The Executive Turnover Risk Premium

The following post comes to us from Florian Peters, Assistant Professor of Finance at the University of Amsterdam and Alexander Wagner, Professor of Finance at the University of Zurich.

In our forthcoming Journal of Finance paper, The Executive Turnover Risk Premium, we make the simple point that forced turnover risk explains an important part of the cross-sectional variation of compensation for the CEOs of public U.S. corporations. The empirical magnitude of the turnover risk premium—about 7% greater subjective compensation for a one percentage point increase in turnover risk—is in line with calibrated theoretical predictions.

To identify the turnover risk premium, we use sources of job risk that are arguably outside the CEO’s control such as changing industry conditions. This strategy relies on the idea that, in practice, firing occurs not only when the CEO reveals low general ability. Rather, a board may fire a CEO when industry conditions change in such a way that his skill set no longer matches the new industry requirements. It is this kind of exogenous risk exposure that should plausibly be compensated in CEO pay.

We employ this approach, but are mindful of the fact that several firm, CEO, and pay characteristics may be related to both turnover risk and compensation, thus potentially confounding our estimates of the causal effect of turnover risk. We incorporate these variables in our analysis as best we can, and show that none of them fully explains our results.

The relevance of these findings is two-fold. First, by documenting that higher job risk is compensated with higher CEO pay in the cross section, this paper complements the argument brought forward by Kaplan and Minton (2012) that part of the average development of executive pay over time can be explained by decreasing CEO tenures.

Second, the cross-sectional evidence speaks to a central issue in the debate on executive compensation. Some argue that CEO pay is largely determined by market forces; see, for example Kaplan (2008). Others argue that CEOs may be entrenched and may be able to set their own pay and job security; this argument has been most forcefully made by Bebchuk and Fried (2004). Our findings run counter to a prediction of a simple model where pay is determined by CEO entrenchment or power. Specifically, if more powerful CEOs are able to set their own pay and job security while less powerful CEOs are not, that would imply a negative correlation between turnover risk and compensation in the cross section. The reason is that entrenched CEOs would aim for higher compensation and lower turnover risk while less powerful CEOs would be more moderately paid and, at the same time, exposed to higher turnover risk. This is not what the data show.

It is clear that some CEOs do achieve spectacular compensation packages while at the same time being apparently immune to the risk of being fired. But precisely in light of these cases of egregious abuse of power and failing corporate governance, it is reassuring that, with respect to the relationship between pay and turnover risk, the available evidence suggests that on average the market for CEOs works in a way that is consistent with a model of competitive pay.

The full paper is available for download here.

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