Ceo Compensation Guide

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CEO Compensation
Carola Frydman1 Dirk Jenter2
November 2010

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Sloan School of Management, Massachusetts Institute of Technology, Cambridge, Massachusetts 02142; email: frydman@mit.edu Graduate School of Business, Stanford University, Stanford, California 94305; email: djenter@stanford.edu

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Abstract This paper surveys the recent literature on CEO compensation. The rapid rise in CEO pay over the past 30 years has sparked an intense debate about the nature of the pay-setting process. Many view the high level of CEO compensation as the result of powerful managers setting their own pay. Others interpret high pay as the result of optimal contracting in a competitive market for managerial talent. We describe and discuss the empirical evidence on the evolution of CEO pay and on the relationship between pay and firm performance since the 1930s. Our review suggests that both managerial power and competitive market forces are important determinants of CEO pay, but that neither approach is fully consistent with the available evidence. We briefly discuss promising directions for future research.

Key Words
Executive compensation, managerial incentives, incentive compensation, equity compensation, option compensation, corporate governance

Electronic copy available at: http://ssrn.com/abstract=1582232

1. Introduction
Executive compensation is a complex and contentious subject. The high level of CEO pay in the United States has spurred an intense debate about the nature of the pay-setting process and the outcomes it produces. Some argue that large executive pay packages are the result of powerful managers setting their own pay and extracting rents from firms. Others interpret the same evidence as the result of optimal contracting in a competitive market for managerial talent. This survey summarizes the research on CEO compensation and assesses the evidence for and against these explanations. Our review suggests that both managerial power and competitive market forces are important determinants of CEO pay, but that neither approach alone is fully consistent with the available evidence. The evolution of CEO compensation since World War II can be broadly divided into two distinct periods. Prior to the 1970s, we observe low levels of pay, little dispersion across top managers, and moderate pay-performance sensitivities. From the mid-1970s to the early 2000s, compensation levels grew dramatically, differences in pay across managers and firms widened, and equity incentives tied managers’ wealth closer to firm performance. None of the existing theories offers a fully convincing explanation for the apparent regime change that occurred during the 1970s, and all theories have trouble explaining some of the cross-sectional and time-series patterns in the data. Many of the theoretical studies we review explore how various characteristics of real-world compensation contracts can be consistent with either rent extraction or optimal contracting. Although useful, demonstrating that a given compensation feature can arise in an optimal contracting (or rent extraction) framework provides little evidence that the feature is, in fact, used for efficiency reasons (or to extract rents). Partly as a result, there is no consensus on the relative importance of rent extraction and optimal contracting in determining the pay of the typical CEO. To help answer this question, models of CEO pay will have to produce testable predictions that differ between the two approaches. We expect that the renewed interest in theoretical work on CEO pay and the emergence of new data will deliver both the predictions and the testing opportunities needed to resolve this debate. Promising recent contributions have examined the effects of 2

Electronic copy available at: http://ssrn.com/abstract=1582232

exogenous changes in the contracting environment on CEO compensation, firm behavior, and firm performance. For example, industry deregulations have been...
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