Performance-Pay-and-Top-Management-Incentives[1]

PerformancePayandTop-ManagementIncentives*MichaelC.JensenGraduateSchoolofBusinessAdministrationHarvardUniversityKevinJ.MurphyWilliamE.SimonGraduateSchoolofBusinessAdministrationUniversityofRochesterJune,1989(forthcoming,JournalofPoliticalEconomy,April1990)AbstractOurestimatesofthepay-performancerelation(includingpay,options,stockholdings,anddismissal)forchiefexecutiveofficersindicateCEOwealthchanges$3.25forevery$1,000changeinshareholderwealth.Althoughtheincentivesgeneratedbystockownershiparelargerelativetopayanddismissalincentives,mostCEOsholdtrivialfractionsoftheirfirm'sstockandownershiplevelshavedeclinedoverthepast50years.Wehypothesizethatpublicandprivatepoliticalforcesimposeconstraintsthatreducethepay-performancesensitivity.Declinesinboththepay-performancerelationandthelevelofCEOpaysincethe1930sareconsistentwiththishypothesis.*WehavebenefitedfromtheassistanceofStephanieJensen,NatalieJensen,MaryRojek,andMikeStevenson,andfromthecommentsofGeorgeBaker,CarlissBaldwin,RayBall,GaryBecker,JosephBower,JamesBrickley,JeffreyColes,HarryDeAngelo,RobertGibbons,GailenHite,CliffordHolderness,RobertKaplan,StevenKaplan,EdwardLazear,RichardLeftwich,JohnLong,JayLorsch,PaulMacAvoy,JohnMcArthur,KennethMcLaughlin,KennethMerchant,AndrallPearson,SherwinRosen,RonaldSchmidt,G.WilliamSchwert,RobertSimons,JeroldWarner,RossWatts,andJeroldZimmerman.ThisresearchissupportedbytheDivisionofResearch,HarvardBusinessSchool,theManagerialEconomicsResearchCenter,UniversityofRochester,andtheJohnM.OlinFoundation.PERFORMANCEPAYANDTOP-MANAGEMENTINCENTIVESMichaelC.JensenandKevinJ.MurphyTheconflictofinterestbetweenshareholdersofapubliclyownedcorporationandthecorporation'schiefexecutiveofficer(CEO)isaclassicexampleofaprincipal-agentproblem.IfshareholdershadcompleteinformationregardingtheCEO'sactivitiesandthefirm'sinvestmentopportunities,theycoulddesignacontractspecifyingandenforcingthemanagerialactiontobetakenineachstateoftheworld.Managerialactionsandinvestmentopportunitiesarenot,however,perfectlyobservablebyshareholders;indeed,shareholdersdon'toftenknowwhatactionstheCEOcantakeorwhichoftheseactionswillincreaseshareholderwealth.Inthesesituations,agencytheorypredictsthatcompensationpolicywillbedesignedtogivethemanagerincentivestoselectandimplementactionsthatincreaseshareholderwealth.ShareholderswantCEOstotakeparticularactions—e.g.,decidingwhichissuetoworkon,whichprojecttopursue,andwhichtodrop—whenevertheexpectedreturnontheactionexceedstheexpectedcosts.ButtheCEOcomparesonlyhisprivategainandcostfrompursuingaparticularactivity.AbstractingfromtheeffectsofCEOriskaversion,compensationpolicythattiestheCEO'swelfaretoshareholderwealthhelpsaligntheprivateandsocialcostsandbenefitsofalternativeactionsandthusprovidesincentivesforCEOstotakeappropriateactions.ShareholderwealthisaffectedbymanyfactorsinadditiontotheCEO,includingactionsofotherexecutivesandemployees,demandandsupplyconditions,andpublicpolicy.Itisappropriate,however,topayCEOsonthebasisofshareholderwealthsincethatistheobjectiveofshareholders.MICHAELC.JENSENANDKEVINJ.MURPHYPAGE2JUNE4,1989Therearemanymechanismsthroughwhichcompensationpolicycanprovidevalue-increasingincentives,includingperformance-basedbonusesandsalaryrevisions,stockoptions,andperformance-baseddismissaldecisions.Thepurposeofthispaperistoestimatethemagnitudeoftheincentivesprovidedbyeachofthesemechanisms.Ourestimatesimplythateach$1,000changeinshareholderwealthcorrespondstoanaverageincreaseinthisyear'sandnextyear'ssalaryandbonusofabouttwocents.WealsoestimatetheCEO-wealthconsequencesassociatedwithsalaryrevisions,outstandingstockoptions,andperformance-relateddismissals;ourupper-boundestimateofthetotalchangeintheCEO'swealthfromthesesourcesthatareunderdirectcontroloftheboardofdirectorsisabout75¢per$1,000changeinshareholderwealth.Stockownershipisanotherwayanexecutive'swealthvarieswiththevalueofthefirm.CEOsinoursampleholdamedianofabout.25%oftheirfirms'commonstock,includingexercisablestockoptionsandsharesheldbyfamilymembersorconnectedtrusts.Thus,thevalueofthestockownedbythemedianCEOchangesby$2.50wheneverthevalueofthefirmchangesby$1,000.Therefore,ourfinalall-inclusiveestimateofthepay-performancesensitivity—includingcompensation,dismissal,andstockholdings—isabout$3.25per$1,000changeinshareholderwealth.CEOsinlargefirmstendtoownlessstockandhavelesscompensation-basedincentivesthanCEOsinsmallerfirms.Inparticular,ourall-inclusiveestimateofthepay-performancesensitivityforCEOsinfirmsinthetophalfofoursample(rankedbymarketvalue)is$1.85per$1,000,comparedto$8.05per$1,000forCEOsinfirmsinthebottomhalfofoursample.Webelieveourresultsareinconsistentwiththeimplicationsofformalagencymodelsofoptimalcontracting.Theempiricalrelationbetweenthepayoftop-levelexecutivesandfirmperformance,whilepositiveandstatisticallysignificant,issmallforanoccupationwhereincentivepayisexpectedtoplayanimportantrole.Inaddition,ourestimatessuggestthatdismissalsarenotanimportantsourceofmanagerialincentivessincetheincreasesindismissalMICHAELC.JENSENANDKEVINJ.MURPHYPAGE3JUNE4,1989probabilityduetopoorper