In our paper, Strategic Flexibility and the Optimality of Pay for Sector Performance, which is forthcoming in the Review of Financial Studies, we propose a model in which a CEO chooses the firm’s strategy as she faces uncertainty regarding future sector movements. She can put forth (personally) costly effort to generate an informative signal about future sector returns. The optimal contract rewards the CEO for firm performance induced by sector movements so as to provide her incentives to exert effort to forecast the sector movements and choose the firm’s optimal exposure to them.
As our model shows, benchmarking the CEO’s performance against her sector is the same as not offering her pay for sector performance and will make firm investment decisions insensitive to sector movements. This practice is suboptimal if sector performance affects firm performance. Our model also helps pin down situations in which the sensitivity of pay to sector performance is more likely to be present. We find that multi-segment firms, especially those in which the sector performances of the different segments are less positively correlated, will offer pay contracts that are more sensitive to sector performance as compared to single segment firms. This is because such firms provide greater opportunity to the CEO to actively shift resources towards sectors that are likely to outperform. We also find that the sensitivity of pay to sector performance will be greater in any firm that offers greater strategic flexibility to the CEO to alter firm exposure to sector movements and for more talented CEOs. Our model also shows that the optimal contract rewards a risk-averse CEO more when sector performance is good than punishes her when sector performance is bad; that is, the optimal contract is asymmetrically sensitive to good and bad sector performance.
We take the theory’s empirically-testable predictions to CEO compensation data spanning 1992 through 2006 and find strong empirical support for the model. Using industry returns to proxy for sector performance, we confirm previous studies and document the dependence of CEO compensation on sector performance. Also, as CEOs are likely to have a greater role in setting firm strategy, we expect CEO pay to be more sensitive to sector performance as compared to pay of other executives. Our empirical results support this conjecture. Consistent with our model, we find that CEO pay is more sensitive to sector performance for multi-segment firms as compared to single segment firms. We further find that the sensitivity of CEO pay to sector performance in multi-segment firms is greater when the sector performances of the different segments are less positively correlated. Our results are also robust to controlling for the quality of firm-level corporate governance using the Bebchuk, Cohen and Ferrell (2009) entrenchment index.
To test whether the observed pay for sector performance is greater in firms that offer more strategic flexibility to the CEO, we introduce two proxies at the industry level meant to capture the extent of strategic flexibility. We find that pay for sector performance is in fact greater for the subsample of firms in industries with high market-to-book ratios and R&D expenditures. If pay for sector performance provides incentives for the CEO to exploit the available strategic flexibility, then we should expect firms with greater pay for sector performance to show some evidence of CEOs exploiting their strategic flexibility to a greater extent at the firm level. To test this prediction, we classify firms with positive industry-adjusted R&D expenditures and asset-growth rates as exploiting their strategic flexibility to a greater extent. Consistent with our conjecture, we find that CEO pay is more sensitive to sector performance in firms that have positive industry-adjusted R&D expenditures the following year and positive industry-adjusted asset-growth rates during the sample period. Further, using additional proxies, we find evidence indicating that 1) the likelihood of a disciplinary CEO turnover is sensitive to sector performance only in firms from industries with high market-to-book ratios and R&D expenditures, 2) there is greater pay for sector performance for more talented CEOs, and 3) there is asymmetric pay for sector performance present in multi-segment firms, in firms that offer greater strategic flexibility to their CEOs and for more talented CEOs.
The widespread lack of relative performance evaluation (RPE) and the positive sensitivity of CEO pay to sector performance and its persistence over time highlights that it may not be all about inefficient rent extraction. Our contribution in this paper is to offer an optimal contracting explanation for the observed pay for sector performance. Our empirical analysis provides significant support for our model and highlights important cross-sectional patterns in the observed pay for sector performance. This shows that at least for certain firms, the observed correlation between pay and sector movements may be designed to provide the CEO appropriate incentives to select the firm’s strategy by managing its exposure to external factors relevant to its performance. An additional contribution of our paper is to highlight an alternative way to model a CEO’s role as one of choosing a firm’s exposure to sector movements. We believe our view of a CEO’s role can be fruitfully employed to study other corporate decisions.
The full paper is available for download here.