June 20, 2013

Big Ideas: Sam Allgood and Kathleen Farrell

Dr. Sam Allgood and Dr. Kathleen Farrell
Dr. Sam Allgood, Edwin J. Faulkner Professor of Economics, and Dr. Kathleen Farrell, senior associate dean and State Farm Professor of Finance at the University of Nebraska—Lincoln College of Business Administration recently published a research article in the Journal of Corporate Finance that examined compensation packages for more than 1,400 CEOs over a 14-year period. The research sought to determine whether CEO compensation was specifically related to how well the executive fit the job for which they were hired.

"Initial compensation packages are the most important contracts negotiated by boards because CEOs rarely take pay reductions," said Allgood. "So it’s important to know whether or not these initial contacts reflect the potential value of the match between CEOs and their firms."

The research found CEOs with tenures of over four years were the ones who received clearly higher compensation packages. The data tends to support the importance of board independence when choosing a CEO, as well as having access to consistent information about executive job candidates both from within and outside a company.

Longer tenured CEOs hired from within a firm made an average of 26 percent more than executives who were internally promoted but left their company before the four-year period. When hires came from outside the firm their pay tended to be equal whether that individual ended up being a good match or not.

Because most CEO turnover happens early in an executive’s tenure, the researchers chose the four-year time frame as the standard for identifying whether the CEO was a “good match.”

"If boards are effectively evaluating new hires, the new hires that were a better fit for the firm should be paid more," said Farrell.

The study found in more recent years, firms have done a better job of hiring good matches regardless of whether they came from inside or outside the company. This suggests boards have access to more reliable data now, which may be the result of increasing board independence and changes in the corporate environment following regulatory measures enacted in the 2002 Sarbanes-Oxley Act, which created higher standards for all U.S. public boards to follow.

The article titled “Do boards know when they hire a CEO that is a good match? Evidence from initial compensation,” was co-authored by Rashiqa Kamal of the University of Wisconsin-Whitewater.

Related media stories:

Omaha World-Herald article

Phys.org article