Performance Pay and Top Management Incentives

Jensen and Murphy

Journal of Political Economy 1990 vol. 98 #2

Executive Summary:

This paper looks at the pay-performance relationship for CEOs. On average, CEO wealth changes by $3.25 per $1000 of shareholder value. This is $8.05 for small firms and $1.85 for large firms. Most of this is in the form of managerial owned stock. The authors point out that managerial ownership has declined over the past 50 years and have caused a reduction in pay-performance sensitivities. This may be due to politically imposed constraints.

This is a classic work in the field. It laid the groundwork for much of the executive compensation research that followed.

"The conflict of interest between shareholders…and CEO is classic example of principle-agent problem. If shareholders had complete information…, 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….In these situations, agency theory predicts that compensation policy will be designed to give manager incentives to select and implement actions that increase shareholder wealth."

Data: 2,213 CEOs at 1295 companies listed in Forbes from 1974-1986.

This paper looks at the sensitivity of CEO compensation to shareholder returns. Specifically the authors look at changes in CEO pay for every thousand-dollar change in shareholder value. They find that for every $1000 increase in shareholder value, CEO salary and bonus goes up by 2 cents. When salary revisions, stock options, and dismissals (those things that are under direct control of the Board of Directors) are considered CEO pay goes up by 75 cents. When stock ownership (median CEO owns .25% of wealth) $2.50 is gained by CEO. Thus in total pay for performance sensitivity averages $3.25 per $1000.

Note they calculate changes in salary and bonus as the PV of the change that is associated with improved performance. That is, it is assumed that the CEO receives the new pay permanently until age 70.

Pay-performance sensitivity estimates for CEO dismissals assume that CEO has no other potential jobs. This, probably incorrect assumption, leads to higher pay-performance dismissals for younger CEOs since they will be out of work for a longer time. However, the authors point out "The data suggest that CEOs bear little risk of being dismisses by their board of directors." Given this, the upper bound for CEO dismissal for a firm with a negative 75% 2-year return is only 28.4cents per $1000 of shareholder losses.

Table 3

CEO ownership As a percentage of Shares O/S Dollar Value (in millions)

For 746 firms listed in 1987 Forbes Executive Compensation

While the percentage ownership was higher for the small firms, the dollar-value invested in large firms is greater. Accordingly, in small firms, defined as those that are below the median market value, CEO pay is more sensitive to performance (due to more options and more ownership). At these firms the pay-performance sensitivity is $8.05 per $1000. On the other hand, at large firms the pay-performance sensitivity is only $1.85. Jensen and Murphy interpret high sensitivities as "indicating a closer alignment of interests between CEO and shareholders" and the empirical sensitivities suggest that there is a low degree of alignment.

The authors attempt to explain this low pay-performance sensitivity. They point out that it is consistent with several hypotheses: it may be that CEOs do not matter that much, or "their actions may be easily monitored," or "political forces in the contracting process" may be limiting the pay.

Surprisingly, the authors report that in 1986 dollars, the average salary and bonus for the top quartile CEOs fell from $813,000 in the 1934-1938 period, to $645,000 in the 1974-1986 period.

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