For some time now, the role of CEOs has attracted much attention from researchers. There is a clear consensus that these executives are key drivers of business performance, yet that said, in the academic sphere many have pointed out that CEOs may often enjoy advantages at the expense of shareholders. This controversy has sparked a heated debate.
A common approach to dealing with the question is to consider what’s called the “pay effect of luck,” in other words, the exogenous events that can impact both the company and the CEO. Contrary to the assumption that shareholders don’t take luck into account when they design incentive packages for CEOs, there is demonstrable proof that this factor actually equates to higher pay. According to this hypothesis, CEOs are in a position to influence the process of determining compensation to their own advantage. This pay-for-luck approach enhances the opportunities that arise for CEOs on the labor market, which in turn makes it more expensive for companies to retain these company leaders.
Many studies focus on luck as a determinant of how much CEOs are paid in their current company. In our research, instead, we decided to explore how luck shapes their job prospects as well as the performance of their new firms when they change jobs. Specifically, we’ve contributed to the literature by investigating:
Our work is based on the idea that the pay-for-luck factor in their current company strengthens CEOs’ bargaining power on the labor market. According to our hypothesis, lucky CEOs can leverage a “high reservation value,” which refers to the minimum threshold in terms of compensation and job assignments, representing the limit for negotiating with a potential employer. This triggers a mechanism by which lucky CEOs leave their current company, but only to work for other companies that can offer particularly remunerative compensation packages in industries with favorable conditions (where the competition is less intense, for example).
We conducted our analysis beginning with a sample of 1,500 US S&P companies from 1992 to 2018. In keeping with the prevailing literature, we measured luck by utilizing exogeneous variations in firm value based on trends in crude oil prices and the economic cycle. In all likelihood, CEOs and companies would have no control over these factors. But when the market value of their companies rises, these executives get the chance to shine on the labor market. What’s more, in this lucky situation these very CEOs are far more likely to leave their company. And the luck that their departing companies enjoy may be associated with the higher pay that CEOs will receive when they move to their new companies. In fact, our findings show that thanks to luck, these CEOs get significantly higher pay in their new companies. This derives mainly from non-cash compensation (such as stock awards and options) rather than wages and bonuses.
We focus on the relationship between CEO compensation and events that are beyond their control (which we call luck). As our findings clearly reveal, the “pay-for-luck” mechanism is very pervasive, both because CEOs can weigh in on the process of determining pay, and because luck multiplies their opportunities in the management labor market. This prompts shareholders to raise the pay of their CEOs to prevent them from leaving.
Empirical evidence confirms that CEOs impact corporate policies and, more in general, company performance a great deal. However, we also know that CEOs can use their power for personal gain, for instance, by formulating remuneration systems that translate into personal benefits rather than greater value for shareholders. Among other things, CEOs who become media celebrities get higher pay but, at the same time, offer poor performance.
Here are more of our findings:
To sum up, our study seems to show that despite the higher compensation, hiring a lucky CEO comes with a substantial drop in company performance. So the ideal payment system should offer incentives for individual effort, and avoid rewarding CEOs for lucky events that are beyond their control.