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

Executive Compensation and Firm Performance in Germany
for compensation, e.g. biographical variables (age, tenure, education) or bargaining
power. Hence we specify the following linear fixed effects model:
w ijt = γ 1 π jt + γ 2 Rank(σ 2 jt)π jt + γ 3 Rank(σ 2 jt) + λ i + µ t + ɛ ijt , (1.1)
where λ i is an executive fixed effect, µ t is a year dummy, and ɛ ijt is the error
term. Note that by using the rank measure we ensure that our estimates of γ 2
are not affected by a possible relationship between our risk measure and the level
of compensation. 29 Moreover, we do not include control variables such as board
size, ownership structure or industry which are (almost) time invariant during the
relatively short sample period. Since no executive moves from one firm to another
during this period, such (almost) time-invariant differences in the cross section are
captured by executive fixed effects. There should be little variation over time in
firm size either, but we confirm the robustness of the basic estimation results by
adding firm size as a control variable in separate regressions.
The estimated coefficients γ 1 and γ 2 can be transformed into pay-performance
sensitivities at any percentile of the distribution. The pay-performance sensitivity
for a manager employed by a firm with given risk is γ 1 + γ 2 Rank(σjt). 2 Thus the
pay-performance sensitivity at the firm with median risk is γ 1 + γ 2 0.5, and the payperformance
sensitivities at firms with the minimum and maximum observed risk
levels (Rank(σjt) 2 values of zero and one) are γ 1 and γ 1 + γ 2 , respectively.
1.5 Results
1.5.1 Pay-Performance Sensitivities Based on Stock Returns
We first estimate equation (1.1) with firm performance measured by annual stock returns.
The estimation results for the sample period 2005-2009 are given in Table 1.6.
Column 1 shows the results without firm size as a control variable. However, Core
and Guay (2002) and Cichello (2005) found that it is essential to explicitly control
for firm size when looking at the relationship between executive compensation and
firm risk because of the observed negative relationship between pay-performance
sensitivity and firm size. Columns 2 and 3 of Table 1.6 show the results when we
29 This argument is less an issue for the stock return variance because this risk measure is not
related to firm size. The rank measure is more important when we measure firm risk by EBIT
variance which is, as a firm-size related measure, likely to be correlated with total compensation.
27