HOW DOES VARIABILITY IN CASH FLOWS AND RETURNS INFLUENCE HOW TOP EXECUTIVES ARE PAID?

Abstract

I invoke agency theory to evaluate how top executives’ compensation contracts are structured, conditional on risk in the firm’s operating environment, focusing on the total, fixed, and variable components. The results suggest that companies exert some effort to adhere to agency theoretic principles in designing top executive compensation contracts. However, imperfections in the pay setting process mean that there is ample room for powerful CEOs to seek rents. Furthermore, when risk in the operating environment is measured with volatility in returns, non-CEO top executives sometimes bear greater risk than CEOs, collecting a greater percentage of their compensation in variable pay than most CEOs. The results are most distinct in the extreme deciles of volatility, suggesting that firms may be paying greater attention to compensation design in the most extreme settings of volatility. I offer potential explanations for this phenomenon.