Industry homogeneity and performance impact on relative pay performance in executive compensation

Abstract

It is generally agreed that executives would do a better job managing shareholder interests if their pay was linked more directly to the performance of their firms, relative to that at peer firms. However, studies concerning the use of relative performance evaluation in executive compensation have found only weak evidence relating executive pay to peer-firm adjusted performance. This study introduces a simple model that considers executive switching and replacement cost effects on the power of the incentives that a firm can employ. The model predicts that firms with high replacement costs will find it difficult to pre-commit to a relative performance contract. The empirical results are partially consistent with the model. Firms from more homogeneous industries are more likely to pre-commit to a relative performance contract. Furthermore, the weaker (stronger) performing, more homogeneous firms, which should have lower (higher) replacement costs are more (less) likely to pre-commit. With respect to the degree of relative performance compensation paid after performance is realized, the evidence is mixed. Both industry homogeneity and performance ranking have an impact on the degree to which relative performance evaluation is found. Overall, the results suggest that the availability of an accurate signal concerning relative performance, as well as the level of a firm’s executive replacement costs, have an impact on its willingness to utilize a relative performance compensation system.