the decoupling of ceo agency theory

8/7/2019 The Decoupling of CEO Agency Theory

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The Decoupling of CEO Pay and Performance: An Agency Theory PerspectiveAuthor(s): Henry L. Tosi, Jr. and Luis R. Gomez-MejiaSource: Administrative Science Quarterly, Vol. 34, No. 2 (Jun., 1989), pp. 169-189Published by: Johnson Graduate School of Management, Cornell UniversityStable URL: http://www.jstor.org/stable/2989894 .Accessed: 01/04/2011 21:01

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The Decoupling of CEOPayand Performance:An AgencyTheory PerspectiveHenry L.Tosi, Jr.Universityof Florida,GainesvilleLuis R. Gomez-MejiaUniversityof Coloradoat Boulder

K 1989 by Cornell University.0001-8392/89/3402-01 69/$1 .00..It is common to thank the anonymous re-viewers of a paper. Inthis case, we wantthem to know that they added in a verysignificant way to this study. Their com-ments provided helpful guidance thatmade a nice study a much better article.Their comments helped both of us learn agreat deal about a theoretical domain withwhich we were unfamiliar. The way theydealt with this project could well be a tu-torial for everyone who serves as a re-viewer.

This paper examines the extent to which monitoring andincentive alignment of Chief Executive (CEO)compensa-tion and influence patterns of various actors on CEO payvary as a function of ownership distribution within thefirm. Based on the reports of 175 chief compensation of-ficers in manufacturing, it was found that the level ofmonitoring and incentive alignment was greater inowner-controlled than management-controlled firms. Forboth types of firms, there was a direct relationship be-tween monitoring and the risk level to the CEOof annualbonuses and long-term income, although the relationshipwas stronger among owner-controlled firms. Intheowner-controlled firms, there was more influence overCEOpay by majorstockholders and boards of directors. Inmanagement-controlled firms, the CEOpay influence wasseparated from major stockholders and boards. The re-sults suggest that a behavioral approach to measuringagency theory concepts can provide some new insightsinto the process used to determine CEOpay.'Inrecent years there has been considerabledisagreementabout whether the structureof CEOcompensationin largefirms is designed so that executive decision makingis di-rectedtowardmaximizingfirmperformance(e.g., KerrandBettis, 1987; Finkelsteinand Hambrick,1988). The questionwould be moot if traditionalmarket-basedmodels of eco-nomics were applicableinwhich it is assumed thatthe man-ager and owner are the same person.Thisowner-managerbears the risksof decisions and receives the rewardsof suc-cess (Marris,1964). However,inthe largestbusiness firms inthe UnitedStates, there is a separationof ownershipfromcontrol.Owners makevirtuallyno decisions about the opera-tion of the firm.These are left to the management,which hasthe fiduciaryresponsibilityto act inthe interests of share-holders.A largeliteratureon managerialcapitalismhas been con-cernedwith these issues for more than half a century.Berleand Means (1932) arguedthat while stockholders had legalcontrolof largeU.S. corporations,itwas management,infact,that exercised effective control.As holdingsin largefirms be-came more and more dispersed, communicationandcon-certed actionamongthem became increasinglydifficult.Lackingindividualinfluence and havingclaims on a verysmallfractionof the corporation,atomistic owners became far re-moved fromcorporatepolicyand decision making.While theboardof directorsis presumedto representstockholdersandhas formalpower over management, top executives playamajorrole inappointingthe boardandfrequentlyuse theboard as a vehicle to legitimizedecisions that may not be inthe best interestof owners (e.g., Galbraith,1967; Mace,1971; Allen, 1974; Herman,1981). Not being subject to ex-ternalconstraints, managershave broaddiscretionto pursuetheirown objectives,even when these come intoconflictwith those of stockholders(Marris,1964; Williamson,1964;Monsen and Downs, 1965). Forexample, increasingsales(Baumol,1967; Galbraith,1967)orcorporatediversificationthrough mergersand acquisitions(Kroll,Simmons,andWright,1989) may be vigorouslypursuedby managementatthe expense of profitabilityand to justifyhigherexecutive pay.169/AdministrativeScience Quarterly,34 (1989): 169-189


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Forvery large firms, the percentage of stock requiredfor anexternal partyto exercise significantcontrolmaybe quitesmall (McEachern,1975; Salamonand Smith, 1979; Salancikand Pfeffer, 1980; Gomez-Mejia,Tosi,and Hinkin,1987; Kroll,Simmons, and Wright,1989). Managersappearto behave dif-ferently when there is a single equityholderwho controls aslittleas 5 percent of the voting stock (e.g., Boudreaux,1973;Palmer, 1973; Gomez-Mejia,Tosi, and Hinkin,1987). Thesefirms are called owner-controlled.When there is no equityholderwith at least 5 percent of the stock, the firm is calleda management-controlledfirm.There is a body of research that suggests how the concen-trationof equity holdings in the firm influences the behaviorof management. Owner-and management-controlledfirmsdifferinterms of riskaversion (Palmer,1973), executive tran-sitions (Salancikand Pfeffer, 1980), antitrustactivities (Cheva-lier, 1969; Blairand Kaserman,1983), executivecompensation (Wallace,1973; McEachern,1975; Allen,1981; Arnould,1985; Gomez-Mejia,Tosi, and Hinkin,1987;Dyl, 1988), mergersandacquisitions(Ahimudand Lev, 1981;Kroll,Simmons, andWright,1989), and choice of accountingand inventorymethods (Niehaus, 1985; Hunt, 1986).Some believe that the evidence supportsthe propositionthat,ingeneral, "compensationpackagesof the top level helpalign managers'and shareholders'interests"(Jensen andZimmerman, 1985: 20) and that "on average ... compensa-tion policies encourage executives to act on behalf of theirshareholdersandto put inthe best managerialperformancethey can" (Murphy,1986: 126). However,other researchshows that the relationshipbetween executive payand per-formancemaybe strongerinowner-controlledthan in man-agement-controlledfirms(McEachern,1975; Allen, 1981;Arnould,1985; Gomez-Mejia,Tosi,and Hinkin,1987; Dyl,1988; Kroll,Simmons, and Wright,1989). Gomez-Mejia,Tosi,and Hinkin,(1987: 65) argued thatManagement-controlledfirmsclearlydesign compensationsystemsto avoidthe vagariesof fluctuatingperformance.... [Elxecutivesinmanagement-controlledfirmsappearto have the best of bothworlds. Theirbasic salarieswere functionsof firms'size, a relativelystable factor,theirlong-termincomes were greaterwhen perfor-mance was good and the scale of theirorganizationsprovidedadownside hedge against poor performance.Thus,an importantportionof the compensationof managersinmanagement-controlledfirms may be decoupled from per-formanceand, by inference, less inalignmentwith theowners' interests. These CEOs bear less compensation-re-lateduncertaintyand riskthan those inowner-controlledfirms.Executivesin management-controlledfirmscan reducetheirriskand force the owners to bear more because theyhave greatercontrolover organizationaldecision processes.Agency Theory and Executive CompensationDifferencesinthe executive compensation structureof man-agement- and owner-controlledfirmscan be understoodinterms of agency theory. In agency theory, the organizationisseen as a nexus of implicitand explicitcontracts among par-ticipantssuch as owners, employees, managers, other sup-pliers of capital,and so forth (Jensen and Meckling,A1976;170/ASQ, June 1989


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CEO Pay and PerformanceFama and Jensen, 1983) who make contributions to the orga-nization and in return receive payments from it (Stinchcombe,1965; Eisenhardt, 1985, 1989; White, 1985; Mitnick, 1986).Owners are seen as principalswho contract with and are de-pendent on the actions of the manager (the agent). The term"contract" is used to mean the agreement between the prin-cipal and the agent that specifies the rights of the parties,ways of judging performance, and the payoffs for them (Famaand Jensen, 1983). The costs of this relationship are called"agency costs." These costs include, at least, losses to theprincipal because the agent does not act in the principal's in-terests and the cost, of monitoring the activities of the agent.Because agents control organizational resources and are likelyto know more about the tasks that they perform for the prin-cipal, an information asymmetry exists that could give an ad-vantage to the agents (Prattand Zeckhauser, 1985). Theprincipal usually wishes to counter this asymmetry and seeksto devise ways (which incur agency costs) to prevent theagent from making decisions to divert resources away fromthe principal's interests.In the owner-managed firm of traditionaleconomics, this is noproblem, because markets would drive decisions towardmaximization of owners' interests. Lacking market forces, incomplex organizations where there is separation of owner-ship and control, managerial discretion is not so constrained(see Jensen and Meckling, 1976; Fama, 1980; Fama andJensen, 1983). For example, Kroll,Simmons, and Wright(1989: 2) found, consistent with Marris's (1964) managerialcapitalism hypotheses, that in management-controlled firms,CEO compensation increases in tandem with increases infirm size through mergers and acquisitions "in spite of somesignificant evidence suggesting that such activity affordsshareholders few if any benefits."Such behavior is possible because of the way that "organiza-tions allocate the [four]steps in the decision process acrossagents" (Fama and Jensen, 1983: 302). The steps are (1) ini-tiation (generating alternative ways to use resources andstructure contracts), (2) ratification(the choice of decision al-ternatives), (3) implementation (executing the choices), and(4) monitoring (measuring and rewarding performance). Thesteps of initiation and ratificationare called decision manage-ment. Decision control includes implementation and moni-toring."Contracts" specify how these steps are allocated to agents.They define the "rules of the game" for the top-managementranks, including two critical dimensions: (1) the system formonitoring the agent's actions, and (2) the reward structure,which includes the degree to which managerial incentives arealigned with the interests of owners (Jensen, 1983). In thisstudy monitoring is defined as the direct or indirect observa-tion of the agent's effort, or behavior, over some period oftime (Jensen and Meckling, 1976; Singh, 1985). It can beachieved through budgets, responsibility accounting, rules,and policies. Incentive alignment is defined as the degree towhich the reward structure is designed to induce managersto make decisions that are in the best interests of stock-171/ASQ, June 1989


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holders.Agency costs may be reducedthroughthe use of ei-ther or both.Other things equal, agents (managers)will preferless moni-toringandlower risksin the rewardsystem (Harrisand Raviv,1979). Thiscan be achieved by decouplingpayfrom perfor-mance throughorganizationalpoliciesand practices, such aswidelydispersed equity holdingsand managerialcontroloverthe boardof directors.Managers maythen design a compen-sation structureinwhich they would bearless personalrisk.This would permitthem to choose those courses of actionthatare intheir self-interest,even if they conflictwith thewelfare of the owners (Demski, Patell,and Wolfson, 1984).Forexample,they may diversifytheir employment risk,assuggested by Ahimudand Lev (1981)throughacquisitionandmergers. Rationalowners willanticipatethese resource-di-verting behaviorsand attempt to monitorthem and/orstruc-ture the rewardsystem accordingly.If they are successful,owners can capitalizeon managers'"localexpertise"andspecializationwhile reducingpotentialagency costs (Demski,Patell,andWolfson, 1984).Inowner-controlledfirms, shareholders"retainapprovalright(by vote) on matters such as board membership.... Othermanagement rights are delegated . .. to the board" (FamaandJensen, 1983: 310); decision managementand decisioncontrolfunctions are delegated to managers,butthe board"retainsthe rightsto hire, fire,and set the compensationoftop level executives." In management-controlledfirmsthetop executives are, more than likely,influentialin both deci-sion managementand decision control,while principals(owners)or theirrepresentatives(boardof directors)are notparticularlystrong inanyof the stages. Thoughthere is no re-search that examines this issue, one can anticipatethat theCEOand other actors underhis or her command(e.g., con-sultants)are more likelyto be influentialthanprincipalsinsetting executive compensationin management-controlledfirms. As Williams(1985: 66-67) pointedout:Inpractice,contraryto the basic tenets of the [compensation]modelprocedure,the chief executive often has his handin the pay settingprocess almost from the first step. Hegenerallyapproves,or at leastknows about,the recommendationof his personnelexecutive be-fore it goes to the compensationcommittee, and maytakea pre-game pass at the consultant'srecommendationtoo. Both(personnelexecutives and consultants)rely uponthe good graces of the chiefexecutive fortheir livelihood.The consultantinparticular-who istypicallyhiredby management-would like to be invitedfor a returnengagement. Theboard'scompensationcommittee doesn't operateindependentlyof the chief executive either.The effects of monitoringand incentive alignmentin reducingagency costs have been coveredextensivelyelsewhere. Sha-vell (1979) and Holmstrom(1979) have shown that there arepotentialgains to monitoring,except in the unlikelysituationinwhich the agent's actions cannot have negativeconse-quences for the owner. Whileperfect monitoringmaybe im-possible or too expensive, imperfectinformationcan be usedin practiceto alleviate"moralhazard"by penalizingtheagent's dysfunctionalbehavior(Holmstrom,1979). Boththeoryand research have led to the conclusionthatagencycosts are minimizedwhen CEOcompensationis relatedto172/ASQ, June 1989


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CEOPay and Performancefirm performance or other types of information regarding ac-tions taken by executives (Mirrlees, 1976; Holmstrom, 1979;Lazear and Rosen, 1981; Grossman and Hart, 1983; Lambert,1983; Murphy, 1986).HypothesesThis study examined three hypotheses about executive com-pensation in management- and owner-controlled firms. Thelogic above leads to the first two sets of hypotheses. The firstis a straightforward hypothesis related to the level of moni-toring and incentive alignment in the two types of firms:Hypothesis 1: The level of monitoring and incentive-alignment ac-tivities will be greater in owner-controlled firms than in manage-ment-controlled firms.The second set of hypotheses focuses on the nature of com-pensation policies as a function of the type of control. Fromhypothesis 1, one would expect that owner-controlled firmswill shift a larger portion of the financial risk to managers.However, regardless of the type of control, when there aremonitoring and incentive-alignment mechanisms in place,managerial compensation will be at some risk:Hypothesis 2a: There will be lower compensation risk in CEO paypolicies in management-controlled firms than in owner-controlledfirms.Hypothesis 2b: Monitoring and incentive alignment will increase thelevel of risk in CEO pay policies in both management- and owner-controlled firms.The logic for hypothesis 2a is that if there is separation ofownership and control and divergent interests, executives inmanagement-controlled firms will design policies so that theirpay may depend somewhat on outcomes, such as firm per-formance, "but never leave [them] bearing all the risk" (Sha-vell, 1979: 56). This is consistent with research that showsthat there is a downside hedge in the pay of CEOs in man-agement-controlled firms, given that it is more strongly re-lated to size, not performance (Dyl, 1988). The converse isalso true. One would expect that owner-controlled firms willseek to transfer some of the risks to managers, and thisshould be reflected in their compensation policies (Antle andSmith, 1986).Hypothesis 2b is based on the premise that, even in differentownership structures, monitoring activities can provide infor-mation that may be used to establish greater risk sharing be-tween the agent and the principal(Holmstrom, 1979). In theabsence of monitoring, the agent will attempt to minimizerisks and transfer all the costs of uncertainty to the principal.Similarly, policies that align CEO pay more strongly withperformance will induce managers to behave in the best inter-ests of stockholders, so that even in management-controlled firms the executive is likely to be more at risk.The third set of hypotheses is concerned with the influenceof various actors in setting executive compensation. Researchhas shown that the structure of CEO pay is related to thetype of control (McEachern, 1975; Allen, 1981; Gomez-Mejia,Tosi, and Hinkin, 1987; Dyl, 1988; Kroll,Simmons, andWright, 1989), but the relative influence of the differentparties in pay determinationhas not been studied. The parties173/ASQ, June 1989


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Thisgenerictitle is used consistentlythroughoutthe manuscriptfor the sake ofsimplicityto denote the most senior com-pensationofficerwithinthe firm.Themostcommon positiontitles includeDirectorofCompensation,VicePresident-Compen-sation,VicePresident-CorporateDirectCompensation,SeniorManagementCon-sultant-ExecutiveandManagerialCom-pensation,andManagerCorporateCompensationandBenefits.

are likely to include major stockholders, boards of directors,outside consultants, compensation committees, and chiefcompensation officers (Crystal, 1988).1Owners and their representatives should be more influentialin pay determination in owner-controlled firms and the CEOshould be more influential in pay determination in manage-ment-controlled firms than in owner-controlled firms. Fol-lowing hypothesis 1, there is more monitoring and incentivealignment in owner-controlled firms; thus the significant eq-uity holder (or a representative board) who has the interest toexercise influence on CEO compensation also has the powerto do so. The board will represent the owners' interests be-cause the owners will be more influential in the selection ofboard members.In management-controlled firms, board appointments will becontrolled by management, and members will serve at itspleasure (Herman, 1981). Consultants may be used to createthe appearance of a rational pay-determination process(Pfeffer, 1980). Compensation committees will be selected bymanagement and will represent the interests of the constitu-ency that chose them. Finally,the influence of the compen-sation official is likely to be lower in management-controlledfirms because of the dominant role of the CEO, as notedabove. Thus, the following pattern of influence over CEOcompensation is hypothesized:Hypothesis 3a: Inmanagement-controlledfirms (1) the influenceexercised on CEOpay by the chief executive officer(CEO)andout-side consultantswillbe greaterthaninowner-controlledfirms;and(2) the influenceexercised on CEOpay by majorstockholders,theboardof directors,the compensationcommittee, and the chief com-pensationofficer(CCO)will be less than in owner-controlledfirms.As noted by Williams (1985), one of the main criticisms of theCEO pay-setting process is that the executives themselvescan influence their pay level and frequently use outside con-sultants to legitimize these decisions. As a result, there areminimal "checks and balances" within the decision system.Hypothesis 3b follows from Hypothesis 2b. If monitoring andincentive alignment increase the CEO compensation risk, itfollows that there must be a shift in the balance of powerfrom the agent to the principal. Thus, the level of monitoringand incentive alignment should be inversely related to the in-fluence on CEO pay exercised by the CEO and hired consul-tants and positively related to the influence exercised bymajor stockholders and their representatives:Hypothesis 3b: Forbothmanagement-and owner-controlledtypesof firms, monitoringand incentivealignmentwillbe relatedto (1)lower influenceinthe pay process bychief executives and outsideconsultants;and (2) higherinfluenceinthe pay process by majorstockholders,boardsof directors,compensationcommittees, andthe chief compensationofficer(CCO).These hypotheses were tested with data from a survey ofchief compensation officers.METHODThere are three ways in which agency theory has been ap-proached. One is the use of mathematical models to developand support its propositions, without empirical verification174/ASQ, June 1989


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CEO Pay and Performance(e.g., Holmstrom,1979; Shavell, 1979; Jensen, 1983;Demski, Patell,and Wolfson, 1984). A second is to use mea-sures of stockholderconcentrationto inferthe level of mon-itoringor the alignmentof interests (McEachern,1975; Sa-lamon and Smith, 1979; Salancikand Pfeffer, 1980). A thirdisto draw conclusions about agency effects from statisticalre-lationshipsbetween pay and financialperformancemeasures(e.g., Antle and Smith, 1986; The Journal of Accounting andEconomics, 1986, special edition on compensation).This research takes a more directapproach.A sample of chiefcompensation officers (CCOs)was surveyed about the levelof monitoringand incentive alignmentin the firms, how thecompensation process works inthe company, the risk-relatedfeatures of the executive compensation package,and the in-fluence of variousstakeholders in developing CEOpay poli-cies and practices.A questionnairewas sent to the CCOs of 500 manufacturingcompanies randomlyselected from the membershipdirectoryof the AmericanCompensationAssociation. Strictanonymityand confidentialitywas assured. The samplewas limitedtomanufacturingto maintainsome comparabilityof technology,marketconstraints,capitalintensity,and other characteristics(Hambrick,1983)and because CEOcompensation practicesvary significantlyamong variousindustries(Deckop, 1988).Responses were receivedfrom 175 (35 percent) CCOs.Onehundredwere in management-controlledfirms, and the re-mainder(75) were inowner-controlledfirms.The CCOwas chosen as the respondentfrom each firm,forseveral reasons. First,this executive is likelyto be amongthemost informedaboutorganizationalpay policies, practices,the process used to set CEOpay, monitoringactivities, andthe incentive structurefor CEOs. Giventhe complexityofCEOcompensation,this knowledgeshould enhance the va-lidityof responses. Second, these CCOsare usuallykeymembers of the compensation committee of the boardof di-rectors because of their expertise (Cook, 1981). In additiontoestablishingexecutive pay policies inconsultationwith theboard, responsibilitiesof this committee include"reviewingofficerperformancein orderto allocate financialrewards,re-viewing management succession plans, reviewingbusinessperformanceandsetting long-termstrategic goals (suchasthose requiredforexecutive long-termincentiveplans),se-lectingand removingseniorofficers,and maintainingover-sight and controlover executive perquisites"(Cook,1981:15). Third,the CCOis the usual source for informationonCEOanddirectorcompensationfor studies of top-manage-ment pay,of the type reportedannuallyin Business Week.MeasuresThe questionnairecontaineditems pertainingto demographicand firmcharacteristics,CEOpay policyand practices,andmonitoringand incentivestructuresof CEOcompensation.The specific measures used to test the hypotheses are de-scribed below.Ownershiptype. Ownershiptype was assessed by twoitems. One item, designed to determine whether or not thefirm was owner-controlledor management-controlled,asked175/ASQ, June 1989


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2The 5-percentownershipcut-offcriterionwas chosen for severalreasons. First,itis a conventionthat has been meaningfullyused in several previousstudies to clas-sifyfirmsinto management-and owner-controlledtypes (see O'Reilly,Main,andCrystal,1988).Second, as arguedby Sa-lancikandPfeffer(1980:658), while "theexact amountof stock needed to controla firmeffectivelyis unknown,as is theprecisefunctionalrelationshipbetweenownershipconcentrationand control....if theorypredictsdifferencesdependingon ownershipclassification,anda classifi-cationis foundthat is consistentwiththetheory,thenthere is reasonableassurancethat the categorizationhas some validity."Third,an empiricalstudyby Dyl (1988:22)on the effect of ownershipdistributiononexecutive payfoundthat differentmea-sures of concentrationarehighlycorre-latedand "yieldvery similarresults."Finally,fine-grainedownershipor controlmeasuresare not feasibleusing the anon-ymoussurveyapproachin this study.3Whilesome would arguethat "system-atic"performanceof the firm,basedonexternalfactors,shouldbe filteredout ofexecutives' paydecisions (see AntleandSmith,1986),one couldalso make thecase that the CEOis at least partlyre-sponsiblefor strategicorganizationalmoves such as choosinga productlineoridentifyingcompetitiveniches(see Hofer,1980; Rumelt,1982).

if there was "any single individualor institution outside thefirm which owns 5 percent or more of the company's stock?"(O'Reilly, Main, and Crystal, 1988).2 A firm was classified asowner-controlled when there was a "yes" response andmanagement-controlled when there was a "no" response.The second item evaluated if the firm was owner-managedby asking if there was "any individualwithin the firm (e.g., theCEO)that owns 5 percent or more of the company's stock?"No firm in the sample was owner-managed.Monitoring and incentive structure. Monitoring and incentivealignment were measured by a set of items about the pro-cesses used to establish CEO pay in the firm (see AppendixA). The items were developed based on the literatureand thelogic underlying the hypotheses to be tested in the study.Respondents indicated the extent of agreement with eachitem on a 5-point Likert-typescale ranging from "strongly dis-agree" to "strongly agree." The items measure (1) the de-gree to which CEO pay policies and practices were designedwith the best interests of the firm in mind (shareholders,business strategies, ability to pay), (2) the degree to whichthe CEO pay-setting process and criteriacan be manipulatedby the executive, (3) the extent to which executives are maderesponsible for firm outcomes,3 (4) the security enjoyed byexecutives through such programs as golden parachutes, and(5) the extent to which the design of the pay package takesinto account motivational concerns and not just tax consider-ations.All items in Appendix A were averaged into a single com-posite scale that was labeled "monitoring." This was done forthree reasons. First, empirical assessment of the items indi-cated that there were not separate monitoring and incentive-alignment subscales. A principalaxis factor analysis wasperformed, and there was only one factor with an eigenvaluegreater than 1.0 (see Appendix A). In addition, the a prioriscales designed to measure monitoring and incentive-align-ment dimensions were very highly correlated (r = .81).Second, the use of a single monitoring index is consistentwith the definition proposed by Jensen (1983) in which theincentive structure is seen as but one dimension of moni-toring. Third, given that this study was exploratory, the com-posite scale seemed reasonable.Compensation risk. The relative riskto the CEO of the firm'scompensation policies was assessed by a composite scalecombining three dimensions: variability,downside risk, andlong-term orientation (see Ellig, 1984). Each dimension wasmeasured by a single item with a 5-point Likert-typescale,ranging from low (1) to extremely high (5). Variabilityis theextent to which the executive pay package is designed sothat a substantial portion of income will be received on astable, relatively fixed, predictable basis over time with min-imum uncertainty. Downside risk indicates the degree towhich the executive pay package has a downside hedgeagainst poor firm performance. Such a downside hedge mightentail minor or no penalties contingent on lower values of theperformance indicators (e.g., earnings per share). Long-termorientation is the degree to which the executive's pay is tiedto long-term firm performance. The longer the time horizoninvolved, the greater the amount of uncertainty the executive176/ASQ,June 1989


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CEO Pay and Performancefaces in the pay schedule, because the number of unforeseenand uncontrollable events tend to increase exponentially(Murphy, 1986).The three compensation-risk characteristics described abovewere asessed for both CEO bonuses and long-term income(see Appendix B). Long-term income was defined to includetypes of programs most commonly used in industry (Ellig,1984). These were stock options, stock appreciation rights,stock purchase plans, stock awards, performance shareplans, phantom stock plans, and other related, long-term in-come programs. Bonuses were defined as cash awards tothe CEO during a specific short-term period (e.g., annually).Base salary was not rated, since it is generally treated as a"fixed" component of the pay package given as a condition ofemployment and is less subject to fluctuation (MilkovichandNewman, 1987).A compensation-risk score was calculated separately for bothbonus and long-term income by averaging the responses tothe three items. A high compensation-risk score indicates thatthe policies that govern, and the criteria for awarding, long-term income and/or bonuses provide for greater managerialrisk bearing.Influence measures. The effects of various actors on CEOcompensation (hypothesis 3) were measured by asking theCCO to indicate the relative influence exercised by differentactors on a 5-point scale, ranging from "none" to "very high"(see Appendix B). These actors are the-CEO, major stock-holders, board of directors, compensation committee, outsideconsultants, and the CCO.Control variables. Three control variables previously demon-strated to be related to CEO compensation were assessed:job tenure, outside hire, and firm size (Roberts, 1959; McEa-chern, 1975; Agarwal, 1981; Gomez-Mejia, Tosi, and Hinkin,1987). Job tenure was measured by the number of years theCEO had held that position. CEOs who had been hired fromoutside the company were coded as "1" and CEOs whowere promoted internallywere coded as "O." Firmsize wasa composite score of the standardized values of total dollarsales and the total number of employees in the firm.RESULTSThe overall correlation matrix is shown in Table 1. Table 2 re-ports means and standard deviations for monitoring, charac-teristics of CEO compensation, and extent of influenceexercised by the various actors.Hypothesis 1 was tested by assessing the significance of themean differences in monitoring by type of firm. Table 2shows that the mean level of monitoring is significantly higherfor owner-controlled than management-controlled firms (p

the decoupling of ceo agency theory

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