Effectiveness of CEO pay‐for‐performance

Abstract

Abstract Firm performance has a generally positive, but diminishing relationship with the level of CEO pay‐for‐performance sensitivity to stock returns, consistent with the tradeoffs between incentives and risk sharing that underlie the use of pay‐for‐performance. Two moderating risk variables capture this tradeoff and significantly shape the pay‐for‐performance relationship: a firm's business risk and the standard deviation of its stock returns. At higher levels of pay‐for‐performance sensitivity, the future performance of higher risk firms is more negatively related to sensitivity than for lower risk firms. Our results support the notion that CEO risk aversion limits the benefits from incentive pay, and that when too much risk is placed on the CEO, firm performance suffers. Compensation managers should take these results into account when making changes in CEO pay‐for‐performance plans.