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Asymmetric Benchmarking in Compensation: Executives are Paid for (Good) Luck But Not Punished for Bad

Author

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  • Gerald T. Garvey

    (Drucker Graduate School of Management, Claremont Graduate University)

  • Todd T. Milbourn

    (Olin School of Business, Washington University)

Abstract

Principal-agent theory suggests that a manager should be paid relative to a benchmark that captures the effect of market or sector performance on the firm's own performance. Recently, it has been argued that we do not observe such indexation in the data because executives can set pay in their own interests, that is, they can enjoy "pay for luck" as well as "pay for performance". We first show that this argument is flawed. The positive expected return on stock markets reflects compensation for bearing systematic risk. If executives' pay is tied to market movements, they can only expect to receive the market-determined return for risk-bearing. We then reformulate the argument in a more appropriate fashion. If managers can truly influence the nature of their pay, they will seek to have their pay benchmarked only when it is in their interest, namely when the benchmark has fallen. Using a variety of market and industry benchmarks, we find that there is essentially no indexation when the benchmark return is up, but uncover substantial indexation when the benchmark has turned downwards. These empirical results are robust to a variety of alternative hypotheses and robustness checks, and suggest an increase in expected direct compensation of approximately $75,000 for the median executive in our sample, or about 5% of total compensation.

Suggested Citation

  • Gerald T. Garvey & Todd T. Milbourn, 2003. "Asymmetric Benchmarking in Compensation: Executives are Paid for (Good) Luck But Not Punished for Bad," Claremont Colleges Working Papers 2003-01, Claremont Colleges.
  • Handle: RePEc:clm:clmeco:2003-01
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    References listed on IDEAS

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    Cited by:

    1. Ruth Bender, 2004. "Why Do Companies Use Performance-Related Pay for Their Executive Directors?," Corporate Governance: An International Review, Wiley Blackwell, vol. 12(4), pages 521-533, October.
    2. Ruth Bender, 2007. "Onwards and Upwards: why companies change their executive remuneration schemes, and why this leads to increases in pay," Corporate Governance: An International Review, Wiley Blackwell, vol. 15(5), pages 709-723, September.

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