Background

It is a generally accepted fact that pay is strongly linked to the performance of a candidate. The CEOs drive the magnitude of holding of equity in the firm. The composition seems to have shifted away from guaranteed compensation in the form of cash salaries, towards pay-at-risk in the form of stock options and equity. However, it is found that the growth in executive pay, in the wider historical context, is a comparatively recent phenomenon.

Stock Opetions

Stock options and ordinary equity shares are directly related to firm’s performance. As their prices increase, the value of CEO’s holdings in the firm also increase. In this sense, pay is linked to performance. We can establish an indirect link with salaries, but the correlation of pay to performance is much weaker for salaries than stock and options.

It is important to distinguish between ‘CEO pay’ and ‘CEO incentives’. CEO pay is the remuneration received in a given period of time in exchange of labour services. This includes salaries, bonuses received, value of option grants, and other share based compensation. In contrast, CEO incentives are the incremental change in total CEO wealth brought about by an incremental change in performance.

Trend

Core and Guay (2010) demonstrated how CEO pay and incentives changed from 1993 to 2008. They found that in year 2000 the median CEO had incentive of $50.2 million. If the stock price fell by 20% then the CEO’s incentive would fall by $10.4 million.

POT_2012_AR_Graph_89a

This figure is much greater than the median CEO’s total compensation for year 2000, which in their data was $6.3 million. They observed the same effect for different years. Hence,they concluded that CEO wealth incentives were much greater than CEO annual pay each year.

However, many people have contested the absolute genuineness of the hypothesis. The goal of most executive incentive plans is to focus leaders on hitting goals and achieving outcomes. But researchers believe that if you want performance, performance is the wrong goal to fixate on. Contingent pay only works for routine tasks. It is detrimental to acts where one requires creativity.

Motivation Vs Performance

Extrinsic motivation leads to suppression of the intrinsic instincts. As a large proportion of a person’s pay is based on variable financial incentive, those people are more likely to cheat. For a complex job such as senior management, it is not possible to precisely measure performance. Use of any measurement by an organization will definitely lead to imperfect quantification.

The relation between pay and performance is a fundamental issue in the executive compensation literature. From an economic perspective the pay-for-performance link is informative about the severity of the agency problem. The stronger is the link between pay and performance, the less severe are agency concerns.

Thus, to conclude, pay-for-performance tells us the compensation received by the CEO is justified by the improvements in firm performance. In this sense, the CEO’s compensation is justified and is attributed as his reward.

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