Executive Compensation

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2006

Conyon

25

Executive Compensation and Incentives
Martin J. Conyon*

Executive Overview
The objective of a properly designed executive compensation package is to attract, retain, and motivate CEOs and senior management. The standard economic approach for understanding executive pay is the principal-agent model. This paper documents the changes in executive pay and incentives in U.S. firms between 1993 and 2003. We consider reasons for these transformations, including agency theory, changes in the managerial labor markets, shifts in firm strategy, and theories concerning managerial power. We show that boards and compensation committees have become more independent over time. In addition, we demonstrate that compensation committees containing affiliated directors do not set greater pay or fewer incentives.

Introduction
xecutive compensation is a complex and controversial subject. For many years, academics, policymakers, and the media have drawn attention to the high levels of pay awarded to U.S. chief executive officers (CEOs), questioning

whether they are consistent with shareholder interests.1 Some academics have further argued that flaws in CEO pay arrangements and deviations
from shareholders’ interests are widespread and
considerable.2 For example, Lucian Bebchuk and
Jesse Fried provide a lucid account of the managerial power view and accompanying evidence.3 Marianne Bertrand and Sendhil Mullainathan too
provide an analysis of the ‘skimming view’ of CEO
pay.4 In contrast, John Core et al. present an
economic contracting approach to executive pay
and incentives, assessing whether CEOs receive
inefficient pay without performance.5 In this paper, we show what has happened to CEO pay in the United States. We do not claim to distinguish
between the contracting and managerial power
views of executive pay. Instead, we document the
pattern of executive pay and incentives in the
United States, investigating whether this pattern
is consistent with economic theory.

E

The Context: Who Sets Executive Pay?
efore examining the empirical evidence presented in this paper, it is important to consider the pay-setting process and who sets executive
pay. The standard economic theory of executive

B

compensation is the principal-agent model.6 The
theory maintains that firms seek to design the most
efficient compensation packages possible in order to
attract, retain, and motivate CEOs, executives, and
managers.7 In the agency model, shareholders set
pay. In practice, however, the compensation committee of the board determines pay on behalf of shareholders. A principal (shareholder) designs a
contract and makes an offer to an agent (CEO/
manager). Executive compensation ameliorates a
moral hazard problem (i.e., manager opportunism)
arising from low firm ownership. By using stock
options, restricted stock, and long-term contracts,
shareholders motivate the CEO to maximize firm
value. In other words, shareholders try to design
optimal compensation packages to provide CEOs
with incentives to align their mutual interests. This
is the contract approach to executive pay. Following
Core, Guay, and Larcker,8 an efficient (or optimal)
contract is one “that maximizes the net expected
economic value to shareholders after transaction
costs (such as contracting costs) and payments to
employees. An equivalent way of saying this is that
. . . contracts minimize agency costs.”
Several important ideas flow from this definition. First, the contract reduces manager opportunism and motivates CEO effort by providing incentives through risky compensation such as stock options. Second, the optimal contract does not imply a “perfect” contract, only that the firm designs the best contract it can in order to avoid opportunism and malfeasance by the manager, given the

* Martin Conyon is an Assistant Professor of Management at the Wharton School, University of Pennsylvania. Contact:...
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