Three Essays on Executive Compensation - KOPS - Universität ...

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Executive Compensation and Firm Performance in Germany 1.2.1 Empirical Evidence on Pay, Performance and Risk Most empirical research on the relationship between executive compensation, firm performance and firm risk is motivated by theoretical work of Holmström and Milgrom (1987, 1991), who model how shareholders design a compensation scheme to align their interests with those of an employed manager. In particular, the principal (shareholder) employs an agent (manager) to run a project with an uncertain payoff. The agent can influence the project payoff. Since the principal cannot observe the agent’s behavior, he designs a financial incentive scheme by relating the agent’s compensation to the project payoff. This implies a risk transfer to the agent. Holmström and Milgrom (1987, 1991) assume that the principal is risk neutral while the agent is not. Hence the agent demands a risk premium for compensation risk which increases with payoff uncertainty (project risk). This leads to the key prediction of the model, namely that the sensitivity of compensation to firm performance (pay-performance sensitivity) is smaller in riskier firms with more volatile payoffs. Despite the predicted relationship between executive compensation, performance and firm risk, estimates of pay-performance sensitivities from early empirical studies neglect firm risk. Jensen and Murphy (1990) find a significant, but very low sensitivity of CEO compensation to stock performance in U.S. corporations for the period 1974-1986. Hall and Liebman (1998) estimate pay-performance sensitivity of U.S. CEO compensation including the annual change in value of stock and option holdings. Similar to Jensen and Murphy (1990), they do not control for firm risk, but unlike them, they find a strong pay-performance relationship for U.S. CEO compensation in 1980-1994, mostly coming from stock and option holdings. Unlike Jensen and Murphy (1990) and Hall and Liebman (1998), Core et al. (1999) control for firm risk (measured by the standard deviation of return on assets) and find a negative impact of risk on compensation of U.S. CEOs in 1982-1984. However, their research design cannot estimate the impact of firm risk on the link between compensation and firm performance, i.e. on pay-performance sensitivity as postulated by Holmström and Milgrom (1987, 1991). Aggarwal and Samwick (1999) measure the impact of firm risk on pay-performance sensitivity by controlling not only for firm risk but also for the interaction between firm risk and firm performance, measured by stock returns and by stock return variance, respectively. In their sample of U.S. executives in 1993-1996, Aggarwal and Samwick (1999) find a significantly positive pay-performance sensitivity which decreases, for given firm performance, in 13
Executive Compensation and Firm Performance in Germany firm risk. Cichello (2005) argues that one has to explicitly account for firm size when using the variance of stock market value as a measure for firm risk. For CEOs of U.S. corporations during 1993-2000, he finds that the negative relationship between firm risk and pay-performance sensitivity still holds, but pay-performance sensitivity is smaller for CEOs of larger firms. These findings are empirical support for Holmström and Milgrom’s (1987, 1991) hypothesis of a negative relationship between firm risk and pay-performance sensitivity. However, the empirical evidence is not always supportive. Instead of measuring pay-performance sensitivity directly, Core and Guay (1999) look at company stock and option grants to executives as an alternative measure for the degree to which executive compensation is linked to firm performance. They find a positive impact of firm risk, measured by stock return volatility, on the degree to which firms let executives participate in firm performance with stock and option grants. They argue that monitoring executives is costlier in firms operating in a risky environment. As a substitute, owners of riskier firms provide executives with more incentives to make sure they work toward firm value maximization. Prendergast (2002) makes a similar argument. He surveys the empirical literature on the relationship between risk and incentives and concludes that empirical evidence in support of Holmström and Milgrom’s (1987, 1991) prediction of a negative relationship between firm risk and pay-performance sensitivity is limited. His explanation for a positive relationship is that shareholders of firms operating in environments with a lot of uncertainty (risky firms) give managers more discretion over the choice of activities. The intuition is that uncertainty makes shareholders less confident how the management should operate the daily business of the firm and therefore they delegate more responsibility. This delegation is accompanied by output-based incentives and hence a positive relationship between firm risk and pay-performance sensitivity. In this study we analyze pay-performance sensitivity based on stock market and accounting measures of firm performance. Therefore our work is also related to studies from the accounting literature about the use of different performance measures in executive compensation. Lambert and Larcker (1987) argue that the relative weight placed on performance measures in executive compensation should be related to the measure noisiness. They find that U.S. firms in the period 1970- 1984 indeed place relatively more weight on stock market performance if its variance 14
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Erklärung Ich versichere hiermit,
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