Estimating Pay-for-Performance Sensitivity in the Presence of Relative Performance Evaluation

43 Pages Posted: 17 Aug 2011 Last revised: 16 Apr 2020

See all articles by Shane S. Dikolli

Shane S. Dikolli

Darden School of Business University of Virginia

Christian Hofmann

Ludwig Maximilian University of Munich (LMU) - Faculty of Business Administration (Munich School of Management)

Thomas Pfeiffer

University of Vienna - Accounting and Control

Date Written: April 14, 2020

Abstract

We study how a compensation researcher’s empirical use of a net performance measure (i.e., after deducting compensation expense) instead of a gross performance measure (i.e., before deducting compensation, consistent with principal-agent theory) affects inferences regarding managerial effort incentives. We analytically demonstrate that as long as boards use relative performance evaluation, it is irrelevant whether managerial compensation is based on gross or net performance because a researcher can construct an unbiased estimate of managerial incentives from interpreting compensation regressions. However, we also show that the direct coefficient on a net performance measure in a compensation regression will, in theory, yield either an upward or downward bias in the estimate of managerial incentives. We provide empirical evidence of, on average, a downward bias in a cross-sectional estimation of pay-for-performance sensitivity, which also suggests a possible explanation for surprisingly weak CEO incentives interpreted in prior studies.

Keywords: Executive Compensation, Relative Performance Evaluation, Performance Measurement

JEL Classification: J33, M40, M46

Suggested Citation

Dikolli, Shane and Hofmann, Christian and Pfeiffer, Thomas, Estimating Pay-for-Performance Sensitivity in the Presence of Relative Performance Evaluation (April 14, 2020). Available at SSRN: https://ssrn.com/abstract=1910819 or http://dx.doi.org/10.2139/ssrn.1910819

Shane Dikolli (Contact Author)

Darden School of Business University of Virginia ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
4342431018 (Phone)

Christian Hofmann

Ludwig Maximilian University of Munich (LMU) - Faculty of Business Administration (Munich School of Management) ( email )

Kaulbachstr. 45
Munich, DE 80539
Germany

Thomas Pfeiffer

University of Vienna - Accounting and Control ( email )

Oskar-Morgenstern-Platz 1
Vienna 1090, Vienna
Austria
+43-1-4277-38002 (Phone)
+43-1-4277-38004 (Fax)

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