Working Paper: CEPR ID: DP9182
Authors: Pierre Chaigneau; Nicolas Sahuguet
Abstract: We develop a stylized model of efficient contracting in which firms compete for CEOs. The optimal contracts are designed to retain and insure CEOs. The retention motive explains pay-for-luck in executive compensation, while the insurance feature explains asymmetric pay-for-luck. We show that the optimal contract can be implemented with stock-options based on a single performance measure which does not filter out luck. When the capacity to dismiss underperforming CEOs differs across firms, and the ability of different CEOs is more or less precisely estimated ex-ante, endogenous matching between CEOs and firms can explain the observed association between pay-for-luck and bad corporate governance. The model also predicts that an improvement in the governance of badly governed firms has spillover effects that increase CEO pay in all firms.
Keywords: CEO pay; corporate governance; pay-for-luck; stock options
JEL Codes: G34; M12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal contracts for CEOs designed to retain and insure them (M12) | pay-for-luck in executive compensation (M52) |
| retention motives (M51) | asymmetric pay-for-luck structure (J33) |
| positive shocks to performance or ability (D29) | increased pay (J33) |
| negative shocks (F69) | do not result in equivalent decreases in compensation (J33) |
| endogenous matching between firms and CEOs (M12) | observed association between pay-for-luck and poor corporate governance (G38) |
| bad governance (D73) | employ CEOs with higher levels of pay-for-luck (M12) |
| improvements in corporate governance (G38) | increase CEO pay across all firms (M12) |
| pay-for-luck is stronger in firms with poor governance (G38) | structure of CEO pay is influenced by retention motives and labor market dynamics (J33) |