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In recent years, rewarding CEOs with long-term forms of compensation (e.g., stock options, performance plans, restricted stock) has become more popular than using year-end pay adjustments. Surprisingly, there is little empirical evidence to support the benefits of this trend. This study found that the benefits of long-term compensation flowed primarily to CEOs as they received significantly greater levels of total compensation than CEOs in firms that emphasized year-end pay adjustments. Paradoxically, however, firms that emphasized year-end pay adjustments performed significantly better than firms that were heavy users of long-term forms of contingent compensation. (c) 2001 John Wiley & Sons, Inc.
Introduction
Executive pay has generated extensive criticism from academics, the business press, unions, and other corporate constituenties because of seemingly skyrocketing levels of total compensation. For instance, it is not uncommon for firms to be criticized for failing to tightly link executive pay to firm performance (e.g., Jensen & Murphy, 1990) with some scholars having noted that Chief Executive Officer (CEO) pay does not correlate strongly with firm performance, and that this correlation tends to be weaker when firm performance declines (Hambrick & Finkelstein, 1995). In recent years, large United States (US) firms have been eagerly implementing long-term contingent compensation plans (e.g., stock options, restricted stock, long-term performance plans) (Yermack, 1995). Surprisingly, there is little empirical evidence that long-term contingent compensation plans accomplish what they were intended to dothere is no solid evidence that they lead to greater levels of firm performance (Finkelstein & Hambrick, 1996). In addition, critics of executive compensation have recently turned their attention to these long-term contingent compensation packages and complained that such plans may result in abnormally high pay levels not justified by firm performance.
In essence, there are two ways that firms can tie executive pay to firm performance. First, firms can strive to make annual adjustments to CEO salary and bonus levels in accordance with the level of firm performance achieved ("annual adjustments"). Second, the board can structure CEO pay with long-term contingent forms of pay so that future pay levels are contractually tied to the level of firm performance attained ("long-term contingent compensation"). In theory, either pay-for-performance mechanism should result in incentive alignment. Inasmuch as compensation is a strong motivator for many people, the basic premise...