Executive Compensation: A Survey of Theory and Evidence

Executive compensation is a rich, complex, and controversial topic. In addition to there being an intense debate among academics on its drivers, the efficiency of current practices, and the case for reform, few topics have sparked as much interest among the general public. Politicians, regulators, investors, and executives themselves have all taken strong positions on whether and how to reform pay.

This paper sheds light on this debate by surveying the theoretical and empirical literature on executive compensation. We start in Section 2 by presenting the stylized facts, starting with U.S. data on public firms going back to 1936. We show that, while the level of pay has generally increased over time, this trend has been neither constant nor uniform, contrary to popular belief. We next decompose total pay into its components, illustrating in particular the rise and fall of option compensation, and discuss the increasing use or disclosure of other forms of pay, such as performance-based equity, (multi-year) bonus plans, pensions, perquisites (“perks”), and severance pay. We then present evidence on the level and composition of pay in non-U.S. countries, and survey recent findings on pay in U.S. private firms.

There is considerable debate among both academics and practitioners on what causes the observed trends in pay. There are three broad perspectives. One is the “shareholder value” view, which argues that compensation contracts are chosen to maximize value for shareholders, taking into account the competitive market for executives and the need to provide adequate incentives. Section 3 presents a simple unifying model of the level and sensitivity of pay, in both a static and dynamic setting, under shareholder value maximization. We discuss its empirical implications and the extent to which a shareholder value view can explain the stylized facts. We also address the optimality of relative performance evaluation and debt-based pay, and whether incentives should be provided using stock or options. Section 4 discusses the “rent extraction” view, which argues that contracts are set by executives themselves to maximize their own rents. Since the theoretical development of this view is more limited, we focus on presenting empirical findings suggestive of rent extraction, such as pay for non-performance, hidden pay, and the association of certain practices with poor corporate governance. A third perspective, which we discuss in Section 5, is that pay is shaped by institutional forces, such as regulation, tax, and accounting policies.

While Sections 3-5 explore the determinants of executive pay, Section 6 summarizes evidence on its effects. Such evidence is relatively scarce, since compensation contracts are endogenous and causal identification is difficult, but we discuss some promising approaches. Section 7 tackles policy interventions that have been proposed, and in some cases enacted, and critically evaluates them using both theory and evidence. Section 8 suggests directions for future research, and Section 9 concludes. We also include an Appendix that provides an overview of institutional detail, such as legislation, disclosure requirements, accounting treatments, and tax treatments, focusing on the U.S. but also discussing the U.K. and Europe. We hope this overview will be particularly useful to those new to the literature.

In addition to the specific conclusions of each chapter, we make the following broader points.

• Observed compensation arrangements result from a combination of potentially conflicting forces—shareholders’ desire to maximize firm value, executives’ desire to maximize their rents, and the influence of legislation, taxation, accounting policies, and social pressures. No one perspective can explain all of the evidence, and a narrow attachment to one perspective will distort rather than inform our view of executive pay.
• Recent theoretical contributions make clear that shareholder value models can be consistent with a wide range of observed compensation patterns and practices, including the large increase in executive pay since the 1970s. The challenge is now to confront these new models more rigorously with the data, explore their limitations, and contrast them with (mostly yet-to-be-written) rent extraction models.
• Theories of executive pay must take into account the specific features of executives’ jobs; models of the general principal-agent problem are not automatically applicable to executives. For example, the skills of executives may be particularly scarce, and CEOs have a much larger impact on firm value than rank-and-file employees, which can fundamentally change the nature of the optimal contract.
• Theorists should consider very carefully their modeling choices. Seemingly innocuous features of the modeling setup, often made for tractability or convenience (such as the choice between additive or multiplicative utility and production functions, or between binary and continuous actions) can lead to large differences in the model’s implications—and thus conclusions as to whether observed practices are consistent with theory.
• Compensation contracts have evolved over time. For example, the U.S. has seen a shift in the largest component of CEO pay from cash in the 1970s to options in the 1980s and 1990s and to performance-based stock in the 2000s. The reasons for this evolution are not fully understood. Likely drivers include boards learning over time how to improve pay practices as well as regulatory and institutional changes.
• Attempts to improve CEO pay should focus on the incentives created, and especially on the sensitivity of CEO wealth to long-term performance. The level of pay receives the most criticism, but usually amounts to only a small fraction of firm value. Badly structured incentives, on the other hand, can easily cause value losses that are orders of magnitudes larger.
• Any high-powered incentive contract creates incentives to manipulate the performance measure(s) it relies upon. However, finding that a pay practice, such as equity-linked pay, is associated with manipulation does not imply that incentive contracts are worse than no incentive contract.
• Most of what we know about executive pay concerns CEOs of U.S. public firms. We need more research on top executives other than CEOs, countries outside the U.S., and private firms.
• Identifying the causal effect of compensation contracts on any interesting outcome variable is extraordinarily difficult. These contracts are endogenous—executives, directors, and compensation consultants spend time and effort designing them, taking into account unobservable firm, industry, and executive characteristics. As a result, compensation contracts are inevitably correlated with these unobservable characteristics, which in turn affect firm behavior, performance, and value.
• There are almost no instrumental variables or natural experiments that create as-good-as-random variation in compensation contracts. The few exceptions have significantly advanced our understanding of the causal effects of executive pay, and we strongly welcome any additions to this short list. On the other hand, insistence on clean identification frequently results in the use of bogus “instruments” that almost certainly violate the exclusion restriction, a focus on narrow questions, or the avoidance of research on executive pay altogether. Much can be learned from papers that do not attempt to identify causal effects, and instead carefully study how firms endogenously choose compensation contracts in different settings.

The complete paper is available for download here.