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Market-Indexed Executive Compensation: Strictly for the Young

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  • Gerald T. Garvey

    (Drucker Graduate School of Management, Claremont Graduate University)

  • Todd T. Milbourn

    (Olin School of Business, Washington University)

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    Abstract

    Academics have long argued that incentive contracts for executives should be indexed to remove the influence of exogenous market factors. Little evidence has been found that firms engage in such practices, also termed "relative performance evaluation". We argue that firms may not gainmuch by removing market risks from executive compensation because (i) the market provides compensation for bearing systematic risk via the market risk premium and therefore the executive desires positive exposure to such risks, and (ii) the executive can, in principle, adjust her personal portfolio to o.set any unwanted market risk imposed by her compensation contract. A testable implication is that stock-based performance incentives will be weaker when idiosyncratic risks are large but that market risks will have little e.ect. The data tend to support this hypothesis. In the full sample of CEO compensation from ExecuComp, stock-based incentives are strictly decreasing in firm-specific risk. Market-specific risks, however, are insignificantly related to incentives. The story changes somewhat when we distinguish between younger and older CEOs. Our theory is arguably less applicable to younger CEOs who have more non-tradeable exposure to systematic risk through their human capital. Consistent with this argument, we find that market risks have a negative e.ect on stock-based incentive pay for younger CEOs, while they don’t for older CEOs. This in turn implies that the traditional argument for indexation is indeed valid for younger CEOs, and we find some evidence in favor of this proposition. Specifically, we find evidence of indexation for younger but not for older CEOs. Even for younger CEOs, however, the e.ect is far too weak to remove the e.ects of market risk. This is consistent with our finding that market risk reduces pay-performance for young CEOs, but leaves the question of why there is not more indexing for such executives.

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    Bibliographic Info

    Paper provided by Claremont Colleges in its series Claremont Colleges Working Papers with number 2001-19.

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    Date of creation: May 2001
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    Handle: RePEc:clm:clmeco:2001-19

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    1. Kocherlakota, N., 1995. "The Equity Premium: It's Still a Puzzle," Working Papers 95-05, University of Iowa, Department of Economics.
    2. Bengt Holmstrom, 1982. "Moral Hazard in Teams," Bell Journal of Economics, The RAND Corporation, vol. 13(2), pages 324-340, Autumn.
    3. Johnson, Shane A. & Tian, Yisong S., 2000. "Indexed executive stock options," Journal of Financial Economics, Elsevier, vol. 57(1), pages 35-64, July.
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    7. Garvey, Gerald T, 1997. " Marketable Incentive Contracts and Capital Structure Relevance," Journal of Finance, American Finance Association, vol. 52(1), pages 353-78, March.
    8. Jensen, M.C. & Murphy, K.J., 1988. "Performance Pay And Top Management Incentives," Papers 88-04, Rochester, Business - Managerial Economics Research Center.
    9. Joseph G. Haubrich, 1991. "Risk aversion, performance pay, and the principal-agent problem," Working Paper 9118, Federal Reserve Bank of Cleveland.
    10. Guiso, Luigi & Jappelli, Tullio & Terlizzese, Daniele, 1994. "Income Risk, Borrowing Constraints and Portfolio Choice," CEPR Discussion Papers 888, C.E.P.R. Discussion Papers.
    11. Brian J. Hall & Jeffrey B. Liebman, 1998. "Are CEOs Really Paid Like Bureaucrats?," The Quarterly Journal of Economics, MIT Press, vol. 113(3), pages 653-691, August.
    12. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    13. Rajesh K. Aggarwal & Andrew A. Samwick, 1999. "The Other Side of the Trade-off: The Impact of Risk on Executive Compensation," Journal of Political Economy, University of Chicago Press, vol. 107(1), pages 65-105, February.
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