Pay for luck: new evidences from the institutional determinants of CEOs' compensation

Abstract

Purpose The optimal contracting view assumes that compensation arrangements should not reward performance upward that is beyond the management's control. Critics to this view assert, however that unearned compensation boom may be suggestive of pay for luck. Hence, the authors ask if CEOs' incentive pay is sensitive to lucky as to purely corporate performance. If such, one could question: Are CEOs rewarded for luck? Do institutional features matter for CEOs pay‐for‐luck? How does systematic incentive effect sensitive to luck's nature? Accepting the premises of both contacting and skimming agency's approaches, this paper aims to answer these questions. Design/methodology/approach General and separate ordinary least squares (OLS) and instrumental variables (IV) estimations have been run to estimate the general sensitivity of CEOs' pay, respectively, to performance and luck. These estimations are based on a sample of 300 publicly traded firms covering four countries from the Anglo‐American and Euro‐Continental corporate governance models for the period 2004 to 2008. Findings In support of the paper's theorizing, it was found that CEOs pay to be positively related to outside contingencies as well as to shareholders' interests. Positive pay sensitivity to exogenous shocks, which we label systematic incentive effect, shows that management take advantage of lucky external events. Further analyses show, moreover, two stylized facts. First, this effect is asymmetric as executives are rewarded more for good luck than penalized for bad luck. Second, it is less generous under stronger corporate governance, higher investor rights protection, and stricter law enforcement rules. The latter institutional factors seem to be overwhelmingly influential variables in explaining the differences in such effect across countries. Research limitations/implications The paper contributes to the CEO compensation research by: showing that a simple contracting view can mislead shareholders about the effective CEOs' skills and efforts; and filling the lack of consensus within the empirical literature as to whether pay for luck depends on institutional features such as the law enforcement level, the degree of investors' right protection, and the corporate governance system's quality. Originality/value The paper's findings offer insights to shareholders, pay consultants, and regulators about the effects that unobservable macroeconomic shocks can have towards the design and the efficiency of a CEO pay contract. The findings help, however, academics understanding the international pay gap's causes.

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