Abstract
This study investigates the relationship between CEO pay and firm performance, the asymmetric nature of pay-performance sensitivity, and the effect of CEO participation on the pay-setting process, for publicly-listed New Zealand firms during 1997 to 2002. The research is conducted using a unique hand-collected panel data set containing information about executive compensation, firm performance, ownership, firm governance and CEO participation in the pay-setting process. The sample covers the six-year period following the introduction of manadatory disclosure requirements that were imposed on executive and director compensation in 1997.
An initial descriptive analysis of the data reveals a large pay difference between worker and CEO pay. In addition, pay-performance indexes for the highest and lowest paid CEOs document differences between the change in CEO pay relative to real shareholder returns. An examination of the sensitivity between growth in CEO pay, and contemporaneous and lagged firm performance using a firm fixed-effects model, shows that not only is pay significantly related to firm size and performance but also board size, compensation risk and director share ownership.
Models of the relationship between growth in CEO compensation and firm performance indicate the pay-performance sensitivity generated by cash and the change in the value of stock option holdings is reported to be three-times the magnitude of the sensitivity due to salary and bonus payments alone. In addition, growth in CEO compensation is asymmetrically related to changes in firm performance. CEO cash compensation is positively related to increases in firm value only. Total compensation is related to contemporaneous returns and positive lagged returns. Change in CEO wealth is positively related to contemporaneous returns but is more sensitive to losses. However, change in wealth also increases when lagged returns are positive and negative, implying that CEOs are able to extract pay in excess of that which is optimal under the contracting view of executive compensation.
Furthermore, firms in which CEOs demonstrate a low level of participation in the pay-setting process earn higher levels of pay, whch also grows at significantly greater rates than their high-participation counterparts. In particular, growth in low-participation wealth is more sensitive to positive and negative contemporaneous returns as well as being negatively related to negative lagged excess returns. This finding is opposite to theoretical predictions and can be explained by the tightly held nature of the high-participation firms which typically have fewer directors, are exposed to higher return volatility and have greater director and CEO beneficial share ownership.
Consistent with the trickle-down effect, there is a positive relationship between growth in the non-performance related cash compensation awarded to CEOs and the growth in pay earned by their exectuive directors and employees. In addition, growth in non-CEO executive pay is not related to firm performance when there is an overpayment effect and CEOs exercise a high level of participation in the pay-setting process. Consistent with the contracting view, growth in non-CEO executive pay is positively related to firm performance with no benefits from CEO overpayments when stock option awards are included in the CEO pay contract.