Does the Market for CEO Talent Explain Controversial CEO Pay Practices?
K. J. Martijn Cremers, Yaniv Grinstein
Review of Finance, Volume 18, Issue 3, July 2014, Pages 921–960, https://doi.org/10.1093/rof/rft024
Considerable debate remains among academics and practitioners regarding the economic forces that drive CEO compensation practices. Some view the market for CEO talent as the main economic force that drives the level and form of CEO compensation. Others argue that these forces have little effect on CEO compensation because of frictions such as managerial entrenchment and transaction costs of replacing managers, arguing instead that compensation practices are by and large driven by the bargaining power that the CEO has. The debate has intensified in recent years due to several controversial compensation practices, a first example of which is the tendency of firms to benchmark CEO compensation to that of other CEOs. Although some find benchmarking consistent with competitive compensation, others argue it is a way for CEOs to increase their compensation by benchmarking themselves to highly paid CEOs. A second controversial practice is the tendency of firms to compensate their CEOs for firm performance that is outside their control. Some argue that this practice is driven by CEO’s self-interest. Others, argue that it reflects competitive compensation practices, as it embeds both CEO performance and the change in the market value of CEO talent (since higher market price reflects higher marginal contribution to CEO talent and therefore the higher price for CEO talent). A third controversial practice has been the tendency of firms to provide large compensation packages to their CEOs in recent years. Some have attributed the large increase in pay to the power that CEOs have over their boards of directors, while others argue that pay has risen because the return to CEO talent has increased.
In this study we examine the extent to which the above controversial practices can be explained by the market for CEO talent. We hypothesize that if these pay practices are driven by a competitive market for CEO talent, we would expect them to be more prevalent in industries where CEO talent is less firm-specific. Our proxy for the importance of CEO firm specific talent is the percentage of insider CEOs in the industry in which the firm operates (Parrino (1997)).
Overall, we conclude that CEO talent pools are related to benchmarking and pay for luck. Industries where CEO talent is less specific have stronger tendency to benchmark CEO compensation to other CEOs and to rely more on pay-for-luck. These findings are consistent with the role of the market for CEO talent in shaping these practices. However, we do not find evidence that talent pools explain the overall rise in CEO pay. Adopting the methodology of Gabaix and Landier (2008), we examine whether corporate size, proxying for CEO talent in their model, relates to compensation levels more strongly in industries where CEO talent is less firm-specific. We find very little evidence of weaker relation between compensation and firm size in industries with more firm-specific skills. We conclude that firm size may be a proxy for something else that is not directly related to talent, within the equilibrium model in Gabaix and Landier.