Referee Finance

Home of the Financial Intelligence Lab

  • Increase font size
  • Default font size
  • Decrease font size

Are CEOs Rewarded for Luck? The Ones without Principals Are

E-mail Print PDF

Are CEOs Rewarded for Luck? The Ones without Principals Are

Marianne Bertrand and Sendhil Mullainathan

CEO pay is generally viewed in the context of principal of agency models. Simple models of contracting suggest that shareholders will not reward CEOs for observable luck which is defined as changes in firm performance that are beyond the CEO’s control.

The first part of this study examines whether or not CEOs are in fact paid for luck using three measures of luck. First, a case study of the oil industry is analyzed where large movements in oil prices tend to affect firm performance on a regular basis. Secondly the changes in the industry –specific exchange rate for firms in the traded good sector are examined. Thirdly year-to-year differences in mean industry performance to proxy for the overall economic fortune of a sector is analyzed.

The skimming model perspective states that the separation of ownership and control allows CEOs to gain effective control of the pay setting process. On account of filling the board with supporters and complexity of the pay process, many CEOs de facto set their own pay to a level that become constrained by the unwillingness to draw share holder’s attention. The direct implication of the skimming model is analyzed by regressing compensation on firm fixed effects, time fixed effects and CEO specific variables .The measures included performance measures of accounting returns or stock market returns, governance, presence of shareholders (on the board and overall), CEO tenure, board size and fraction of directors who are insiders. The dataset for the regression analysis consisted of 51 largest American Oil companies between 1977 and 1944. The sensitivity of pay to luck is analyzed through two-stage procedure. In the first stage, performance is predicted using luck in order to isolate changes in performance that are caused by luck. In the second stage it is examined how sensitive pay is to these predictable changes in performance. Two measures of luck: movements in exchange rate and mean industry performance were regressed upon variables like income, income divided by assets, shareholder wealth and sample size. It is also examined how pay for luck differs between well-governed and poorly governed firms.

The results based on the three measures suggest that CEO pay responds significantly to luck .The average firm rewards its CEO as much for luck as it does for a general movement in performance. There seems to very little if any filtering at all. The results also hold well for discretionary components of pay like salary, bonus and option grants. The results find that better governed firms pay less for luck. Irrespective of whether large shareholder is present or not, the CEO would have to be rewarded for a rise in the value of his human capital. These findings imply that at least some of the pay for luck in poorly governed firms is due to skimming by CEOs.

The case study analysis reveals that while CEOs are always rewarded or good luck, they may not always be punished for bad luck .No statistically significant relationship between CEO’s turnover and industry returns were observed. Firms with more large shareholders show for less pay for luck.       

Marianne Bertrand and Sendhil Mullainathan, “Are CEOs Rewarded for Luck? The Ones without Principals Are”, Quarterly Journal of Economics, Vol. 116, Issue 3 - August 2001.



You can follow us on Twitter  @fintlab and facebook