the final sample contains 7,750 yearly “first differences” in compensation and includes 1,688 executives from 1,049 corporations. Fiscal year stock returns are unavailable for 219 of the 7,750 observations; calendar-year returns are used in these cases. (Deleting these 219 observations does not affect the results.) All monetary variables are adjusted for inflation Kevin J. Murphy and Michael C. Jensen 5 (using the consumer price index for the closing month of the fiscal year) and represent thousands of 1986 constant dollars. Table 1 summarizes estimates of the relation between CEO cash compensation and firm performance as measured by the change in shareholder wealth. Column 1 of table 1 reports estimated coefficients from the following least-squares regression: ∆(CEO salary + bonus)t = a + b∆(shareholderwealth)t . (1) The change in shareholder wealth variable is defined as r tVt-1, where rt is the inflationadjusted rate of return on common stock realized in fiscal year t, and Vt-1 is the firm value at the end of the previous year. Our measu