The Relationship between Firm Performance and Executive Pay: Dynamics, Asymmetries, and Alternative Performance Measures*7)

This study explores the dynamic structure of the pay-for-performance relationship in executive compensation and quantifies the effect of introducing a more complex model of financial performance on the estimated performance sensitivity of executive pay. The results suggest that current compensation responds to past performance outcomes, but that the effect decays considerably within two years. This contrasts sharply with models of infinitely persistent performance effects implicitly assumed in much of the empirical compensation literature. We find that both accounting and market performance measures influence compensation and that the salary and bonus component of pay as well as total compensation have become more sensitive to firm financial performance over the past decades. There is no evidence that boards fail to penalize executives for poor financial performance or reward them disproportionately well for good performance. Finally, the data suggest that boards may discount extreme performance outcomes both- high and low- relative to performance that lies within some "normal " band in setting compensation