Managerial Ability and Compensation Design

Abstract

This research views the contingent terms in compensation as a tool for the compensation committee to capture the unknown managerial ability while it continues to serve as an incentive mechanism. As a specific mechanism that sorts manages by their ability to help shareholders retain and attract CEO human capital, Lazear (2004) analyzes the role of contingent terms in compensation when managers are more informed about their productivity. Dutta (2008) suggests that the sensitivity of compensation to performance increases with the managerial ability particularly when information risk is higher. Following Lazear (2004) and Dutta (2008), I empirically investigate the association between the managerial ability and pay sensitivity. Using measure of managerial ability developed by Demerjian et al. (2012) and a sample from ExecuComp, I find that sensitivity of total flow compensation to stock return is increasing with CEO ability. I also find that this positive relationship between the CEO ability and the sensitivity is more salient when CEO is relatively younger, when book-to-market ratio is higher, when a firm has R&D spending, and when a firm is not included in S&P 500 index. I interpret that those four contexts reflect greater information asymmetry about the managerial ability and hence firms encounter greater needs of figuring out the managers ability correctly. In additional tests, I examine the potential effects of industry and time period on my main findings. I find that high technology firms make intensive use of the ability-sorting mechanism via incentive contracts, and that the results are stronger in recent periods suggesting that firms and shareholders attention on managerial ability is growing in relation to the compensation strategy.