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Marianne Bertrand | Luck and CEO pay

LiveMint logoLiveMint 08-06-2014 Chanpreet Khurana

Early this year, Philadelphia, US, headquartered management consultancy Hay Group released the findings of a study on Indian chief executive officers’ (CEOs’) pay. According to the study, CEOs in India make up to 78 times the salary of an entry-level professional and a large portion of it is guaranteed pay; that is, it is not performance-linked.

What goes into deciding CEO pay has interested researchers like Marianne Bertrand for years. In 2001, Prof. Bertrand, along with Sendhil Mullainathan (now a professor of economics at Harvard University), published the results of a study on how factors like performance and luck influence CEO pay in the US. The paper, Are CEOs Rewarded For Luck? The Ones Without Principals Are, published in The Quarterly Journal Of Economics, quantified the linkages to show that a 1% increase in accounting performance raised CEO compensation by about 2% and a 1% increase in shareholder wealth raised pay by about 0.3%, irrespective of whether luck caused this rise.

In an email interview, Prof. Bertrand, now the Chris P Dialynas distinguished service professor of economics at The University of Chicago Booth School of Business, US, explains how factors like luck, performance and stockholding in the company influence CEO pay. Edited excerpts:

What is “pay for luck”, and how do you calculate it?

There is a well-documented relationship between CEO pay and company performance (accounting or stock market). What is less clear is how that relationship should be interpreted. People typically assume that CEO pay goes up with firm performance to reward the CEO for his/her hard work in raising performance. That’s what we call the contracting view.

But CEO pay also goes up after an increase in performance that is not due to higher effort. For example, focusing on the oil sector, we show a strong relationship between CEO pay and shocks to performance that are due to increase in oil price. This is interesting because CEOs do not control oil prices. The fact that oil company CEOs are paid more when oil price goes up is an example of “pay for good luck”. We interpret this as the CEO being able to pay himself or herself more when company performance is higher, whether or not he/she is responsible for that better performance. That’s what we call the skimming model of CEO compensation.

What about companies where the promoter is also the CEO, as is often the case in family-owned businesses in India?

We find pay for luck to be more common in companies where the separation of ownership and control is largest. If the CEO is also a large owner of the company, there is less temptation for him/her to pay himself/herself more when performance is up as he/she would be skimming money from himself/herself as an owner of the company.

What would be the ideal data set to calculate CEO pay?

One obvious idea would be more indexing of a company performance to the performance of other firms in the same industry. That should take out at least some of the luck component (for example, all oil firms benefit when the price of oil goes up).

What global trends do you see in CEO pay today, especially since economies have started recovering from the 2007 crisis?

I have not studied this carefully. My sense is that shareholder activism has gone up and is forcing some restraint in CEO compensation, in the US and Europe at least.

You have noted in your paper on CEO pay that reducing the size of the board from 10 members to six can lead to a 30% drop in pay for luck.

Smaller boards, the presence of large shareholder(s)on boards, a larger share of outsiders on boards are typically associated with better corporate governance. We demonstrate in the paper that pay for luck appears less of a concern in firms that are better managed. In other words, as boards become stronger and more independent of management, CEOs appear more constrained in their ability to skim.

What is the role of shareholders and shareholder activism in deciding CEO pay?

Improvement in corporate governance should help reduce the luck component. Besides strengthening boards (more independence from management, inclusion of large shareholders on the board who are willing to exert pressure on management), some of my other work has documented the important role of an active takeover market in reducing managerial entrenchment and improving CEO incentives/effort.

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