Performance-to-Goal in Executive Compensation Contracts

Abstract

Theory and field studies have suggested that performance goals in executive compensation contracts play a pivotal role in inducing CEOs effort toward organizational goals. I show empirical evidence consistent with the prior literature by investigating relationship between performance goal achievement and executive compensation. First, CEOs major economic incentives are placed on achieving their own performance goals rather than analyst earnings forecast, past earnings level, and zero-earnings target. Performance goal achievement has greater impact on the size of annual non-equity incentive compensation than other key determinants of CEO pay have, which include firm size, firm-wide performance as opposed to CEOs individual performance, firm industry, CEO characteristics, and corporate governance score. Second, I find that typical relationship between performance goal achievement and CEO pay is designed nonlinearly ex ante, largely inconsistent with prior theoretical support of linear association. Ex post, evidence indicates that CEOs actively respond to incremental change in economic incentive around the exact point of meeting performance goal and around each threshold along the performance goal achievement horizon. Finally, I report the improvement of association between executive pay and shareholder wealth (pay-performance sensitivity) when CEOs meet performance goals and when performance goal achievement level is higher and is within the incentive zone. In conclusion, this study reveals the concurrent practice of performance evaluation and compensation of CEOs of the largest U.S. companies. Performance goals are important control mechanism widely adopted by the corporate boards, and this study posits that the mechanism contributes to increase in shareholder wealth.