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CEO “Pay for Luck” Versus “Pay for Performance” Explained
CEO compensation was a hot topic from Wall Street to Main Street even before the financial crisis focused public and regulatory scrutiny on investment banking execs and their salaries. It is also the topic of an award-winning paper by Olin professors Todd Milbourn and Radha Gopalan, along with Fenghua Song of Penn State, that received the Citigroup Award for best paper at the Centre for Analytical Finance Summer Research Conference on "Recent Advances in Corporate Finance." The conference was held in July and the paper titled “Strategic Flexibility and the Optimality of Pay for Sector Performance.”While standard contract theory suggests that a CEO should be paid relative to a benchmark that removes the effects of sector performance, there is evidence that CEO pay is strongly and positively related to such sector performance. This relationship has been coined "pay for luck." In their paper, Milbourn, Gopalan and Song model a CEO charged with selecting a firm’s strategy, which determines the firm’s exposure to sector performance. Consistent with their predictions, the authors’ empirical analysis indicates that the observed sensitivity of pay to sector performance is almost fully confined to multisegment firms and is greater in firms that offer greater strategic flexibility to alter sector exposure, for more talented CEOs and for CEOs as compared with their subordinate executives.
Click here to read the complete paper.
