Explaining the Association between Monitoring and Controversial CEO Pay Practices: an Optimal Contracting Perspective

Abstract

Puzzling associations between low levels of ownership concentration and CEO pay practices such as pay-for-luck, a low pay-performance sensitivity, a more asymmetric pay-performance relation, and high salaries, have been documented. They have been interpreted as evidence that CEO pay is not set optimally. We explain these associations in a model in which firms design contracts optimally to attract and retain CEOs. The results are driven by the matching process: firms with greater ownership concentration have a higher monitoring capacity, and can better handle the downside risk of hiring CEOs with more uncertain ability. The outside option of these CEOs is more sensitive to their performance net of luck, which generates a higher pay-performance sensitivity and less pay-for-luck. If managerial skills are sufficiently transferable across firms and the cost of CEO dismissal is sufficiently high, these CEOs are less valuable and therefore receive relatively lower salaries.