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Weekly UpdatesControversy has been prevalent for many years surrounding the relationship between executive pay and firm performance. Public interest has fueled, and often creates, many of the debates regarding levels of executive pay (Byrne and Hawkins, 1993). A recent example of this controversy appeared in the main article entitled "Pay for No Performance," in the 1998 special section on Executive Pay in the Wall Street Journal (Mercer et al., 1998). This article implies there is a trend of decreased financial risk associated with being a CEO. Investors have seen CEO financial risk change as executive compensation has assumed different forms over the years. In the 1950s the predominate forms of compensation were salaries and cash bonuses. Stock options became popular in the 1960s and the use of appreciation rights, restricted stock and performance units appeared in the 1970s and 1980s.
In each decade, with the advent of new compensation components, one question has been foremost in the minds of investors, "Has the CEO earned the pay he/she receives?" Investors want to know the effect on both the owners and the firm of the implementation of a new component of CEO's pay. Investors are not always disgruntled and some investors are completely satisfied with the pay received by CEOs. These investors most likely feel the CEO is doing his/her job well when the stock price rises. Granted, this is a desired outcome for any business, but can market prices be viewed in isolation? Did the state of the economy and the industry drive the stock price more than changes in the value of the firm that came about through the decisions made by the CEO?
Researchers have examined some of these issues in an attempt to address both public support and criticism. Research on the financial implications of executive compensation has typically been in one of two areas. One area of financial research has analyzed various components of executive compensation to assess the effects of those components on aspects of firm performance. Another branch of financial research has considered how shareholders perceive the adoption of compensation packages or package components. In the latter case, the results have been mixed. Efficient markets theory suggests shareholders impound information efficiently and should respond to the adoption of a component of compensation accordingly. The results of studies that have examined the market's reaction to the adoption of a long-term, performance-based compensation component have been inconclusive, however. Some studies found positive reactions to the adoption of long-term components (Larker, 1983; Brickley et al., 1985) while another la rger study found negative results (Gayer et al., 1992).
Studies examining the relationship between performance-based compensation components and improved firm performance as measured using accounting variables have been conflicting as well. Some studies have shown that accounting-based compensation components motivate managers to make decisions that increase their own wealth but do not improve firm performance (Healy, 1985; Dechow and Sloan, 1991; Lambert and Larker, 1987). Others have shown a significant relationship between improvement in accounting variables and increased executive compensation (Ely, 1991; Abowd, 1990), but these studies did not link improvement in accounting variables to improved firm performance.
The relationship between executive pay and firm performance continues to be an area of interest and controversy because of issues such as public concern, implementation of new tax laws, and the prevalence of mergers and acquisitions. Prior studies related to the relationship between pay and performance have produced conflicting results. Inconsistencies exist in part because a majority of these studies have considered only one accounting measure of performance and have treated this measure as being equally important across firms. In addition, these studies have predominately measured performance variables for a short time period.
The purpose of this study is to analyze the question posed by many investors regarding whether or not certain components of a firm's compensation package motivate the CEO to improve firm performance. Examining the consequences of adopting specific components of an executive compensation package is important to boards of directors and compensation consultants in aiding them in structuring compensation packages that best suit the needs of the firm and the executive. In addition, such analysis is important to investors as it aids investors in evaluating the performance of the CEO relative to changes in firm performance. This questionable link between pay and performance is addressed more directly by examining the relationship between adoption of a performance-based compensation component, performance plans, and improved firm performance. Weaknesses of earlier studies are addressed in this article. The decision horizon problem presented in prior research is addressed by analyzing both a short-term and long-term horizon. Utilizing different methodology than prior papers, the issue of assessing one accounting measure as being equally important across all firms is addressed. This issue is avoided by examining the relationship between performance plan adoption and firm performance across nine industry groups using variables that are specific to each of the industry groups.
Relevant literature is examined in the next session. The hypothesis development and an explanation of the methodology follows. Results of the analysis are then presented. The paper concludes with a discussion of the results, their implications, study weaknesses and suggested areas for future research.
Relevant Literature
Agency Theory
The relationship predicted to exist between firm performance and executive pay is rooted in agency theory. Agency theory posits that a contract exists between agent (management) and principal (shareholders), and that the actions of the agent can be better monitored through the use of incentives that link the goals of the agent to those of the principal (Jensen and Meckling, 1976; Fama 1980; Fama and Jensen, 1983). The objective is to structure incentives such that the agent's goal of increased personal wealth does not come at the expense of the wealth of the shareholders.
The various components of executive compensation packages have frequently been controversial and have been studied from both theoretical and empirical perspectives. Holmstrom (1979) argues that optimal compensation contracts should be based on any variables that provide incremental information that can be used in evaluating the CEO's unobservable actions. Traditionally, the long-term components of compensation packages have been designed to include accounting measures, such as return on equity, as a measure of executive performance. Not everyone agrees that using accounting measures in compensation contracts provides the best solution to the agency theory problem. For example, Healy (1985) and Dechow and Sloan (1991) argue that basing compensation on accounting measures can be counterproductive and may motivate managers to make decisions that will increase their own wealth but may not necessarily increase shareholder or firm wealth. Other studies (Larker, 1983; Brickley et al., 1985; Tehranian and Waegelein, 1985; Kumar and Sopariwala, 1992) have examined the market's reaction to the adoption of long-term components of compensation packages and concluded that shareholders perceive the adoption of a performance plan as positive. Shareholder initial perceptions may be misleading, however, because studies have failed to ascertain if adoption of long-term incentives such as performance plans improve overall firm performance and thus shareholder wealth. It is possible that, over time, increased shareholder wealth is due to overall improvements in the market or general industry trends and not necessarily to management decisions.
Despite the conflicting results of past studies, companies continue to have accounting based measures of performance in compensation contracts (Mercer et al., 1997). Greater usage of accounting-based performance measures may be seen in future compensation contracts. Developments related to tax laws, additional disclosure requirements, and public image may influence companies to consider changing some non-performance-based forms of compensation to performance-based components in their compensation packages. An additional factor that may drive the increase use of accounting-based performance plans is that traditional stock option plans may not adequately compensate executives in certain companies (Brozovsky and Sopariwala, 1995).
Linking Compensation to Performance
Pavlik et al. (1993) point out that few studies have directly tested the idea that future performance should improve with stronger links between pay and performance. Previous studies (Abowd, 1990; Crystal, 1993; Gerhart and Milkovich, 1990; Hallock, 1998; Schaefer, 1998) have primarily examined one feature of one accounting measure or used very general performance measures. Another problem with prior studies has been that the particular accounting measure chosen for analysis has been predicted to be equally important for all firms in the sample, regardless of industry. All firms are not the same and thus experience different production environments (Ely, 1991). In measuring firm performance, it is important to take into consideration different features of a given industry. For example, performance measures should consider the strength of the industry within the economy: (1) whether the industry is in a growth, stable, or declining phase, (2) whether the industry moves in the same direction as the general eco nomy (cyclical) or whether it is contracyclical, (3) whether industry competition is regional, national or international, and (4) whether industry success is based on price, quality, image, distribution, or some other factor (Kaplan and Atkinson, 1989). Comparing the same accounting measure across industries is unlikely to capture these differences. As argued by Ely (1991), production environments should be highly correlated across industries. Therefore, using the same performance measures across firms may bias the results for those firms whose production environments are not conducive to the particular measures chosen.
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