Working Paper: NBER ID: w3149
Authors: John M. Abowd
Abstract: An effective performance-based compensation system must increase the probability of high performance corporate outcomes in order to justify the incremental expense relative to a straight salary system. A positive relation between current performance and current compensation indicates that the pay system is performance-based in practice, if not explicitly. This study considers whether increasing the sensitivity of current compensation to current performance is associated with higher performance in the future. For accounting-based performance measures, there is only weak evidence that greater performance-based compensation is associated with improved future performance. However, for economic and market performance measures, there is stronger evidence. Payment of an incremental 10% bonus for good economic performance is associated with a 30 to 90 basis point increase in the expected after tax gross economic return in the following fiscal year. Payment of an incremental raise of 10' following a good stock market performance is associated with a 400 to 1200 basis point increase in expected total shareholder return. These results are comparable in magnitude when compared to the intrinsic variability of the performance measure considered.
Keywords: performance-based compensation; corporate performance; economic performance; market performance
JEL Codes: J33; M52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increase in sensitivity of current compensation to current performance (F32) | higher future performance (D29) |
| 10% bonus for good performance (J33) | 30 to 90 basis point increase in expected after-tax gross economic return (G12) |
| 10% raise following good stock market performance (M52) | 400 to 1200 basis point increase in expected total shareholder return (G34) |