How does incentive-based pay influence CEO behavior

November 8, 2016

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On the 5th of September of this year, the Guardian posted an article elaborating on the growing compensation for top managers in UK Firms.

“The UK’s largest firms paid directors bigger bonuses in 2015 than the previous year, despite a fall in the number of shareholders backing their remuneration plans, according to analysis by Deloitte. The median salary increased by 2% in 2015, in line with the previous three years, and the median amount that could be earned as a bonus remained at 150% of salary, where it has been since 2007. But its analysis of the UK’s largest companies found that bonus payments in respect of performance increased last year, with the median payout rising to 77% of the maximum possible, from 73% in 2014. Only four companies paid no bonus to executive directors, it said, while seven companies paid the maximum amount possible”.

At the top of a firm’s management is the CEO, who, as the name suggests, makes the executive decisions within a firm. For his daily business he will be compensated accordingly. At least, that is how it is supposed to be. In the past, there have been numerous scandals in the news, in which a CEO received extraordinary amounts of pay, while his job of keeping the firm healthy and at its (near) optimal performance was, softly put, not really well done.
Last April, Bob Dudley, the CEO of BP, was about to receive a reward package of fourteen million pounds (almost sixteen million euros, calculated at the current exchange rate), while BP cut thousands of jobs and recorded losses in 2015. Fortunately, sixty per cent of the shareholders voted against this package, which characterizes a current trend against enormous amounts of executive pay.
It is safe to say that executives of (top-level) firms should be rewarded a large amount of pay, since the job they are doing is highly specialized and the reward should be accordingly. However, if the firm they are managing is performing poorly, their pay should shift with this performance. A way to do this is by giving the managers an incentive to exert costly effort, by linking his remuneration to the firm performance, thus, by rewarding him with stock options or dividend-based pay. The problem that arises with this kind of reward structure, is that a CEO will behave in self-interest or even fraudulent. Hence, how should a CEO be compensated and how does this affect firm performance?

CEO compensation

As introduced previously, a CEO can be rewarded in different ways, but the most common way is a combination of a base salary with bonuses, or cash compensation. Since there have been scandals about the abnormal high salaries of CEOs of a wide array of financial institutions, from NPOs to stock-listed firms, a set of rules and regulations have been implemented, trying to constrain executive compensation. For example, the SEC recently accepted a rule forcing publicly-traded companies to disclose their pay ratio. This rule is mandated by the Dodd-Frank Act and obligates a firm to show the compensation of its CEO to the median compensation of its employee. Such a rule helps shareholders to get insight in the firm and relaxes agency problems.

Agency theory

Agency theory is a well-known supposition in economics. It explains the relationship between agents and principals, which, in the most common case, are respectively managers and stakeholders of a firm. The problem in agency theory is that there are different goals in conducting business for both parties. For example, a manager profits from short-term investment, because this boosts revenue in a certain year, and often the size of his pay-check is linked with year-to-year returns. However, such a short-term investment rarely leads to sustainable growth over the years. On the contrary, a shareholder of a publicly listed firm benefits from long-term investment, since this increases the value of the firm in the long-run.
Causes for agency problems are information asymmetry and moral hazard. With information asymmetry, one party in a business transaction has more information that the opposite party. In agency theory this means quite often that the agent, the manager, has more information than the principal, the shareholder, when he’s conducting business in name of the firm. Moral hazard is the phenomenon in which one of the parties deviates from normal actions, because of the simple reason that he does not face (the same) risks. Therefore, if an agent has more information about a certain transaction, for which he knows only the shareholder will face risks, and he knows he will only benefit, even if it is marginal, in theory he will continue with that transaction.

Compensation model

Since the way a CEO is compensated must be determined before the impact of such a compensation on firm performance can be measured, Benmelech, Kandel and Veronesi (2008) discussed a model for CEO compensation. Their model assumes that there are two ways to reward a CEO with an incentive based compensation; either dividend-based pay or equity-based, for example stock options. Furthermore, they assume that a firm matures at a certain time and with this, the growth rate that accompanies their investments decreases.
If a firm matures, they cannot sustain their high growth rate and a CEO, with the assumption of information asymmetry, is forced to choose; either he tells the shareholders the corporation cannot sustain current growth, through which revenues slow down and the stock price falls, or he conceals the deteriorating growth rate and continues with suboptimal and risky investments to uphold the image of high growth. However, in the last case, if the board discovers that the CEO has been lying and investing suboptimal, he will get fired. This results in a static reporting game, in which the CEO either tells the truth or lies, and through which he changes the stock price.
Assuming the CEO is compensated based on dividends, he has less incentive to put in costly effort to chase high growth rates, since high-growth opportunities lead to high investment, which results in low dividends. Furthermore, if the CEO gets compensated based on the stock-price; he will engage in high investments that lead to high growth rates, which leads to a higher stock price and consequently a higher compensation for the manager. Now, in the first situation, when the firm matures and the manager gets rewarded based on dividends, it causes a pure Nash equilibrium and therefore, he will reveal the truth to continue with optimal investment. However, in the second case, Benmelech, Kandel and Veronesi find that it will result in a pooling Nash equilibrium and the CEO will conduct suboptimal investments to sustain false high growth rates and eventually invest in negative NPV projects to chase high dividends, to conceal the truth for shareholders.
Shortly put, the mission for shareholders is to compensate a CEO in a way such that it aligns the manager’s incentive with that of the shareholders. In other words, the CEO should handle in such a manner that he or she pursues high growth rate, but remains honest about firm performance. With purely dividend-based compensation the CEO will use a low effort/reveal strategy and on the contrary a purely stock-based compensation will result in a high effort/conceal strategy. Following the conclusions of Benmelech et al. the board should reward the CEO with a combination of dividend and stock-based compensation. They discuss that different sizes of firms have different weights on the dividend and stock-components of the combined strategy. For example a high growth firm, with high investment and large return on capital, should put little weight on the stock-component of the strategy, since the stock-component heavily contributes to the conceal strategy with high growth rate.


In 2014, Cooper, Gulen and Ragha Vendra Rau published a paper on CEO incentive compensation and future stock price performance. In accordance with the previously discussed paper of Benmelech, Cooper and Gulen acknowledge the fact that incentive based pay negatively influences firm performance. In contrast, they do not differentiate between different kinds of incentive based pay, but take it as a whole, and measure total compensation as incentive based pay plus the salary and bonuses. However, they do contribute another factor to the influence of CEO compensation on firm performance.
Cooper and Gulen find that different kind of manager styles affect the influence a CEO’s compensation has on the future stock price. For example, two managers can have the same incentive based pay, however, while their pay is the same, they have different effects on future firm performance. Such a manager characteristic, and the one Cooper and Gulen base their research on, is overconfidence. They measure this overconfidence as a proportion of unexercised in-the-money options to total compensation.

Firm performance

To determine the influence of a certain CEO remuneration on firm performance, a definition for firm performance is in place. Cooper and Gulen define firm performance as stock price and returns on capital, or market capitalization. Firm performance is either classified as short-run performance or as long-run performance. Short-run performance is the year-to-year returns on capital. Furthermore, long-term performance relates more to the stock price, since this is a better indicator for firm performance over a longer period of time.
In the research of Cooper and Gulen, they establish that incentive based pay negatively correlates with future performance. However, as mentioned before, they find that if the manager in question has high overconfidence as well, this could be worse for future firm performance. Cooper and Gulen find that a combination of high overconfidence leads to a negative influence on firm performance of -6%. If a manager has high overconfidence, this will subsequently mean that he will be more likely to engage in risky investments or has empire-building preferences. If a certain CEO recklessly tries to expand the size of his firm, by riskful acquisitions, expanding their staff or increasing the value of the assets they possess, rather than increasing the benefits of the shareholders, the executive officer is probably practicing the art of empire building.
Furthermore, Cooper and Gulen explain that if high overconfidence is combined with high tenure, the time the CEO has served in his current position, the proportion of incentive based pay correlates even more negatively, -9%, with firm performance.
However, as Benmelech explained: there is an option to brighten the results of Cooper. By adjusting the incentive based pay to a combination of dividend and stock option pay, the incentive for a CEO to raise the firm’s stock price increases. Nonetheless, the result of Cooper’s and Gulen’s research still stands. As long as a CEO is overconfident, the firm will still perform less, no matter the pay.

Dit artikel is geschreven door Tim van Wilsum


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