A review of CEO compensation

CEO’s compensation has been a contentious subject. This review surveys the research

that has been done in this filed and puts extra emphasis on the recent research over the

past ten years. The central topic of this survey is the determinants of CEO’s

compensation. Both theoretical research and empirical research will be discussed.

1. Introduction

The issue of Chief Executive Officers (CEO) compensation has garnered attention from

inside the academia and outside it. Whether CEO is over-paid has long been a matter

of controversy. While the wage of ordinary people has stagnated, we see the rankings

of the highest-paid CEOs, topped by men like David Cote of Honeywell, who in 2013

took home $16 million in salary and bonus, and another $9 million in stock options.

Meanwhile the U.S Bureau of the Census has the annual real median personal income

at $31,099 in 2016. It’s hard not to notice that the huge difference between the wage of

an ordinary US worker and that of a typical CEO creates wealth inequality between

classes. Note also that the highest-paid CEO are all men until number 21, which

suggests a disparity between men and women.

From a theoretical viewpoint, there are in general two opposing views as to whether a

CEO’s compensation is justified. One holds that CEO’s compensation is mainly a

product of managerial power. In other words, a CEO mostly stipulates his compensation.

The other holds that CEO’s compensation is chiefly decided by a competitive labor

market. Neither approach is fully in consistence with empirical evidence. Therefore

either a blend of these two or perhaps a drastic departure from them are needed to make

actual further progress.

On the other hand, the financial crisis of 2007 and 2008 has generated interest anew in

the studying of effects of CEO’s compensation on CEO’s behavior and firm value.

However, it has been difficult to reach convincing conclusion about such effects

because the main problem with measuring the effects of compensation is one of

endogeneity.

2. Components of CEO compensation

The main components of CEO compensation are salary, annual bonus, payouts from

long-term incentive plans, restricted option grants, and restricted stock grants. CEO

receive pension when they retire and severance payments when they leave. The

proportion of each component of CEO compensation has changed significantly from

initially salary based to option-based, to heavily restricted stock grants based over time.

A surge in the weight of option started in 1980s. Intuitively, this is understandable

because the value of option is directly tied to the price of stocks of a firm and therefore

CEO’s incentive is closely linked to firm’s performance. Throughout the 80s and 90s,

stock option was the biggest component of top executive compensation. However, since

the beginning of 21 century, restricted stock grants took over and became the dominant

component in both absolute terms and relative terms. Note that this prominent shifts

has not received attention to research and it will be a breakthrough if researchers give

solid justification for this phenomenon.

pensions, and severance pay are also important components of compensation. While
the component directly linked to firm performance such as stock options and restricted

stock grants is believed to incentivize CEO to engage in risky behavior, pension and

other deferred compensation serve to balance CEO’s tendency towards risk. Bebchuk

& Jackson (2005) estimates that the median actuarial value at retirement is around $15

million, which translates to roughly 35% of the CEO’s total compensation throughout

her tenure. Therefore careless addressing of pension may cause severe underestimation

of CEO compensation. Sundaram et at.(2007) find that CEO compensation exhibits a

balance between debt and equity incentives; the balance shifts systematically away

from equity and toward debt as CEOs grow older. Clemens (2011) studies the effect of

chief executive officer (CEO) optimism on CEO compensation. Using data on

compensation in US firms, he provides evidence that CEOs whose option exercise

behavior and earnings forecasts are indicative of optimistic beliefs receive smaller stock

option grants, fewer bonus payments, and less total compensation than their peers.

Gande et al. (2016) shows that equity incentives embedded in CEO compensation

contracts are positively associated with risk-taking in financial firms, which resulted in

potential solvency problems that left these firms with no other option but to use the

emergency financial assistance provided by the Federal Reserve.

3. Determination of CEO compensation

Rapid rise in CEO compensation since 80s has garnered a lot of debate as to the likely

cause of it. Researchers have put forth a great many theories in an effort to explain the

determinants of executive compensation. There have been mainly five major branches

so far: (1) the managerial rent extraction theory, (2) increasing returns to general rather
than special skills, (3)competitive pay, (4)corporate governance, and (5) “miscellaneous”

theories that are hard to classify.

3.1. The managerial rent extraction theory

The rent extraction theory basically proposes that CEO abuse their power in affecting

their compensation due to weak corporate governance. Bebchuk & Fried (2004)

predicts that rent extraction is mostly concentrated in the form of compensation that is

unobservable or hard to observe, such as stock options, pension and severance pay. This

is an explanation which could provide the justification for the growth in the use of stock

options from the start of 1980s till the end of 1990s. This theory also suggests that the

level of compensation and the use of forms of remuneration that are easier to conceal

such as stock options would be higher in periods when corporate governance is weaker.

Garvey et al. (2006) find that executive pay is tied to only good luck but not bad luck.

Their finding supports the view that executives can truly influence the setting of their

pay: executives will seek to have their performance benchmarked only when it is in

their interest, namely, when the benchmark has fallen. However, Kuhnen & Zwiebel

(2009) proposes that CEOs set their own pay, with both observable and unobservable

components, subject to the constraint that too much rent extraction will get them fired

find that such rent extraction can even survives in market equilibrium because firing is

simply costly and replacing a CEO can also extract rents. CEOs’ power in determining

the compensation might have been overrated because of the overlook of other

committee forces at play. Christian Laux et al (2009) develop a theory to study how the

separation of setting CEO pay and watching CEO affects earnings management. They
find the compensation committee will increase the use of stock-based CEO pay, as the

increased cost of oversight is borne by the audit committee. As a consequence, the

separation of board functions is associated with greater stock-based CEO compensation.

However, the increase in CEO equity incentives does not necessarily lead to a higher

level of earnings management because the audit committee will adjust its oversight

effort in response to a change in CEO incentives

3.2. From specialists to generalists

Researchers have associated the sharp rise in CEO compensation with a shift of demand

for the types of talents. Murphy and Zabojnik (2004) suggests that CEO compensation

increases rapidly because general management skills is valued significantly more

relative to firm specific abilities. The shift fuels the competition for talents, thereby

improving the outside option of executives and allowing them to extract a larger

fraction of firms rents. Therefore Frydman and Saks (2010) predicts a higher average

and more dispersion of pay across executives as managerial skills become more general.

Paul Brockman et al. (2016) show that each attribute has a significant impact on both

the level and structure of CEO compensation. CEOs with a high generalist-outsider

combination receive the highest total compensation, followed by generalist-insiders,

specialist-outsiders, and finally specialist-insiders. Our time-series results show that the

generalist-specialist effect remains constant through time while the insider-outsider

effect diminishes over time. These findings suggest that the generalist premium is the

result of a fundamental shift in the need for generalist skills to manage increasingly-

complex enterprises. In contrast, the outsider premium is more likely caused by a

temporary increase in bargaining power during contract negotiations.

3.3. Competitive compensation

This theory basically champions the idea that rise in CEO compensation has been a

result of market competition. For example, Baker & Hall（2004） finds that an increase

in firm size improves the optimal level of CEO effort, and thus incentives, if the

marginal product of CEO effort increases with the size of the firm. Gabaix et al. (2008)

finds that the span of control and competitive assignment of CEOs to heterogeneous

firms also suggest a positive cross-sectional correlation between firm size and

compensation. Cao et al. (2013) develops an equilibrium model with search theory

where a CEO can choose to stay or quit and search after privately observing an

idiosyncratic shock to the firm. They show that the optimal pay-to-performance ratio is

less than one even when the CEO is risk neutral.

3.4. Corporate governance

This class of theories can be seen as variants of the first kind of theories in that they

admit the managerial power in determining the CEO compensation but also take into

consideration that the existence of committee or board of directors may largely limits

CEOs’ tendency towards setting inappropriately high pay for themselves. Therefore the

growth in CEO pay is the interplay of stricter corporate governance and improved

monitoring of CEOs by boards and large shareholders. The intuition is that CEO job

stability is negatively correlated to monitoring intensity and firms optimally respond by

increasing the level of CEO compensation. (Hermalin 2005). In other words, increase

in the probability of getting fired as corporate governance strengthens must be

compensated by increase in the level of CEO pay.

In response to corporate scandals in 2001 and 2002, major U.S. stock exchanges issued

new board requirements to enhance board oversight. Chhaochharia et al (2009) find a

significant decrease in CEO compensation for firms that were more affected by these

requirements, compared with firms that were less affected, taking into account

unobservable firm effects, time-varying industry effects, size, and performance. The

decrease in compensation is particularly pronounced in the subset of affected firms with

no outside blockholder on the board and in affected firms with low concentration of

institutional investors.

While Chhaochharia et al. (2009) estimate that CEO pay decreases 17% more in firms

that were not compliant with the NYSE/Nasdaq board independence requirement

than in firms that were compliant, Guthrie et al. (2012) document that 74% of this

magnitude is attributable to two outliers of 865 sample firms. In addition, they find that

the compensation committee independence requirement increases CEO total pay,

particularly in the presence of effective shareholder monitoring. Their evidence casts

doubt on the effectiveness of independent directors in constraining CEO pay as

suggested by the managerial power hypothesis.

3.5. Miscellaneous

These are the theories hard to classify. Most of them are of purely empirical nature and

therefore it is difficult to attribute their results to any of the four aforementioned

branches. Chang，et al. (2014) suggest that financial distress risk alters the nature of

the agency relationship in ways that lead firms to provide CEOs with more equity-based
incentives. Their main two findings are that new CEOs receive significantly more

compensation when financial distress risk is higher and financial distress risk is

associated with the incentives provided to new CEOs; distress risk is positively

associated with pay-performance sensitivity and equity-based compensation and is

negatively associated with cash bonuses. Song et al. (2014) find that compensation is

higher when CEOs have employment agreements that are written, longer in duration,

or more explicit in terms. Cesari et al. (2016) find that CEOs in family firms do not

experience an increase in their compensation during the post-acquisition period, while

there is a positive and statistically significant association between the compensation of

CEOs in nonfamily firms and their acquisition activity. Conyona et al. (2018) find that

foreign CEOs and national CEOs with foreign working experience receive significantly

higher levels of total compensation compared to similar UK CEOs without such

characteristics. Yu et al. (2017) find that geographical relationships are related to lower

pay–performance sensitivity, and that the correlation mainly exists in poor performance

periods, suggesting that geographical relationships weaken the effectiveness of

compensation contracts.

4. Other Research and new perspectives

Arora et al. (2005) offers a completely new perspective on CEO pay by investigating

whether the adoption of long-term incentive plans aligns the interest of the CEO with

the interest of the primary stakeholders in the firm. Using the fixed-effect regression,

their results indicate a significant association between the change in CEO compensation

and the claims of the customers, shareholders, and employees.

5. Conclusion

CEO pay has risen sharply over the last few decades. Researchers have proposed

different theories to account for such a rise. Two contentious kinds of theories have

been developed. One holds that CEO pay is mainly a consequence of labor market force

at play whereas the other posits that managerial power ultimately determines CEO

compensation. CEO compensation’s components have also changed significantly in

absolute terms and relative terms. While researchers have extensively studied the

determinants of rise in pay, research on the changes of and in components does not

seem to have caught much attention as the former research. Therefore, research topics

such as why firms start to use more restricted stock grants than options for CEO

compensation should invite researchers’ interest.

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