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September 20, 2013

Initial CEO Compensation Package and Potential Match

University of Nebraska–Lincoln Senior Associate Dean for the College of Business Administration and State Farm Professor of Finance Kathleen Farrell and Edwin J. Faulkner Professor of Economics Sam Allgood and colleague analyze whether initial compensation packages awarded to CEOs are specifically related to how well the executive fits the job for which they were hired.

Analyzing more than 1,400 CEOs over a 14-year period, they find CEOs who turn out to be good fits – defined as those with tenures of four years or more – are those who enjoy clearly higher compensation packages at the outset of their tenures. CEOs who stay in office at least four years made about 18 percent more in their initial contracts than those whose tenures lasted less than four years.

“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 contracts reflect the potential value of the match between CEOs and their firms.”

The study assigns four years as a “good match” because most CEO turnover happens early in the CEO’s tenure when the firm realizes the person is not a good fit. It is unlikely a CEO would become a bad fit in a four year time period due to changing firm strategic goals unless the CEO was hired to initiate these changes. In addition, a CEO is unlikely to become entrenched over such a short period of time. However, four years provides enough time for CEOs and firms to learn if their fit is a good one according to the study.

The researchers also examine the difference in initial compensation packages for CEOs promoted from within the firm compared with those hired from the outside. The ability of a firm to identify good CEO matches depends on the information available at the time a new hire is made. The researchers hypothesize that boards have more information about CEOs hired from within the firm than for CEOs hired outside the firm. Consistent with their expectations, they find that internally promoted executives who are good matches made an average of 26 percent more than internally promoted executives who left their companies before four years were up. This same relationship does not exist for executives hired from outside the firm.

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

Analyzing three sub-periods over the 14-year sample period to account for regulatory and economic changes, the researchers find that although the positive relation between expected match quality and initial compensation persists across all of the time periods, good matches for both inside and outside CEOs become very similar after 2002. The increased similarities in good matches with inside and outside CEOs in recent years suggests that boards are better able to obtain comparable information about outside candidates. This may be a result of changes in the regulatory environment that impacted board composition, resulting from the enactment of Sarbanes-Oxley.   

The study was published in the Journal of Corporate Finance in 2012. Coauthor of the study is Rashiqa Kamal of the University of Wisconsin-Whitewater.

Research abstract located at http://www.sciencedirect.com/science/article/pii/S0929119912000612.