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Performance Pay and Top-Management Incentives Michael C. Jensen Haniard University Kevin J. Murphy University of Rochester Our estimates of the pav-performance relation (including pav, options, stockholdings, and dismissal) for chief executive officers indicate that CEO wealth changes S3.25 for everv S1,UOU change in shareholder wealth. Although the incentives generated b\\ stock ownership are large relative to pav and dismissal incentives, most CEOs hold trivial fractions of their firms' stock, and ownership levels have declined over the past 50 years. We hypothesize that public and private political forces impose const^iints that reduce the payperformance sensiti\\itv. Declines in both the pay-performance relation and the level of CEO pa\\ since the 1930s are consistent with this hypothesis. The conflict of interest between shareholders of a publicly owned corporation and the corporation's chief executive officer (CEO) is a We have benefited from the assistance of Stephanie Jensen, Natalie Jensen, Marv Rojek, and Mike Stevenson and from the comments of Sherwin Rosen (the editor), George Baker, Carliss Baldwin, Rav Ball, Gan Becker, Joseph Bower, James Bricklev, Jeffrey Coles, Harry DeAngelo, Robert Gibbons, Gailen Hite, Clifford Holderness, Robert Kaplan, Steven Kaplan, Edward Lazear, Richard Leftwich, John Long, Jav Lorsch, John McArthur, Paul MacAvov, Kenneth McLaughlin, Kenneth Merchant, Andrall Pearson, Ronald Schmidt, G. William Schwert, Robert Simons, Jerold Warner, Ross Watts, and Jerold Zimmerman. This research is supported bv the Di\\ision of Research, Harvard Business School; the Managerial Economics Research Center, University of Rochester; and the John M. Olin Foundation. {Journal of Poblual Econ(m\\. 1990. vol. 98. no. 2] 1990 by The University of Chicago. All rights resened. 0022-3808/90/9802-0006$01.50 225 2 26 JOURNAL OF POLITICAL ECONOMY classic example of a principal-agent problem. If shareholders had complete information regarding the CEO's activities and the firm's investment opportunities, they could design a contract specifying and enforcing the managerial action to be taken in each state of the world. Managerial actions and investment opportunities are not, however, perfectly observable by shareholders; indeed, shareholders do not often know what actions the CEO can take or which of these actions will increase shareholder wealth. In these situations, agency theory predicts that compensation policy will be designed to give the manager incentives to select and implement actions that increase shareholder wealth. Shareholders want CEOs to take particular actionsfor example, deciding which issue to work on, which project to pursue, and which to dropwhenever the expected return on the action exceeds the expected costs. But the CEO compares only his private gain and cost from pursuing a particular activity. If one abstracts from the effects of CEO risk aversion, compensation policy that ties the CEO's welfare to shareholder wealth helps align the private and social costs and benefits of alternative actions and thus provides incentives for CEOs to take appropriate actions. Shareholder wealth is affected by many factors in addition to the CEO, including actions of other executives and employees, demand and supply conditions, and public policy. It is appropriate, however, to pay CEOs on the basis of shareholder wealth since that is the objective of shareholders. There are many mechanisms through which compensation policy can provide value-increasing incentives, including performancebased bonuses and salary revisions, stock options, and performancebased dismissal decisions. The purpose of this paper is to estimate the magnitude of the incentives provided by each of these mechanisms. Our estimates imply that each $1,000 change in shareholder wealth corresponds to an average increase in this year's and next year's salary and bonus of about two cents. We also estimate the CEO wealth consequences associated with salary revisions, outstanding stock options, and performance-related dismissals; our upper-bound estimate of the total change in the CEO's wealth from these sources that are under direct control of the board of directors is about 75^ per $1,000 change in shareholder wealth. Stock ownership is another way an executive's wealth varies with the value of the firm. In our sample CEOs hold a median of about 0.25 percent of their firms' common stock, including exercisable stock options and shares held by family members or connected trusts. Thus the value of the stock owned by the median CEO changes by $2.50 whenever the value of the firm changes by $1,000. Therefore, our final all-inclusive estimate of the pay-performance sensitivity TOP-MANAGEMENT INCENTIVES 2 27 including compensation, dismissal, and stockholdingsis about $3.25 per $1,000 change in shareholder wealth. In large firms CEOs tend to own less stock and have less compensation-based incentives than CEOs in smaller firms. In particular, our all-inclusive estimate of the pay-performance sensitivity for CEOs in firms in the top half of our sample (ranked by market value) is $1.85 per $1,000, compared to $8.05 per $1,000 for CEOs in firms in the bottom half of our sample. We believe that our results are inconsistent with the implications of formal agency models of optimal contracting. The empirical relation between the pay of top-level executives and firm performance, while positive and statistically significant, is small for an occupation in which incentive pay is expected to play an important role. In addition, our estimates suggest that dismissals are not an important source of managerial incentives since the increases in dismissal probability due to poor performance and the penalties associated with dismissal are both small. Executive inside stock ownership can provide incentives, but these holdings are not generally controlled by the corporate board, and the majority of top executives have small personal stockholdings. Our results are consistent with several alternative hypotheses; CEOs may be unimportant inputs in the production process, for example, or their actions may be easily monitored and evaluated by corporate boards. We offer an additional hypothesis relating to the role of political forces in the contracting process that implicitly regulate executive compensation by constraining the type of contracts that can be written between management and shareholders. These political forces, operating both in the political sector and within organizations, appear to be important but are difficult to document because they operate in informal and indirect ways. Public disapproval of high rewards seems to have truncated the upper tail of the earnings distribution of corporate executives. Equilibrium in the managerial labor market then prohibits large penalties for poor performance, and as a result the dependence of pay on performance is decreased. Our findings that the pay-performance relation, the raw variability of pay changes, and inflation-adjusted pay levels have declined substantially since the 1930s are consistent with such implicit regulation. I. Estimates of the Pay-Performance Sensitivity We define the pay-performance sensitivity, b, as the dollar change in the CEO's wealth associated with a dollar change in the wealth of shareholders. We interpret higher b's as indicating a closer alignment of interests between the CEO and his shareholders. Suppose, for example, that a CEO is considering a nonproductive but costly "pet 228 JOURNAL OF POLITICAL ECONOMY project" that he values at $100,000 but that will diminish the value of his firm's equity by $10 million. The CEO will avoid this project if his pay-performance sensitivity exceeds b = .0\\ (through some combination of incentive compensation, options, stock ownership, or probability of being Bred for poor stock price performance) but will adopt the project if ^ ected wealth loss is calculated as the turnover probabilitv multiplied bv the present value of $1 million per year beginning next year and lasting until the CEO is 66 years old. All amounts are in 1986 constant dollars, and the real interest rate is assumed to be 3 percent. Based on $1.3 billion shareholder loss, which is the shareholder loss on an average-size ($1.73 billion) firm realizing 50 percent returns in two consecutive years. CEO's dismissal-related wealth loss with the wealth loss of shareholders of an average-size firm (SI.73 billion in our sample), realizing a sequence of two net-of-market returns of 50 percent (i.e., a 2-year cumulative return of 75 percent). Table 5 predicts, for example, that the expected turnover-related wealth loss for a 62-year-old CEO in a firm realizing a 0 percent netof-market return is $346,000, compared to an expected loss of $714,000 if his firm earns 50 percent below market in each of the two previous years. Although the difference in the expected wealth loss associated with dismal performance (compared to average performance) of $368,000 seems large, it is small compared to the CEO's losses on his own stockholdings and trivial compared to shareholder losses. The CEOs in the 1987 Forbes survey between 60 and 64 years old hold a median of $3.2 million worth of stock, and therefore the stock market losses on a 75 percent return for a median CEO are $2.4 million. Moreover, shareholders lose an average of almost $1.3 billion on a 75 percent return; the CEOs' expected dismissal-related losses of $368,000 imply that CEOs lose 2S Ait for each $1,000 lost bv shareholders. Column 6 of table 5 shows that our upper-bound estimate of the CEO's dismissal-performance sensitivity for an average-size firm with a 75 percent 2-year return is 8.6^ and 14.5^ for a 53- and 58-yearold CEO, respectively. We find a much larger dismissal-performance 242 JOURNAL OF POLITICAL ECONOMY sensitivity for a 46-year-old CEO89.0^ per $1,000but this result is driven by our inappropriate assumption that the CEO will never work again if dismissed but will work for his firm until age 66 if not dismissed. The dismissal-performance sensitivity for the 46-year-old CEO falls to 44.5^ per $1,000 if he accepts employment at half his current pay. Our estimates of the dismissal-performance sensitivity in column 6 represent an upper bound for several reasons. First, we have assumed that CEOs leave the labor market after turnover; this assumption may be appropriate for older CEOs but is clearly inappropriate for very young CEOs. Second, table 5 is based on extraordinarily poor performance2 years at 50 percent per yearand the estimated dismissal-performance sensitivity increases with shareholder losses. Eor example, the difference in expected wealth loss for a 62-year-old CEO earning 10 percent less than the market in two consecutive years (compared to 0 percent net-of-market returns) is $58,000, or about 18^ per $1,000 (based on cumulative shareholder losses of 19 percent or $330 million for an average-size firm), compared to 28^ per $1,000 for the $1.3 billion loss in column 6 of table 5. Finally, most CEOs are covered by employment contracts, severance agreements, or golden parachute arrangements that further reduce or eliminate the pecuniary punishment for failure; and pensions, outstanding stock options, and restricted stock typically become fully vested on an involuntary separation. The dismissal-performance sensitivities in column 6 of table 5 can be added to the 30^ per $1,000 pay-performance sensitivity in column 2 of table 1 and the 15^ per $1,000 pay-performance sensitivity for outstanding stock options in column 2 of table 2 to construct an estimate of the total pay-performance sensitivity under direct control of the board of directors. With an average dismissal-performance sensitivity (weighted by the number of observations in each age group) of 30^ per $1,000, our estimate of the total pay-performance sensitivityincluding both pay and dismissalis about 75^ per $1,000 {b ^ .00075). Stock ownership adds another $2.50 per $1,000 for a CEO with median holdings, for a total sensitivity of $3.25 per ,000 {b ^ .00325) change in shareholder wealth. II. Is the Small Pay-Performance Sensitivity Consistent with Agency Theory? Agency theory predicts that compensation policy will tie the agent's expected utility to the principal's objective. The objective of shareholders is to maximize wealth; therefore, agency theory predicts that CEO compensation policies will depend on changes in shareholder TOP-MANAGEMENT INCENTIVES 243 wealth. The empirical evidence presented in Section I is consistent with this broad implication: changes in both the CEO's pay-related wealth and the value of his stockholdings are positively and statistically significantly related to changes in shareholder wealth, and CEO turnover probabilities are negatively and significantly related to changes in shareholder wealth. Although the estimated pay-performance sensitivity (with respect to compensation, dismissal, and stock ownership) is statistically significant, the magnitude seems small in terms of the implied incentives. Consider again our example of the CEO contemplating a pet project that reduces the value of the firm by $10 million. A risk-neutral CEO with median holdings {b ~ .00325) will adopt the project if his private value exceeds $32,500, while a CEO with no stock ownership {b ~ .00075) will adopt the project if his private value exceeds $7,500. For comparison, the median weekly income of our sample CEOs is approximately $9,400. The purpose of this section is to explore whether our results are consistent with formal agency models of optimal contracting. Our task is made difficult by the fact that the theory offers few sharp predictions regarding the form of the contract other than predicting that wages generally increase with observed output. The formal models do yield clear predictions regarding the pay-performance sensitivity when the CEO is risk neutral. Given the impossibility of isolating the CEO's marginal contribution to firm value, a risk-neutral CEO has incentives to pursue appropriate activities only when he receives 100 percent of the marginal profits, or b = 1. The optimal contract, in effect, sells the firm to the CEO: he receives the entire output as compensation but pays the shareholders an up-front fee so that the CEO's expected utility just equals his reservation utility. Jensen and Murphy (1988) show that the b = 1 contract that provides optimal incentives is also the contract that causes managers to optimally sort themselves among firms. Chief executive officers are not risk neutral; indeed, the major reason for the existence of the publicly held corporation is its ability to achieve efficiencies in risk bearing. By creating alienable common stock equity claims that can be placed in well-diversified portfolios of widely diffused investors, risk-bearing costs are reduced to a fraction of those borne by owner-managers of privately held organizations. Thus setting b = 1 in a risky venture subjects risk-averse executives to large risks, and setting b