Do CEO Bonus Plans Serve a Purpose?

Do CEO Bonus Plans Serve a Purpose?

Wayne R. Guay† [email protected]

The Wharton School University of Pennsylvania

John D. Kepler

[email protected] The Wharton School

University of Pennsylvania

David Tsui [email protected] Marshall School of Business

University of Southern California

December 2, 2016

Abstract: Given the substantial stock and option portfolios held by most CEOs, much recent literature on CEO incentives regards cash-based bonus plans as largely irrelevant. This begs the question of why nearly all CEO compensation plans include such bonuses. We re-examine the financial incentives provided by bonuses and their role in executive compensation packages. Using detailed data on bonus plans, we document that the pay-performance sensitivity of CEO cash compensation is much greater than prior estimates and that cash-based pay provides a substantial portion of many CEOs’ total financial incentives early in their tenure. However, we find little evidence that boards adjust bonus plans over time in response to CEO-specific equity holdings. This “stickiness” results in growing disparity between the magnitudes of cash- and equity portfolio-based incentives over a typical CEO’s tenure. At the same time, we find evidence that bonus plans appear to address CEO-specific liquidity needs as well as incentive issues for lower-level executives. We conclude that cash-based plans are designed mainly to offer CEOs liquidity as well as provide incentives for top management team as a whole. JEL classification: G34; J3; M12 Keywords: executive compensation; managerial incentives; pay-performance sensitivity

† Corresponding author. We gratefully acknowledge comments and suggestions from Chris Armstrong, Matt Cedergren (discussant), Carlo Gallimberti, and Rick Lambert, as well as seminar participants at the University of Chicago, Cornell University, Southern Methodist University, the Wharton School, the 2016 American Accounting Association Annual Meeting, and the 2016 UCI/UCLA/USC Accounting Research Conference. We thank Barry Chiu, Tatiana Garcia, Roy Peng, Anye Wanki, and Alex Weber for outstanding research assistance.

- 1 -

1. Introduction

This paper re-examines the financial incentives provided by executive bonuses and the role

of bonus plans in managers’ compensation packages. The vast majority of U.S. executive

compensation plans incorporate bonus payouts, and boards devote considerable time and expense

to designing these often complex plans.1 However, prior literature presents very different views

regarding the importance of bonuses in CEOs’ overall incentive schemes. Principal-agent theory

argues that optimal incentive-compensation contracts can include bonuses and other incentives not

explicitly tied to stock price, even when the principal’s sole objective is maximizing shareholder

value.2 In particular, if stock price is a noisy signal of a manager’s performance (e.g., if prices

change in part for reasons outside the manager’s control), incorporating other measures of the

manager’s performance (e.g., accounting earnings) can reduce noise and help improve incentive

alignment between the manager and shareholders. Consistent with this theory, a long line of

empirical literature concludes that bonus plans provide important incentives and influence CEOs’

investment, financing, and financial reporting decisions.3

In contrast, other literature estimates the monetary incentives that bonus awards provide

and largely concludes that these incentives are modest, both in absolute terms and compared to

equity-based incentives (e.g., Jensen and Murphy, 1990; Hall and Liebman, 1998; Core et al.,

2003).4 Based in part on these findings regarding the magnitude of incentives from bonus plans,

1 We use the term “bonus” in this paper to refer to all forms of short-term cash-based incentive compensation (i.e., annual non-equity-based incentives). 2 For example, see Hölmstrom, 1979; Paul, 1992; Feltham and Xie, 1994 3 Examples of studies emphasizing the importance of cash-based incentive plans include Healy (1985), Lambert and Larcker (1987), Gaver and Gaver (1993), Sloan (1993), Holthausen et al. (1995), Ittner et al. (1997), Matsunaga and Park (2001), and Leone et al. (2006). More recent examples include Murphy and Jensen (2011), Jayaraman and Milbourn (2012), Banker et al. (2012), Indjejikian et al. (2014), Bennett et al. (2015), Gipper (2015), Mukhopadhyay and Shivakumar (2015), and Rhodes (2016). 4 For example, Hall and Liebman (1998) find that for a 10 percent increase in shareholder value, the typical CEO’s cash compensation increases 2.2 percent (about $23,000 in their sample), 53 times less than the corresponding

- 2 -

much of the recent literature on CEO incentives ignores bonus awards and instead focuses

exclusively on “delta” and “vega” incentives stemming from stock and option portfolio holdings.

This view, if correct, raises the question as to why bonus compensation is so pervasive at the CEO

level and why boards devote so much time and energy to designing these plans.

We shed light on this issue by first showing that the actual performance sensitivity of

bonuses is considerably larger than estimates in prior studies, and is comparable in scale to equity

incentives for many CEOs early in their tenures. Prior studies typically estimate bonus

performance sensitivities by regressing bonus payouts (or total cash pay, including salary) on an

assumed measure of firm performance (e.g., accounting earnings) and using the estimated

coefficient as a measure of the sensitivity of cash pay to performance (e.g., Jensen and Murphy,

1990; Hall and Liebman, 1998). Such regression-based measures invariably contain measurement

error and attenuate the magnitude of the estimated sensitivity of cash pay to performance. To

alleviate this issue, we instead compute bonus performance sensitivities using detailed data on the

actual performance measures and the functional forms of payout structures as described in

executive bonus plan proxy statement disclosures.

Our analyses confirm that regression-based estimates severely understate CEO incentives

from bonus plans. Although direct comparisons between the magnitudes of cash- and equity-based

incentives are difficult due to the different underlying performance measures (i.e., bonuses are

largely based on earnings rather than stock price), we compare the two incentive structures based

on one of two alternative assumptions: (i) each firm’s marginal and average price-to-earnings (P/E)

ratios are equal (i.e., a one percent increase in earnings also increases stock price by one percent),

or (ii) all firms are subject to the same marginal P/E ratio (i.e., $1 of additional earnings increases

equity portfolio effect (about $1.25 million). Similarly, evidence in Core et al. (2003) suggests that equity portfolio incentives are more than 100 times greater than cash pay incentives for a typical CEO.

- 3 -

equity value by an equal amount for all firms). Under either assumption, we find that the typical

CEO in our sample receives an extra 25 to 35 percent in bonus (about $300,000 to $450,000) for

a 10 percent increase in shareholder value, which is about one-sixth to one-tenth of the

corresponding equity portfolio sensitivity (about $3 million). For CEOs early in their tenures, who

tend to have smaller equity portfolios (e.g., Armstrong et al., 2016), the gap between cash- and

equity-based incentives is considerably narrower—annual cash-based incentives are about one-

third to one-quarter of total equity portfolio incentives among these executives.5

We consider the possibility that our finding of larger bonus incentives than shown in earlier

work may reflect a structural shift over time in the design of bonus contracts. In recent years,

boards have faced growing shareholder and political pressure to more strongly link executive

annual pay with firm performance, potentially resulting in increasing performance sensitivity of

bonus plans over time.6 However, we find no evidence of an upward trend in bonus performance

sensitivities over the past twenty years.

Our findings suggest that boards design incentive compensation contracts at the start of the

CEO’s tenure with a relatively balanced mix of cash- and equity-based incentives. Over time,

however, equity holdings tend to accumulate because CEOs’ annual equity grants typically exceed

their stock sales (e.g., Core and Guay, 2010; Armstrong et al., 2016). Thus, for longer-tenured

CEOs, equity portfolio incentives come to dominate overall incentives, consistent with conclusions

from prior literature.

5 It is possible that the gap between equity- and cash-based incentives is even smaller than the estimates above on a risk-adjusted basis. Risk-averse executives are expected to discount the expected payoffs of risky incentive structures, and although bonuses are risky, the volatility of equity is typically much greater than the volatility of bonuses. For example, Murphy (2012) assumes a 10 percent risk-adjustment discount on bonus plans compared to a 33 to 67 percent discount for stock options. 6 See, for example, “‘Pay for Performance’ No Longer a Punchline” by Scott Thurm, Wall Street Journal, March 21, 2013.

- 4 -

If bonuses are designed to provide CEOs with meaningful financial incentives earlier in

their tenure, one might ask why boards allow CEOs’ equity portfolio incentives to dominate bonus

incentives later in their career. For example, boards could increase cash-based incentives over time

to match increases in equity portfolio incentives, or perhaps encourage CEOs to sell more of their

equity over time to achieve balance. Alternatively, boards might view the dominance of equity

portfolio incentives as being optimal, but perhaps recognize that it takes some time before CEOs

can build up their equity portfolios, and so provide cash-based incentives in the interim. In this

latter case, boards might phase out the payments from CEOs’ cash-based incentives once their

relative importance becomes minor. However, we find no evidence of either pattern in our data.

We conjecture several reasons why boards may continue to provide CEOs with cash-based

bonus plans even after the incentive effects become relatively minor. One possibility is that the

buildup of significant equity incentives can come at the cost of liquidity, and annual cash-based

payouts can provide executives with cash flow to fulfill their consumption demands. Although

annual salary can also provide liquidity, U.S. tax laws discourage non-performance-based cash

payments to executives in excess of $1 million.7 Thus, cash-based bonuses that are somewhat

weakly tied to performance may serve to fulfill CEOs’ liquidity demands while avoiding the firm-

level tax penalty that would be incurred for providing similar levels of non-performance-based

cash salary.

Boards likely also face pressure from various constituencies to conform compensation

plans to certain norms. For example, compensation consultants and proxy advisory firms such as

Institutional Shareholder Services (ISS) and Glass Lewis tend to focus heavily on CEOs’ annual

pay when evaluating the incentives inherent in executive compensation plans, especially in relation

7 See Section 162(m) of the Internal Revenue Code.

- 5 -

to other CEOs in their peer group (e.g., Glass Lewis, 2015; ISS, 2016). Surprisingly, and in sharp

contrast to the incentive-contracting literature in finance and accounting, these advisors largely

ignore equity holdings when assessing whether a given CEO has strong pay-for-performance

incentives. Empirical evidence also suggests that boards appear to modify compensation plans to

satisfy the preferences of proxy advisory firms (Larcker et al., 2015), and therefore bonus plan

design may reflect this focus on annual pay over portfolio incentives.

Finally, because most executive compensation plans cover a large number of executive

participants, boards and CEOs may feel that it is important for leadership purposes and executive

morale to hold the CEO accountable for the same bonus plan payouts that are borne by other senior

executives (e.g., Edmans et al., 2013; Bushman et al., 2016).8 Lower-level executives typically

receive a greater proportion of their annual pay in the form of bonus payouts and have smaller

accumulated equity portfolios, suggesting that bonuses are likely to represent a more important

component of these executives’ incentives.

We provide several analyses that shed light on the possible roles played by CEO bonuses.

First, we document that bonus plan incentives do not appear to evolve over time in response to

CEO-specific equity portfolio incentives. However, we do find evidence that CEOs with stronger

preferences for liquidity receive more of their incentive pay in the form of bonus (as opposed to

equity). Further, we find a significant positive relation between the proportion of bonus pay and

firm-level stock illiquidity, consistent with Jayaraman and Milbourn’s (2012) finding that stock-

based compensation imposes liquidity costs on CEOs.

Second, consistent with external influences on bonus plan design, we find that cash-based

incentives are significantly positively related to bonus incentives for peer firm CEOs. However,

8 Murphy (2001) finds that that the median executive bonus plan has 123 participants.

- 6 -

we do not find evidence that boards directly adjust bonus plans in response to other forms of

external pressure, such as “say on pay” votes, proxy advisor voting recommendations, or greater

shareholder monitoring. Finally, as an indication that boards design executive bonus plans to create

incentives for the firm’s top management team as a whole rather than each executive individually,

we find that the relative importance of cash-based incentives is substantially greater for other (non-

CEO) top executives at the firm (about twice as important as for the CEO), and that boards tend to

provide very similar bonus plans across all of the firm’s top executives. For example, the CEO and

the fifth-highest-paid executive share an identical set of performance targets at approximately 75

percent of firms in our sample. We also find that although boards often adjust bonus plans

following CEO turnover, these changes are typically implemented across the entire top

management team rather than solely for the CEO.

Collectively, our results help reconcile the perceived importance and widespread use of

executive bonus plans with conclusions from prior literature that CEOs’ financial incentives arise

almost exclusively from their equity portfolios. We document that the performance sensitivity of

CEO cash compensation is much greater than estimates in prior studies, and that bonuses provide

a significant portion of many CEOs’ total financial incentives early in their tenure. However, our

results also suggest that the evolution of equity portfolio incentives over the CEO’s tenure has

little effect on the design of the cash bonus plan. Further, and perhaps even more importantly, our

results point toward cash-based bonuses providing liquidity the CEO, and also providing the top

management team as a whole with important performance-based incentives.

This paper proceeds as follows. Section 2 describes our data, variable measurement, and

the procedure we use to estimate pay-performance bonus sensitivities. Section 3 presents our

- 7 -

results and compares our findings to prior literature. Section 4 examines how boards determine

cash-based incentives and Section 5 concludes.

2. Data and Variable Measurement

We obtain data on executive bonus contracts for 8,888 firm-years between 2006 and 2014

from Incentive Lab. The SEC considerably expanded mandatory disclosures regarding the

structure of these bonus contracts (as well as other forms of incentive compensation) in 2006 and

thus details on bonus structures are sparse prior to that year.9 Bonus contracts are typically

characterized by three pairs of values: a minimum (“threshold”) payment for some minimal

acceptable level of performance, a target payment for an expected level of performance, and a

maximum payment for performance sufficiently above expectations (see, e.g., Murphy, 1999;

Murphy and Jensen, 2011). For example, a CEO may receive a bonus equal to 50 percent of salary

if earnings are $1 billion (the threshold), 100 percent of salary if earnings are $5 billion (the target),

and 200 percent of salary if earnings are $16 billion (the maximum). Payments generally increase

linearly between each of these breakpoints (e.g., if earnings in the preceding example are $3

billion, the CEO would receive a bonus of 75 percent of salary).

Bonus contracts often also incorporate several non-earnings-based performance measures,

including financial metrics such as sales and cash flow as well as non-financial metrics such as

customer satisfaction. For example, 60 percent of a particular CEO’s bonus might be linked to

earnings, with 20 percent linked to sales and 20 percent to customer satisfaction. Table 1 Panel A

reports descriptive statistics for the different types of performance measures used in the bonus

contracts captured by Incentive Lab. The typical firm’s bonus plan includes 2.96 performance

9 See SEC Final Rule Release No. 33-8732A (August 29, 2006).

- 8 -

measures. Earnings-based awards are the most common form of bonus plan: the typical bonus plan

includes more than one earnings-based metric, and 93 percent include at least one such metric.10

We focus only on earnings-based bonuses in our performance-sensitivity computations because

they are by far the most common and it is relatively straightforward to compare their incentives to

those from equity-based compensation. To the extent that the non-earnings-based components of

bonus plans also provide financial incentives, our earnings-based measures will understate the

overall performance sensitivity of the bonus contract (we attempt to quantify this potential

understatement in Section 3).

To calculate the performance sensitivity embedded in CEO bonus contracts, we collect

from Incentive Lab the minimum, target, and maximum performance goals disclosed by the board

and the bonus payouts that correspond to each of these objectives. Because firms are not required

to report the specific performance goals underlying their bonus plans, we are only able to obtain

these items for a subset of the full Incentive Lab sample. We also hand collect directly from proxy

statements the actual performance for each earnings-based performance metric for this subset of

firms.11 We gather financial data from Compustat, stock return data from CRSP, institutional

investor holdings from Thomson Reuters 13F filings, and executive compensation and tenure from

Execucomp.12 We also obtain shareholder voting data and Institutional Shareholder Services (ISS)

recommendations from ISS Voting Analytics. We eliminate a small number of observations

(approximately 50) from Incentive Lab that we identify as having erroneous bonus performance

10 We use the term “earnings-based” to refer to metrics that are a function of the firm’s income. Examples include earnings per share, pretax income, and profit margin. Note that these earnings measures may include various non-GAAP adjustments, such as adding back restructuring charges or tax valuation allowances. 11 Disclosure of the actual performance of the earnings-based measures included in CEO bonus contracts is voluntary, thus we are only able to collect this information for approximately 80% of the broader Incentive Lab sample for which we are able to calculate Bonus Delta. 12 We hand collect missing tenure information directly from firms’ proxy statements obtained via the SEC’s EDGAR website.

- 9 -

goal data.13All continuous variables are winsorized at the 1st and 99th percentiles . Our final sample

consists of 3,327 firm-years from 2006 to 2014 for which we have sufficient data to perform the

bonus performance sensitivity computations described below.

We define the CEO’s bonus performance sensitivity as the ratio of the payout and goal

ranges specified in the plan. Specifically, we compute the payout range as the maximum payout

offered under the plan, less the threshold amount, and the goal range as the performance goal

associated with the maximum payout, less the goal associated with the threshold payout.14 Our

performance sensitivity measure is the ratio of these two ranges, which represents a linear

approximation of the incremental bonus that the CEO receives for each unit of the underlying

performance metric when performance falls between the threshold and maximum performance

levels (thus, our measure does not capture the effects of any “jumps” in bonus payouts for reaching

threshold performance or “capping out” of payouts for exceeding maximum performance). To

illustrate, suppose the CEO in the example above has a salary of $1 million. The maximum payout

would therefore be $2 million (200 percent of salary) and the threshold payout would be $500,000

(50 percent of salary). We would estimate the performance sensitivity of the bonus contract as the

$1.5 million payout range ($2 million less $500,000) divided by $15 billion ($16 billion maximum

earnings goal less $1 billion threshold), or $100 per $1 million of earnings.

While earnings-based measures are the most common basis for CEO bonus plans, the

specific metric that a given board chooses to use varies somewhat between firms. For example,

one firm may base bonus payments on net income, while another may link bonus to EPS. To

13 These erroneous observations primarily reflect situations in which the actual performance measure is a scaled form of earnings, such as EPS or profit margin, but Incentive Lab codes the measure as an unscaled form of earnings, such as net income or EBIT. 14 Some firms report only two performance levels for their bonus contracts (e.g., only the target and maximum, or only the target and threshold). For such firms, we define the payout and goal ranges as the difference between the two levels that the firm specifies. Our findings are very similar if we instead omit such firms.

- 10 -

enhance comparability between firms, we convert all earnings-based sensitivities to net income

sensitivities – that is, the amount of bonus that the CEO receives for a dollar of net income, which

we refer to as unscaled bonus sensitivity. For example, if the bonus plan is based on EPS, we first

compute the CEO’s bonus sensitivity based on EPS (i.e., bonus per dollar of EPS), then convert

this sensitivity to bonus per dollar of net income by dividing by the number of shares outstanding.

15 Similarly, if the bonus is based on pretax income, we first compute the bonus sensitivity to

pretax income, then convert this pretax sensitivity to net income sensitivity by dividing by one

minus the firm’s effective tax rate. Appendix A provides the specific earnings-based measures we

use and describes this net income-conversion process in more detail.

Next, to facilitate comparisons with the dollars of pay for a one percent change in equity

value (i.e., portfolio delta) measures that are common in the equity incentive literature (e.g., Hall

and Liebman, 1998; Core and Guay, 1999), we convert these unscaled bonus-earnings sensitivities

(i.e., dollars of bonus per dollar of earnings) to bonus-stock price sensitivities (i.e., dollars of bonus

per one percent change in stock price), which we refer to as Bonus Delta. Specifically, we estimate

the change in earnings that would increase the firm’s market capitalization by one percent and

compute the corresponding effect on the CEO’s bonus payout. To do so, we convert a one percent

change in market capitalization into an earnings-equivalent amount under one of two alternative

assumptions: (i) each firm’s marginal and average price-to-earnings ratio are equal, and therefore

a one percent change in earnings corresponds to a one percent change in stock price;16 or (ii) all

firms are subject to the same marginal price-to-earnings ratio, and equate earnings and equity value

accordingly (i.e., $1 of earnings increases equity value by a fixed amount; for these computations,

15 We use shares used to calculate diluted EPS to compute this sensitivity. If diluted shares are missing for the firm, we use the number of shares used to calculate basic EPS. 16 For firms with negative earnings, we assume the firm’s marginal P/E ratio equals the industry-year median P/E. Our inferences are unchanged if we instead omit such firms.

- 11 -

we assume a marginal price-to-earnings ratio of 17, the median in our sample).17 We then compute

the amount of bonus the CEO would receive for this amount of earnings equivalent to a one percent

change in market capitalization.

To illustrate, suppose a firm has a market capitalization of $18 billion and earnings of $1

billion (i.e., the firm’s P/E ratio is 18). Under assumption (i), we would assume the firm’s marginal

P/E ratio is 18 and therefore a one percent change in earnings ($10 million) would increase equity

value by one percent ($180 million). Thus, we would multiply unscaled bonus-earnings sensitivity

by 10 million to estimate the bonus the CEO would receive for earnings equivalent to one percent

of equity value. Under assumption (ii), we would instead assume the firm’s marginal P/E ratio is

17 and therefore approximately $10.6 million of earnings would increase equity value by one

percent (again, $180 million). In this case, we would multiply unscaled bonus-earnings sensitivity

by 10.6 million to estimate the bonus the CEO would receive. Appendix B provides examples from

our sample of these bonus sensitivity computations.

Table 1 Panel B reports descriptive statistics for the performance measures used in the

bonus plans in our sample, which are very similar to the overall distribution reported in Table 1

Panel A. Table 2 Panels A and B report descriptive statistics for the full sample of firms covered

by Incentive Lab and the sample of firms for which we have sufficient data to compute Bonus

Delta, respectively, for our sample period of 2006 through 2014. The median firm for which we

can compute Bonus Delta is generally comparable to the median firm in the broader Incentive Lab

sample; the primary differences are that the median firm in our Bonus Delta sample has a

17 A third possible assumption would be to use estimated earnings response coefficients (ERCs; i.e., the coefficient from a regression of stock return on earnings) to proxy for a firm’s marginal P/E ratio. We do not use ERCs because an extensive literature documents that they are generally in the range of 1 to 3, which is too small to be economically reasonable (see, e.g., Kothari, 2001). Nevertheless, for a sense of how using this alternative assumption would affect our results, note that assumption (ii) implicitly assigns an ERC of 17 to all firms. Thus, our Bonus Delta estimates would be approximately 5 to 15 times larger using ERCs to convert equity values to earnings.

- 12 -

somewhat larger book-to-market ratio (0.90 versus 0.84 for the overall Incentive Lab sample) and

a somewhat smaller CEO portfolio delta ($305,000 versus $346,000). We also report descriptive

statistics for Execucomp firms during the same time period in Table 2 Panel C. Compared to

Execucomp firms, firms in Incentive Lab are larger (median MVE of $4.7 billion for Incentive Lab

versus $1.8 billion for all Execucomp firms), consistent with Incentive Lab’s stricter sample

selection criteria (i.e., 750 largest US firms, versus the 1,500 largest for Execucomp).

3. Results

3.1. Bonus pay-performance sensitivities

Table 3 presents our estimated bonus performance sensitivities. As in Hall and Liebman

(1998), we focus on medians due to the highly skewed distribution of executive compensation. We

first consider unscaled bonus sensitivity (i.e., dollars of bonus per dollar of net income). The

median CEO receives about $12,000 per $1 million of net income, or slightly more than one cent

for each dollar of income. That is, the median CEO in our sample’s bonus reflects “fractional

ownership” of about one percent of earnings. At the median P/E ratio in our sample of 17 (i.e., $1

of income increases equity value by $17), this implies that the CEO receives approximately $0.70

in bonus for a $1,000 increase in firm value.18 For comparison, this is approximately 50 times

greater than the estimate from Jensen and Murphy (1990) that CEOs receive $0.0135 in salary and

bonus for a $1,000 increase in firm value and suggests that the performance sensitivity of bonuses

is much higher than previously estimated.

18 A 17× P/E implies $1,000 of earnings results in $17,000 of market capitalization. Therefore, $12 per $1,000 of earnings is equivalent to $17 of market capitalization, implying a CEO bonus of $0.70 per $1,000 of market capitalization.

- 13 -

Next, we consider Bonus Delta (i.e., dollars of bonus for a one percent increase in equity

value). Panel A of Table 3 indicates that, under either of the assumptions linking earnings and

equity value described in Section 2, the median CEO receives about $30,000 in bonus for a one

percent increase in equity value. Relative to the median CEO’s bonus of $1.3 million, this CEO

receives an increase in bonus of approximately 2.3 percent for earnings equivalent to a one percent

increase in equity value.19 In contrast, Hall and Liebman (1998) estimate that the median CEO’s

cash pay increases by about $2,300, or 0.2 percent, for a one percent increase in equity value.

Again, these results suggest that the true performance sensitivity of executive bonus contracts is

at least an order of magnitude larger than prior studies have estimated.

As we note in Section 2, our tests are conducted using bonus sensitivities from earnings-

based plans, and therefore exclude the performance sensitivity of non-earnings-based plans. To

examine the potential influence of this research design choice, we compute bonus sensitivities for

two relatively common non-earnings-based performance metrics (cash flow and sales) and present

the results in Panel B of Table 3. We compute these sensitivities under the same method as the

earnings sensitivities we describe in Section 2 (i.e., ratio of payout range to goal range). We find

that although sales and cash flow sensitivities are smaller than for earnings, for many CEOs these

sensitivities are economically significant. In untabulated analysis, we find that for the typical bonus

contract, earnings-based payouts comprise approximately 67 percent of the total cash award. Thus,

this descriptive analysis suggests that overall cash-based bonus incentives are perhaps about 50

percent greater than those reported in Table 3 for the typical CEO (e.g., perhaps about $45,000 for

a one percent change in market capitalization rather than the roughly $30,000 reported in Table 3

for the median CEO).

19 Relative to total cash compensation (i.e., salary plus bonus), this is an increase of approximately 1.3 percent.

- 14 -

While our results in Table 3 indicate that the nominal performance sensitivity of bonus

plans is much larger than prior studies estimate, the “effective” performance sensitivity of these

plans may be lower than indicated by our estimates if managers can easily achieve the pre-specified

goals. To explore whether bonus plans in fact provide a form of “at-risk” incentive compensation,

we examine the actual performance and corresponding bonus payouts for each performance

measure in our sample of firms for which we can compute our Bonus Delta measure. Table 4

reports summary statistics from this analysis. In Panel A, we find that there is substantial variation

in realized performance, as the interquartile range is approximately 100 percent of the target

payout, and 16 percent of CEOs fail to meet the minimum performance threshold (i.e., they receive

no payment). Target performance also appears to be somewhat conservative on average, as the

median CEO receives 111 percent of the target payout. Further, in Panel B we find that the majority

(i.e., 63%) of all realized performance measures in our sample fall between the minimum threshold

and maximum goal for the fiscal year. Overall, these results indicate that realized performance

does deviate from the target goals set forth in bonus plans and the performance sensitivities we

estimate are not purely nominal.

3.2. Bonus versus equity incentives

Having documented that the performance sensitivity of executive bonus contracts appears

to be much greater than prior literature estimates, we next examine how this result influences the

conclusion in prior literature that equity-based compensation accounts for the vast majority of total

executive incentives.20 As discussed above, we estimate that the typical CEO receives

approximately $30,000 to $45,000 in bonus for a one percent increase in equity value. In

comparison, the same CEO would receive about $300,000 from increased equity portfolio value,

20 Jensen and Murphy (1990); Hall and Liebman (1998); Murphy (1999, 2012); Core and Guay (2010).

- 15 -

about six to ten times larger.21 Thus, while equity portfolios do provide the majority of a typical

CEO’s overall financial incentives, the relative incentive weights that we estimate for earnings and

equity are somewhat more balanced than estimates in prior studies. For example, Jensen and

Murphy (1990) find that equity portfolio incentives are about 100 times larger than cash pay

incentives, while Hall and Liebman (1998) conclude the ratio is approximately 50 times.

We also note that, on a risk-adjusted basis, the gap between equity-based and cash-based

incentives may be even smaller than the estimates discussed above. Risk-averse executives are

expected to discount the expected payoffs of risky incentive structures, and although both bonuses

and equity holdings are risky, the volatility of equity holdings is typically greater than the volatility

of bonuses. For example, Murphy (2012) assumes a 10 percent risk-adjustment discount on bonus

plans, compared to a 33 percent to 67 percent discount for stock options.

Figure 1 compares the relative balance between cash and equity portfolio incentives over

the course of a CEO’s tenure. Notably, when the CEO is first hired, equity portfolio incentives

(about $100,000 for a one percent change in equity value) are about three times cash incentives

($30,000 for a one percent change in equity value). However, this balance shifts over time and,

consistent with prior studies (e.g., Core and Guay, 1999; Armstrong et al., 2016), we find that

equity portfolio incentives increase substantially (and approximately linearly) with tenure. In

contrast, cash bonus incentives are largely unchanged over the course of a CEO’s tenure; there is

a modest increase over time, but the scale is dramatically smaller than the increase in equity

portfolio incentives. The net effect is that equity portfolio incentives become increasingly

dominant as tenure increases. For executives with median tenure (about five years), the balance

21 We compute this equity portfolio effect following Core and Guay (2002).

- 16 -

between cash and equity incentives is comparable to the ratio across our overall sample, and the

importance of equity incentives continues to grow as tenure extends beyond this point.

Taken as a whole, our results indicate that initial CEO compensation contracts contain a

balanced mix of short- and long-term – as well as cash- and non-cash – incentives, but this

compensation mix becomes increasingly skewed as the CEO’s tenure increases. However, we also

draw a distinction between “constrained” and “unconstrained” equity holdings, as defined by

Armstrong et al. (2016). Those authors document that the majority of CEOs’ equity portfolio

incentives are “unconstrained” in the sense that there are no explicit constraints on sales (e.g., stock

grants or in-the-money options with vesting provisions that have lapsed). In Figure 2, we show

that “constrained” equity, which the CEO cannot sell either because it is unvested or due to a

minimum equity ownership guideline, remains relatively constant over a CEO’s tenure and is

reasonably balanced with cash bonus incentives, while unconstrained equity incentives grow

rapidly and are principally responsible for the growing disparity between cash- and equity-based

incentives as CEO tenure increases.

3.3. Why do prior studies find weaker performance sensitivity?

Next, we evaluate potential reasons why our bonus performance sensitivity estimates differ

so significantly from prior literature. One possibility is that, in recent years, the actual performance

sensitivity embedded in bonus contracts is greater than in the samples considered in prior literature.

For example, the sample in Hall and Liebman (1998) spans from 1980 through 1994 and the

sample in Jensen and Murphy (1990) covers 1969 through 1983. In contrast, our bonus sensitivity

computations are based on data from 2006 through 2014. Boards have been under growing

pressure from shareholders and regulators to strengthen the link between pay and performance,

- 17 -

and our larger estimates may capture increased bonus performance sensitivity since the mid-1990s

in response to this pressure.

Another possibility is that the regression-based estimates in prior literature are unable to

reliably detect the underlying performance sensitivity reflected in executive bonus plans. As we

discuss in Section 2, bonus plans tend to have non-linear payout structures and zero performance

sensitivity above or below certain thresholds (e.g., Murphy, 1999; Murphy and Jensen, 2011),

which could attenuate regression-based estimates of performance sensitivities. These estimates

also rely on linking cross-sectional or time-series variation in firm performance to variation in

bonus pay and may be quite noisy because of several potential sources of measurement error in

the performance measures underlying bonus contracts. For example, boards may modify

performance targets based on prior results (e.g., Leone and Rock, 2002) or exclude various

expenses when computing earnings (e.g., Bradshaw and Sloan, 2002), both of which could

attenuate the correlation between bonus pay and underlying firm performance and therefore

potentially cause regression-based sensitivities to underestimate the bonus plan’s actual

performance incentives.

We conduct several tests to examine the validity of these alternative explanations for the

gap between our bonus performance sensitivity estimates and those in prior literature. First, to

evaluate potential time trends in bonus performance sensitivity, we estimate annual bonus-

performance regressions based on the specifications used in prior literature and examine how the

estimated coefficients change over time. Specifically, for each year from 1994 to 2014, we estimate

models of the following form, as in Hall and Liebman (1998):

,

, , , , (1)

- 18 -

where Compensation is salary plus bonus (i.e., total cash pay) and Performance is either the firm’s

stock return or earnings scaled by market value. We use stock return as a performance measure for

consistency with prior literature (e.g., Jensen and Murphy, 1990; Hall and Liebman, 1998) and

earnings because, as discussed in Section 2, earnings are the primary performance measure used

in bonus contracts. As in Hall and Liebman (1998), we use the current period performance

coefficient (i.e., ) to proxy for the performance sensitivity of the bonus plan. Figures 3a and 3b

plot our annual performance sensitivity estimates using stock return and earnings as the

performance measure, respectively. Our sensitivity estimates using stock return as the performance

measure are generally in the range of 0.2 to 0.4 (i.e., a 10 percent increase in stock price

corresponds to a 2 to 4 percent increase in cash pay), comparable to the estimates in Hall and

Liebman (1998). For both performance measures, there is no clear upward pattern: sensitivities in

more recent years are approximately the same as those in the mid-1990s, and casual inspection

suggests that much of the variation in these sensitivities may reflect economic cycles and overall

stock market performance rather than a persistent long-term trend.22

To further explore potential time trends in bonus sensitivities, we examine how the

sensitivities that we directly compute based on bonus plan data have changed over time. Due to

disclosure requirements, our time series for this analysis spans only from 2006 through 2014,

rather than starting from 1994 as in Figure 3. Figure 4 depicts how the median bonus sensitivity

we compute has evolved over this time period. Similar to the regression results, we find no clear

upward pattern, and again the primary source of variation in these sensitivities appears to be driven

by business cycles rather than a secular trend toward greater performance sensitivity. Together,

22 In untabulated analyses, we also examine the variability of cash-based pay relative to the variability of equity-based pay, as in Core et al. (2003), and find no evidence of an upward trend over time.

- 19 -

Figures 3 and 4 suggest that our larger bonus performance sensitivity estimates compared to prior

literature are not driven by differences between sample periods.

Next, we examine how accurately regression-based performance sensitivity estimates

capture the underlying bonus plan’s incentives. We do so by estimating the following variant of

Eq. (1) using only firms for which we can compute an actual bonus performance sensitivity, which

allows us to compare the estimated coefficient to the performance sensitivity that we directly

compute:

, , , , (2)

where Compensation is bonus pay and Performance is earnings before extraordinary items divided

by market value, multiplied by 17 (the median P/E ratio in our sample) and converted to a percent

by multiplying by 100. 23 This scaling yields a performance coefficient in Eq. (2) that is directly

comparable to our scaled bonus sensitivity measure (i.e., Bonus Delta, or how many dollars a CEO

receives for earnings equivalent to one percent of market value).24 Recall that in Table 3, we find

mean Bonus Delta of approximately $70,000. Thus, if Eq. (2) accurately estimates the underlying

performance sensitivity of the bonus contract, the estimated coefficient should be in the range

of 70,000.

Column 1 of Table 5 Panel A reports results from estimating Eq. (2). In contrast to the

“true” coefficient of 70,000, the estimated performance sensitivity coefficient is approximately

500. That is, our regression estimates indicate that for increasing market value by one percent, the

CEO receives about $500—more than 100 times less than our measure (i.e., Bonus Delta) would

indicate. This result suggests that regression-based performance sensitivity estimates may

23 We include firm fixed effects ( ) in all estimations of Eq. (2). 24 Specifically, a one unit increase in Performance is equivalent to earnings increasing by one-seventeenth of one percent of market value. Assuming a marginal P/E ratio of 17, this implies a one percent increase in stock price.

- 20 -

significantly understate the actual incentives embedded in the bonus contract and provides one

plausible explanation for why our estimates vary so substantially from those in prior literature.25

To explore why these regression coefficient estimates differ so much from the performance

sensitivities that we directly compute, we re-estimate Eq. (2) using two alternative specifications.

First, to examine the potential effect of non-linearities due to earnings falling outside of the

performance range defined by the bonus plan, we restrict the sample to observations where actual

earnings fall between the specified “threshold” and “maximum” earnings benchmarks. That is, we

estimate Eq. (2) using only firm-years where actual performance is within the linear “incentive

zone” that we use to estimate performance sensitivity. Column 2 of Table 5 Panel A reports the

results. We find that the coefficient on earnings under this specification is approximately 200 and

not statistically significant, suggesting that non-linearities in bonus structures are not responsible

for our attenuated regression estimates. Second, to examine the effect of varying performance

targets, we redefine the performance measure as earnings in excess of the threshold goal, rather

than raw earnings. Columns 3 and 4 of Table 5 Panel A report the results from estimating Eq. (2)

using our full sample and “incentive zone” observations, respectively. These results are very

similar to those in columns 1 and 2, indicating that adjusting for performance benchmarks does

not meaningfully affect regression-based estimates of performance sensitivities.

Next, to consider the effect of firms excluding certain expenses from earnings when

computing bonus payouts, we measure Performance in Eq. (2) as actual performance reported in

the firm’s proxy statement, rather than earnings before extraordinary items. Table 5 Panel B reports

the results from re-estimating the models in Table 5 Panel A with this alternative performance

measure. In columns 1 and 2, where we do not adjust Performance for the threshold goal, we find

25 Note that the magnitude of this attenuation is independent of our assumed marginal P/E ratio because our Bonus Delta and regression coefficient estimates are both inversely proportional to this assumed P/E.

- 21 -

no significant relation between performance and bonus. In contrast, when we adjust for the

threshold goal in columns 3 and 4, we find a significantly positive relation between performance

and bonus, and these estimates are substantially larger than those in Table 5 Panel A. These

findings indicate that measurement error in the performance measure significantly attenuates

regression-based performance sensitivities, and this measurement error arises both from time-

varying performance thresholds and differences between GAAP earnings and the actual earnings

boards use to compute bonus payouts. However, we find no significant difference between

estimated sensitivities in columns 3 and 4 of Table 5 Panel B, suggesting that the non-linear nature

of bonus plans does not significantly affect regression-based sensitivities. Collectively, the results

in Table 5 indicate that measurement error in the assumed performance measure and unobserved

heterogeneity in firms’ bonus structures are primarily responsible for the attenuated performance

sensitivity estimates in prior literature.

4. How do boards determine bonus structures?

The results in Section 3 suggest that boards do not substantially alter the magnitude of

bonus incentives over the course of a CEO’s tenure as equity portfolio incentives grow. These

findings raise the question of what factors boards do consider when designing bonus plans and

what the purpose is for such plans. For example, if boards aim to maintain a consistent balance

between cash- and equity-based incentives over a CEO’s tenure, we would expect bonus

sensitivities to increase with equity portfolio incentives. Alternatively, boards could also choose

to eliminate cash-based incentives once equity portfolio incentives become sufficiently large.

However, as we show in Figure 1, neither of these outcomes tends to occur – rather, bonus

- 22 -

sensitivities remain quite stable over a typical CEO’s tenure and do not appear to vary

meaningfully with changes in equity portfolio incentives. In this section, we examine several

potential factors that may influence how boards design CEOs’ cash-based incentives to provide

some insight into the intended purposes of these plans.

4.1. CEO equity portfolios

We first more directly examine whether boards attempt to coordinate cash- and equity-

based incentives by modeling CEO bonus incentives (Bonus Delta) as a function of a CEO’s equity

portfolio incentives as well as standard economic determinants of CEO incentives from prior

literature (e.g., Core and Guay, 1999; Armstrong et al., 2016):

, ,

, , ,

, , , (3)

where Delta is the CEO’s stock and option portfolio delta as computed in Core and Guay (2002).26

We also consider whether boards differentially incorporate incentives stemming from

“constrained” equity that the CEO is required to hold due to vesting or minimum stock ownership

requirements and “unconstrained” equity that the CEO can sell without restriction (Armstrong et

al., 2016). For example, boards may focus on incentives from constrained equity, which reflect

equity incentives deliberately required by the board, and largely ignore unconstrained equity. We

decompose Delta in Eq. (3) into Constrained Delta and Unconstrained Delta, where Constrained

Delta is Delta from: 1) vested equity that is subject to an ownership guideline, 2) unvested equity,

and 3) out-of-the-money options, and Unconstrained Delta is Delta minus Constrained Delta, as

in Armstrong et al. (2016). Finally, to examine whether boards emphasize incentives from annual

26 Unless noted otherwise, we include firm- and year- fixed effects ( and , respectively) in all estimations in this section.

- 23 -

pay over portfolio incentives, we also consider Annual Delta, the delta of the CEO’s stock and

option grants in the current year.

The results from estimating Eq. (3) are reported in Table 6. Consistent with the descriptive

results from Figure 1, there is no significant relation between Bonus Delta and Delta, suggesting

that boards do not appear to consider equity portfolio incentives when determining CEOs’ cash-

based incentives.27 We also find no significant relation between Bonus Delta and either

Constrained Delta or Unconstrained Delta. Collectively, these results are striking in that they

suggest that boards largely ignore CEOs’ equity portfolio incentives when designing cash-based

incentives. In contrast, we do find a significant positive relation between Bonus Delta and Annual

Delta, suggesting that boards may focus on balancing cash-based incentives with annual equity

grants rather than overall portfolio incentives.

4.2. Liquidity preferences

Next, we examine whether bonus plans help address CEO liquidity preferences. To explore

this possibility, we estimate the following variant of Eq. (3), where we model the proportion of

the CEO’s annual pay received as bonus as opposed to the pay-performance sensitivity of the

bonus contract:

, , ,

, , ,

, , (4)

where Bonus Mix is the CEO bonus payout as a percent of total compensation. We use four

measures for Liquidity Preference in Eq. (4): three proxies for the CEO’s individual liquidity

preferences and one proxy for firm-level liquidity characteristics. Our first CEO-level liquidity

27 In untabulated analyses, we use insider trading and stock and option vesting as instruments for Delta and continue to find no evidence that boards adjust CEO bonus sensitivity in response to arguably exogenous shocks to CEO equity holdings.

- 24 -

preference measure is based on the “cash mix” (i.e., salary and bonus as a percentage of total

compensation) of the CEO’s first-year compensation, High Hire Date Cash Mix (Industry).

Assuming CEOs have some degree of bargaining power in establishing the parameters of their

compensation when they are first hired, a CEO choosing to receive greater cash mix in his first

year may indicate a stronger preference for liquidity. Specifically, we compute cash mix in a

CEO’s first year and define that CEO’s liquidity preference as low (high) if this first-year mix is

below (above) the industry-year median cash mix (i.e., this measure is constant over time for the

same CEO). Second, we define No Deferred Compensation as low (high) for CEOs who

contributed (did not contribute) to a deferred compensation plan in a given year, as CEOs willing

to defer a portion of their current compensation presumably do not have pressing liquidity needs.

Third, we define measure liquidity preferences using the CEO’s age (Executive Age), as older

CEOs have stronger demands for liquidity (e.g., Lewellen et al., 1987). Finally, we measure firm-

level liquidity preferences following Jayaraman and Milbourn (2012), who find that boards put

greater emphasis on cash- (equity-) based incentives when their firm’s stock is less (more) liquid,

Specifically, consistent with Jayaraman and Milbourn (2012), we measure illiquidity (Stock

Illiquidity) as the negative log ratio of the firm’s annual trading volume to shares outstanding.

Table 7 presents results from estimating Eq. (4). We find consistent evidence that boards

consider CEO-specific liquidity preferences when structuring bonuses, as there is a significant

positive relation between Bonus Mix and High Hire Date Cash Mix (Industry), No Deferred

Compensation, and Executive Age. We also find evidence that boards consider firm-level liquidity

characteristics when designing CEO bonus contracts. In particular, there is a significant positive

relation between Bonus Delta and Stock Illiquidity.

4.3. External pressure and monitoring

- 25 -

We next consider the influence of pressure from external parties on the design of CEO

bonus plans. For example, boards frequently refer to peer-group comparisons when explaining and

justifying their compensation decisions, and Bizjak et al. (2008) and Faulkender and Yang (2010)

find evidence that boards adjust the level of their CEO’s compensation in response to variation in

compensation at peer firms. Furthermore, proxy advisors such as ISS and Glass Lewis also tend to

focus heavily on CEOs’ relative annual pay when evaluating the incentives inherent in executive

compensation plans (e.g., Glass Lewis, 2015; ISS, 2016). As a result, boards may attempt to

benchmark the incentives provided by their CEO’s annual compensation contract to peer group

firms. To examine this possibility, we modify Eq. (3) to include the log of the median Bonus Delta

of the firm’s peer group (Median Peer Bonus Delta):

, ,

, , ,

, , , (5)

To further evaluate the effect of external scrutiny from proxy advisors on the design of

CEOs’ bonus plans, we examine whether these plans respond to proxy advisor recommendations

on executive compensation votes (or, more generally, the existence of such a vote). Specifically,

we estimate the following model:

, , ,

, , ,

, , , (6)

where Compensation Vote indicates whether a shareholder vote on executive compensation

occurred at the annual meeting and ISS Rec indicates whether ISS recommended voting “against”

the compensation plan. We separately consider both the ISS recommendation in the current year

as well as cumulative number of “against” recommendations to account for the possibility that

negative recommendations have persistent effects, rather than only influencing compensation in

- 26 -

the subsequent year. We also consider whether other forms of external monitoring, such as the

presence of institutional investors or blockholders, may influence how boards design CEOs’ bonus

plans by estimating the following model:

, ,

, , ,

, , , (7)

We use three measures for Monitoring in Eq. (7): an indicator for whether the firm is included in

the S&P 500 index (S&P 500), the percentage of shares outstanding owned by institutional

investors (% Institutional Ownership), and the number of investors who own at least one percent

of shares outstanding (Number of Blockholders).

Table 8 Panel A displays results from estimating Eq. (5) and (6) and Table 8 Panel B

displays results from estimating Eq. (7). In Panel A, we find a significantly positive relation

between the firm’s Bonus Delta and Bonus Delta for peer firms’ CEOs, consistent with peer group

effects influencing bonus plan design. However, we find no evidence that boards respond to

shareholder votes on executive compensation or negative ISS recommendations regarding

executive compensation plans. Similarly, in Panel B, we find no evidence that boards alter bonus

plans in response to changes in the degree of external monitoring.28

It is also possible that boards include additional performance measures in the CEO’s bonus

plan, rather than adjust its sensitivity, to signal to external parties that they are adequately

performing their monitoring duties. To examine this possibility, in untabulated analyses, we re-

estimate Eq. (7) using measures of the CEO’s bonus plan complexity (e.g., the number of financial

and non-financial performance measures included in the bonus plan) instead of Log(Bonus Delta)

28 In untabulated analysis we re-estimate Eq. (7) using changes in bonus plan characteristics (i.e., signed and unsigned changes in Bonus Delta, addition or removal of specific performance measures, and Congruity and Measure Spread) as dependent variables instead of Bonus Delta and find similar non-results.

- 27 -

as a dependent variable. Similar to the results in Table 8, we find no evidence that CEO bonus plan

complexity changes in response to changes in the firm’s external monitoring environment.

Collectively, these results suggest that while proxy advisors and institutional investors may have

some influence on the factors that boards consider when designing bonus plans (e.g., focusing on

annual or relative pay rather than portfolio incentives), boards do not appear to deliberately adjust

the incentive levels in bonus plans in response to these monitors.

4.4. Top management team synergies

As noted above, boards may primarily intend for bonus plans to motivate the firm’s top

management team as a whole, rather than incentivizing each executive individually. For example,

Edmans et al. (2013) and Bushman et al. (2016) discuss how, due to cost of effort synergies,

managers sharing a common set of performance measures may be incentivized to exert greater

effort than if each manager were paid on a distinct measure. Thus, boards may continue to include

CEOs in bonus plans as part of collectively incentivizing the firm’s top executives, even if the

CEO’s direct financial incentives from these bonuses are relatively modest. To shed light on the

possibility that boards design “firm-wide” executive bonus plans with the intent of covering the

entire top management team and these bonuses are relatively more important for non-CEO

executives, we recompute Bonus Delta and Delta for the lowest-paid executive for which the firm

discloses compensation data (typically the fifth-highest-paid executive at the firm).29 Table 9 Panel

A provides descriptive statistics for these results. Consistent with cash-based incentives being

relatively more important to these executives, we find that Bonus Delta for the median “lowest-

paid executive” is about one-fourth of equity Delta (as discussed in Section 3.3, the median CEO’s

29 In certain cases, the CEO is the lowest-paid executive at the firm. We omit such observations from this analysis. These situations generally arise when the CEO is a founder of the company and holds a very large equity stake in the firm (e.g., Mark Zuckerberg has consistently been the lowest-paid top executive at Facebook).

- 28 -

Bonus Delta is about one-ninth of equity Delta). If boards design and implement similar bonus

contracts across the firm’s top management, choosing to provide these cash-based incentives to

the firm’s other executives could also result in CEOs receiving similar bonuses even after their

relative incentive effect diminishes.

To explore how closely compensation structure is tied across executives within a firm, we

examine the number of unique (and total) performance measures used in the CEO’s as well as the

lowest-paid executive’s bonus contracts. We define Measure Spread as the difference between the

number of total measures used in the CEO’s bonus contract and the number of total measures used

in the lowest-paid executive’s bonus contract. We also define Congruity as the proportion of

measures in the lowest-paid executive’s bonus contract that are also included in the CEO’s bonus

contract and Perfect Congruity as an indicator that equals 1 if the CEO’s and lowest-paid

executive’s bonuses are based on exactly the same performance measures (i.e., Measure Spread

equals 0 and Congruity equals 1), and 0 otherwise. Table 9 Panel B provides descriptive statistics

for these results. Consistent with boards designing similar bonus contracts across the firm’s top

management, bonus payouts for both the CEO and the lowest-paid executive are based on exactly

the same measures at the vast majority of firms – Perfect Congruity is 1 at almost 75 percent of

firms and Congruity is 1 at 89 percent of firms.

Finally, to further explore the cash-based incentive structure homogeneity across the top

management team at the same firm, we perform two additional tests. First, we consider changes in

bonus plans following CEO turnover. If bonus plans are primarily designed for the top

management team as a whole, new CEOs may simply be assigned a bonus plan that is similar to

the prior CEO (and management team) rather than receiving substantial individual-specific

adjustments. Alternatively, boards may adjust bonus plans after hiring a new CEO (e.g., to set a

- 29 -

different strategic direction for the firm) but implement a common set of changes across the top

management team, rather than adjusting only the CEO’s plan. To examine these possibilities, we

estimate the following model:

Δ , ,

, , ,

, , , (8)

We consider several plan characteristics when estimating Eq. (8): signed and unsigned changes in

Bonus Delta, addition or removal of specific performance measures, and Congruity and Measure

Spread. Panel C of Table 9 reports the results from estimating Eq. (8). We find that CEO turnover

is typically followed by changes in Bonus Delta and the specific measures included in the bonus

plan. However, we find that these changes tend to be mirrored across the top management team,

rather than CEO-specific, as we find no effect of CEO turnover on Congruity or Measure Spread.

These results suggest that while boards adjust bonus plans after hiring a new CEO, these changes

are not designed specifically for the new CEO but rather for the firm’s top management as a whole.

Second, we examine more generally whether boards tend to adjust top management team

incentives together by estimating the following variant of Eq. (3):

, ,

, , ,

, , , (9)

where Lowest Paid Bonus Delta is the Bonus Delta for the lowest-paid executive for which the

firm provides data. Table 9 Panel D reports the results from estimating Eq. (9). Consistent with

top executives within a firm sharing similar incentive compensation structures, we find a strong

association between the bonus structure of the CEO and the lowest-paid executive at the firm.

Collectively, the results from Table 9 are consistent with firms designing “firm-wide” bonus plans

to cover the entire top management team.

- 30 -

5. Conclusion

We document that financial incentives provided by executive bonus contracts are

significantly greater than estimated in previous academic literature. We show executive bonus

contracts can provide meaningful incentives, particularly for CEOs early on in their tenure,

suggesting that boards design incentive compensation contracts at the start of the CEO’s tenure

with a relatively balanced mix of cash- and equity-based pay, but these bonus incentives are

eclipsed by accumulated equity incentives as the CEO’s tenure increases. These results raise the

question of why boards do not adjust executive bonus contracts as CEOs’ equity portfolios grow

over their tenure. We explore several possible explanations, including liquidity preferences,

pressure from shareholders and proxy advisors, and top management team synergies. We find

evidence consistent with some of these explanations, but find no evidence that boards consider

executives’ equity portfolio when designing cash-based incentive compensation. Collectively, our

results help reconcile the ubiquitous use of bonus plans in executive compensation contracts with

prior literature documenting that CEOs’ financial incentives arise almost exclusively from their

equity portfolios.

- 31 -

References Armstrong, Chris, John E. Core, and Wayne R. Guay. "Why do CEOs hold equity?" Available at

SSRN 2544792 (2016). Banker, Rajiv D., Masako N. Darrough, Rong Huang, and Jose M. Plehn-Dujowich. "The relation

between CEO compensation and past performance." The Accounting Review 88, no. 1 (2012): 1-30.

Bennett, Benjamin, Carr Bettis, Radhakrishnan Gopalan, and Todd Milbourn. "Costs of including accounting performance goals in executive compensation." Working Paper (2015).

Bizjak, John M., Michael L. Lemmon, and Lalitha Naveen. "Does the use of peer groups contribute to higher pay and less efficient compensation?" Journal of Financial Economics 90.2 (2008): 152-168.

Bradshaw, Mark T., and Richard G. Sloan. "GAAP versus the street: An empirical assessment of two alternative definitions of earnings." Journal of Accounting Research 40.1 (2002): 41-66.

Bushman, Robert M., Zhonglan Dai, and Weining Zhang. "Management Team Incentive: Dispersion and Firm Performance." The Accounting Review91.1 (2016): 21-45.

Core, John, and Wayne Guay. "The use of equity grants to manage optimal equity incentive levels." Journal of Accounting and Economics 28.2 (1999): 151-184.

Core, John, and Wayne Guay. "Estimating the value of employee stock option portfolios and their sensitivities to price and volatility." Journal of Accounting Research (2002): 613-630.

Core, John, and Wayne Guay. "Is CEO pay too high and are incentives too low? A wealth-based contracting framework." The Academy of Management Perspectives 24.1 (2010): 5-19.

Core, John E., Wayne R. Guay, and Robert E. Verrecchia. "Price versus non-price performance measures in optimal CEO compensation contracts." The Accounting Review 78.4 (2003): 957-981.

Edmans, Alex and Goldstein, Itay and Zhu, John, Contracting with Synergies (2013). ECGI - Finance Working Paper No. 320/2011. Available at SSRN.

Faulkender, Michael, and Jun Yang. "Inside the black box: The role and composition of compensation peer groups." Journal of Financial Economics 96.2 (2010): 257-270.

Feltham, Gerald A., and Jim Xie. "Performance measure congruity and diversity in multi-task principal/agent relations." Accounting review (1994): 429-453.

Gaver, Jennifer J., and Kenneth M. Gaver. "Additional evidence on the association between the investment opportunity set and corporate financing, dividend, and compensation policies." Journal of Accounting and Economics 16.1 (1993): 125-160.

Gipper, Brandon. "Assessing the Effects of Disclosing Management Compensation." Working Paper. Available at SSRN 2514578 (2015).

Hausman, Jerry. "Mismeasured variables in econometric analysis: problems from the right and problems from the left." The Journal of Economic Perspectives 15.4 (2001): 57-67.

Hall, Brian J., and Kevin J. Murphy. "Stock options for undiversified executives." Journal of Accounting and Economics 33.1 (2002): 3-42.

Hall, Brian J., and Jeffrey B. Liebman. Are CEOs really paid like bureaucrats? The Quarterly Journal of Economics Vol. CXIII.3 (1998): 653-691.

Healy, Paul M. "The effect of bonus schemes on accounting decisions." Journal of Accounting and Economics 7.1 (1985): 85-107.

Hölmstrom, Bengt. "Moral hazard and observability." Bell journal of economics (1979): 74-91.

- 32 -

Holthausen, Robert W., David F. Larcker, and Richard G. Sloan. "Annual bonus schemes and the manipulation of earnings." Journal of Accounting and Economics 19.1 (1995): 29-74.

Indjejikian, Raffi J., Michal Matejka, Kenneth A. Merchant, and Wim A. Van der Stede. "Earnings targets and annual bonus incentives." The Accounting Review 89.4 (2014): 1227-1258.

Ittner, Christopher D., David F. Larcker, and Madhav V. Rajan. "The choice of performance measures in annual bonus contracts." The Accounting Review (1997): 231-255.

Jayaraman, Sudarshan, and Todd T. Milbourn. "The role of stock liquidity in executive compensation." The Accounting Review 87.2 (2011): 537-563.

Jensen, Michael C., and Kevin J. Murphy. "Performance pay and top-management incentives." Journal of Political Economy (1990): 225-264.

Kothari, S. P. "Capital markets research in accounting." Journal of Accounting and Economics 31.1 (2001): 105-231.

Lambert, Richard A., and David F. Larcker. "An analysis of the use of accounting and market measures of performance in executive compensation contracts." Journal of Accounting Research (1987): 85-125.

Larcker, David F., Allan L. McCall, and Gaizka Ormazabal. "Outsourcing shareholder voting to proxy advisory firms." Journal of Law and Economics 58.1 (2015): 173-204.

Leone, Andrew J., and Steve Rock. "Empirical tests of budget ratcheting and its effect on managers’ discretionary accrual choices." Journal of Accounting and Economics 33.1 (2002): 43-67.

Leone, Andrew J., Joanna Shuang Wu, and Jerold L. Zimmerman. "Asymmetric sensitivity of CEO cash compensation to stock returns." Journal of Accounting and Economics 42.1 (2006): 167-192.

Lewellen, Wilbur, Claudio Loderer, and Kenneth Martin. "Executive compensation and executive incentive problems: An empirical analysis." Journal of Accounting and Economics 9.3 (1987): 287-310.

Matsunaga, Steven R., and Chul W. Park. "The effect of missing a quarterly earnings benchmark on the CEO's annual bonus." The Accounting Review76.3 (2001): 313-332.

Mukhopadhyay, Tathagat, and Lakshmanan Shivakumar. "Do Compensation Disclosures Matter for SoP Voting?" Working Paper. Available at SSRN 2718438 (2015).

Murphy, Kevin J. "Executive compensation." Handbook of Labor Economics 3 (1999): 2485-2563.

Murphy, Kevin J., and Michael C. Jensen. "CEO bonus plans: And how to fix them." Harvard Business School NOM Unit Working Paper (2011): 12-022.

Murphy, Kevin J. "Executive compensation: Where we are, and how we got there." Handbook of the Economics of Finance. Elsevier Science North Holland (Forthcoming) (2012).

Paul, Jonathan M. "On the efficiency of stock-based compensation." Review of financial studies 5.3 (1992): 471-502.

Rhodes, Adrienne. "The relation between earnings-based measures in firm debt contracts and CEO pay sensitivity to earnings." Journal of Accounting and Economics 61.1 (2016): 1-22.

Sloan, Richard G. "Accounting earnings and top executive compensation. "Journal of Accounting and Economics 16.1 (1993): 55-100.

- 33 -

Appendix A. Earnings-based measures

The specific earnings-based measures we use to compute our bonus sensitivities are (as coded by Incentive Lab): EBIT, EBITDA, EBT, Operating Income, Earnings, EVA, EPS, Profit Margin, ROA, ROE, ROI, and ROIC. We consider the first four measures (EBIT, EBITDA, EBT, and Operating Income) pretax income. We convert pretax bonus sensitivities to after-tax sensitivities by dividing by one minus the firm’s effective tax rate. We define the effective tax rate as income tax expense divided by the sum of pretax income and special items, bounded by 0% at the low end and 35% at the high end. If we cannot compute a tax rate, we assume 35%. For example, if we compute a pretax bonus sensitivity of $10 per $1,000 of pretax income and the firm’s tax rate is 20%, our estimated after-tax sensitivity would be $10 / (1 - 20%) = $12.50 per $1,000 of after-tax income. We consider the next two measures (Earnings and EVA) after-tax income and make no adjustments. We consider the last six measures (EPS, Profit Margin, ROA, ROE, ROI, and ROIC) scaled versions of after-tax income. We convert their sensitivities to after-tax income sensitivities by dividing by shares outstanding, revenue, total assets, shareholders’ equity, and invested capital, respectively, where we define invested capital as the sum of short- and long-term debt, shareholders’ equity, and non-cash current assets, less current liabilities. For example, if we compute an EPS bonus sensitivity of $10,000 per $1 of EPS and the firm has 1 million shares outstanding, our estimated after-tax sensitivity would be $10,000 / 1 million = $10 per $1,000 of after-tax income. In some cases, firms report their goals either as margins or per share (e.g., the measure may be EBIT per share). We convert sensitivities based on such goals into dollar sensitivities by dividing by sales and shares outstanding, respectively, in addition to the conversions described above. In other cases, firms report their goals as growth (e.g., EPS growth). We do not compute sensitivities for these firms because the baseline value from which growth is computed is typically unclear (e.g., the prior year’s EPS value for compensation purposes may exclude various items, which makes it impossible to convert a growth rate into dollars).

- 34 -

Appendix B. Bonus sensitivity calculation examples

Example 1

Company: Robert Half International Fiscal Year: 2008 CEO: Harold Messmer, Jr. CEO cash bonus structure as reported in proxy statement

Threshold Target Maximum Range

$ Payout 3,327,273 (A) 6,654,546 (B) 9,000,000 (C) 5,672,727 (D = C – A)

Goal: EPS 0.95 (E) 1.90 (F) 3.8 (G) 2.85 (H = G – E)

Bonus Delta calculation

Description Calculation

Bonus per $1 EPS 1,990,431 (I) D / H

Share outstanding (millions) 150.943 (J) From Compustat

Bonus per $1 million of net income 13,187 (K) I / J (unscaled bonus

sensitivity)

1 % of market capitalization (millions) 31.426 (L) From Compustat

1% of actual net income 2,501,810 (M) From Compustat

Marginal Price-Earnings Ratio 12.56 (N) L / M

Increase in net income to add 1% market capitalization, assuming a firm-year marginal Price-Earnings ratio (millions)

2.502 (O) L / N

Increase in net income to add 1% market capitalization, assuming a 17× Price-Earnings ratio (millions)

1.849 (P) L / 17

Increase in bonus for a 1% increase in market capitalization, assuming a firm-year marginal Price-Earnings ratio

32,991 O * K

Increase in bonus for a 1% increase in market capitalization, assuming a 17× Price-Earnings ratio (Bonus Delta)

24,383 P * K

- 35 -


Example 2

Company: Corning Incorporated Year: 2009 CEO: Wendell Weeks CEO cash bonus structure as reported in proxy statement


$ Payout 0 (A) 1,030,000 (B) 2,060,000 (C) 2,060,000 (D = C – A)

Goal: Net Income (millions)

808 (E) 1,477 (F) 2,146 (G) 1,338 (H = G – E)



Bonus per $1 million net income 1,540 (I) D / H (unscaled

bonus sensitivity)

1 % of market capitalization (millions) 299.884 (J) From Compustat

1% of actual net income 20,080,000 (K) From Compustat

Marginal Price-Earnings Ratio 14.93 (L) J / K


20.08 (M) J / L


17.64 (N) J / 17


30,923 I * M


27,166 I * N

- 36 -


Example 3

Company: Qualcomm Year: 2007 CEO: Paul Jacobs CEO cash bonus structure as reported in proxy statement


$ Payout 403,127 (A) 1,679,698 (B) 4,199,244 (C) 3,796,117 (D = C – A)

Goal: $ EBT (millions)

3,320 (E) 4,150 (F) 6,225 (G) 2,905 (H = G – E)



EBT range (millions) 2,905 (I) H

Percent of payout tied to EBT 60% (J) From Incentive Lab

Payout range tied to EBT 2,277,670 (K) J * D

Bonus per million dollars in EBT 784 (L) K / I

Effective tax rate 9% (M) From Compustat

Bonus per million dollars net income 861 (N) L / (1-M) (unscaled bonus sensitivity)

1 % of market capitalization (millions) 695.6 (O) From Compustat

1% of actual net income 33,030,000 (P) From Compustat

Marginal P/E Ratio 21.06 (Q) O / P


33.03 (R) O / Q


40.918 (S) O / 17


28,439 N * R


35,230 N * S

- 37 -

Appendix C. Variable definitions

Measure of cash bonus pay-performance sensitivity Bonus Delta Change in CEO bonus payout for a change in income that increases stock

price by 1%, assuming a 17× P/E ratio, where the unscaled bonus sensitivity is computed as the ratio of the payout range to the goal range where payout range (goal range) is the distance between the maximum and minimum bonus payout (earnings target for bonus)

CEO Characteristics

Added Measures

Count of the number of unique performance measures in the CEO’s bonus contract in the current fiscal year that were not in the CEO’s bonus contract in the prior fiscal year

Annual Delta Computed following Core and Guay (2002) as the sensitivity of the CEO’s stock and option grants in the current year to a 1% change in stock price

Bonus-Equity Delta Ratio Bonus Delta divided by Portfolio Delta

Bonus Total annual CEO bonus payout (in $ thousands) during the fiscal year

Bonus Mix Total annual CEO bonus payout (i.e., Bonus) scaled by total annual CEO compensation

CEO Turnover Indicator equal to one during the last fiscal year of the CEO’s tenure, and zero otherwise

Congruity Proportion of the number of measures included in the lowest-paid executive's bonus contract that are also included in the CEO's bonus contract

Constrained Delta Sum of Portfolio Delta from 1) vested equity that is subject to an ownership guideline, 2) unvested equity, and 3) out-of-the-money options

Delta Computed following Core and Guay (2002) as the sensitivity of the CEO's stock and option portfolio to a 1% change in stock price

Executive Age Age of the CEO during the fiscal year

High Hire Date Cash Mix (Industry)

Indicator equal to one if the CEO's Cash Mix upon hiring is greater than the median Cash Mix for other CEOs hired during the same year in the same industry, and zero otherwise

Measure Spread Difference between Number of CEO Measures and Number of Lowest-Paid Executive Measures

No Deferred Compensation Indicator equal to one if the CEO did not elect to defer any compensation during the fiscal year, and zero otherwise

Number of CEO Measures Count of the number of unique measures used in the CEO's bonus contract

Perfect Congruity Indicator equal to one if both i) Congruity equals one and ii) Measure Spread equals zero, and zero otherwise

Removed Measures

Count of the number of unique performance measures not in the CEO’s bonus contract in the current fiscal year that were in the CEO’s bonus contract in the prior fiscal year

Salary Total annual CEO salary (in $ thousands) during the fiscal year

Tenure Number of years that the executive has been CEO of the firm

Total Compensation Total annual CEO compensation (in $ thousands) during the fiscal year

- 38 -

Unconstrained Delta Total Portfolio Delta minus Constrained Delta

Firm Characteristics

% Institutional Ownership The percentage of shares outstanding owned by institutional investors

Bonus Earnings Actual earnings for the fiscal year as included in the CEO’s bonus contract and defined in the firm’s annual proxy statement. All amounts are scaled by market value of equity, divided by 17 to scale by our median P/E ratio, multiplied by 1,000 to be in $000s of dollars, and divided by 100 (to be interpreted as a percent)

Bonus Earnings – Goal Threshold Bonus Earnings minus earnings goal threshold as identified in the firm’s proxy statement, scaled by market value of equity

Book–to–Market Assets Book value of assets divided by market value of assets, computed as total debt plus market value of equity

Compensation Vote Indicator equal to one if a shareholder vote on executive compensation occurred at the annual meeting during the fiscal year, and zero otherwise

Cumulative ISS Recommendation Count of the total number of times ISS recommended that shareholders vote against the executive compensation plan at the annual meeting since 2003

Current ISS Recommendation Indicator equal to one if ISS recommended if ISS recommends that shareholders vote against the executive compensation plan at the annual meeting during the fiscal year, and zero otherwise

GAAP Earnings Income before extraordinary items scaled by market value of equity, divided by 17 to scale by our median P/E ratio, multiplied by 1,000 to be in $000s of dollars, and divided by 100 (to be interpreted as a percent)

GAAP Earnings – Goal Threshold Income before extraordinary items minus income goal threshold as identified in the firm’s proxy statement, scaled by market value of equity

Free Cash Flow Operating cash flow minus common and preferred dividends divided by average total assets

Idiosyncratic Volatility Standard deviation of the residual return from a market model regression using daily stock returns during the 12 months prior to the fiscal year end

Incentive Zone Indicator equal to one if the earnings from the CEO’s bonus contract ended up between the threshold earnings goal and maximum earnings goal for the fiscal year as defined in the firm’s proxy statement, and zero otherwise

Median Peer Bonus Delta Median Bonus Delta for the firm’s peer group in a given year as identified in its proxy statement

MVE Market capitalization of the firm at the end of the fiscal year

Number of Blockholders The count of the number of investors who own at least one percent of shares outstanding

S&P 500 Indicator equal to one if the firm is included in the S&P 500 index (as identified in the Compustat Index Constituents database) in a given year, and zero otherwise

Stock Illiquidity The natural logarithm of the ratio of total shares traded annually divided by shares outstanding, multiplied by minus one

Stock Return Buy and hold returns during the 12 months prior to fiscal year-end

- 39 -

Figure 1. Bonus and Equity Portfolio Incentives Over Tenure

This figure shows the median bonus and equity portfolio sensitivities by tenure for CEOs. Bonus Delta is the sensitivity of a CEO’s cash bonus to a change in earnings equivalent to a 1% change in stock price, assuming a fixed 17× P/E ratio (the median in our sample). Portfolio Delta is the sensitivity of a CEO’s stock and option portfolio to a 1% change in stock price, computed following Core and Guay (2002).

0

100

200

300

400

500

600

700

1 2 3 4 5 6 7 8 9 10

Med

ian

ΔC

EO

Wea

lth

($0

00s)

for

1%

ΔS

tock

Pri

ce

Tenure

Bonus Delta Portfolio Delta

- 40 -

Figure 2. Bonus and Constrained versus Unconstrained Equity Incentives Over Tenure

This figure shows the median bonus and constrained versus unconstrained CEO equity portfolio sensitivities by CEO tenure. Bonus Delta is the sensitivity of a CEO’s cash bonus to a change in earnings equivalent to a 1% change in stock price, assuming a fixed 17× P/E ratio (the median in our sample). Constrained Delta is the sum of Portfolio Delta from i) vested equity that is subject to an ownership guideline, ii) unvested equity, and iii) out-of-the-money options. Unconstrained Delta is the CEO’s total Portfolio Delta (computed following Core and Guay, 2002) minus Constrained Delta.

0

50

100

150

200

250

300

350

400

450

1 2 3 4 5 6 7 8 9 10

Med

ian

ΔC

EO

Wea

lth

($0

00s)

for

1%

ΔS

tock

Pri

ce

Tenure

Bonus Delta Constrained Delta Unconstrained Delta

- 41 -

Figure 3. Pay-for-Performance Sensitivities Over Time

This figure plots the time trend in pay-for-stock price performance by estimating annual cross-sectional regressions of the relation between CEO cash compensation (Salary and Bonus) and firm performance (measured by Stock Returns and Earnings in Panels A and B, respectively) following Hall and Liebman (1998). Specifically, we plot the coefficients from the following regressions estimated by year:

Figure 3a. Pay-for Stock Return Performance Sensitivities Over Time

,

, , , ,

Figure 3b. Pay-for-Earnings Performance Sensitivities Over Time

,

,, , ,

0

0.1

0.2

0.3

0.4

0.5

1990 1995 2000 2005 2010 2015

Sto

ck R

etu

rn

Year

β₁

0

0.1

0.2

0.3

0.4

0.5

0.6

1990 1995 2000 2005 2010 2015

Ear

nin

gs

Year

β₁

- 42 -

Figure 4. Bonus Delta Over Time

This figure plots annual median CEO Bonus Delta from 2006 through 2014, where Bonus Delta is the sensitivity of a CEO’s cash bonus to a change in earnings equivalent to a 1% change in stock price, assuming a fixed 17× P/E ratio (the median in our sample).

0

10

20

30

40

50

60

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Med

ian

∆ C

EO

Wea

lth

($0

00s)

for

1%

∆ S

tock

Pri

ce

Year

Bonus Delta

- 43 -

Table 1. Descriptive Statistics: Bonus Performance Measures

This table presents descriptive statistics for the different types of performance measures used in CEO bonus contracts during our sample period of 2006 through 2014. Earnings measures comprise any measure based on EBIT, EBITDA, EBT, Operating Income, Earnings, EVA, EPS, Profit Margin, ROA, ROE, ROI, and ROIC. Cash Flow measures include measures based on Funds from Operations and other Cash Flow measures. Sales measures include measures based on Gross Sales, Net Sales, and Same Store Sales. Other measures include measures based on Working Capital, Gross Margin, Operating Expenses, and other qualitative metrics (e.g., Customer Satisfaction). Panel A presents descriptive statistics for all firms in the Incentive Lab database (S&P 750 firms) from 2006 through 2014. Panel B presents descriptive statistics for only observations with sufficient information in the firm’s proxy statement to compute our bonus sensitivity measure, Bonus Delta.

Panel A. Average number of cash bonus performance measures (all Incentive Lab firms)

Measure Avg. no. per firm % of firms

Earnings 1.77 93%

Cash Flow 0.27 23%

Sales 0.51 35%

Other 0.42 30%

Avg. measures per firm 2.96 (Number of firm-years = 8,888)

Panel B. Average number of cash bonus performance measures (with calculable Bonus Delta)

Measure Avg. no. per firm % of firms

Earnings 1.90 100%

Cash flow 0.25 22%

Sales 0.46 33%

Other 0.36 27%

Avg. measures per firm 2.97 (Number of firm-years = 3,327)

- 44 -

Table 2. Descriptive Statistics: Incentive Lab and Execucomp Samples

This table presents descriptive statistics for key variables used in our tests. All variables are defined in Appendix C. Panels A and B present descriptive statistics for the Incentive Lab sample and Panel C presents descriptive statistics for the broader Execucomp sample. All descriptive statistics are for years 2006 through 2014.

Panel A. All Incentive Lab Firms Variable N Mean SD Min P25 Median P75 Max Firm characteristics MVE ($ millions) 6,683 13,233 29,325 17 2,319 4,687 11,721 626,550 Idiosyncratic Volatility 6,683 0.28 0.17 0.13 0.17 0.24 0.34 2.10 Book–to–Market Assets 6,683 1.15 1.23 0.09 0.54 0.84 1.24 9.16 Free Cash Flow 6,683 0.09 0.07 –0.86 0.04 0.08 0.13 0.34 Earnings 6,683 0.01 0.27 –3.29 0.03 0.05 0.07 0.27 CEO characteristics Salary 6,683 953 324 1 750 949 1,100 1,950 Bonus 6,683 1,791 1,685 0 686 1,332 2,325 7,863 Total Compensation 6,683 7,669 5,755 198 3,832 6,171 9,668 31,994 Portfolio Delta 6,683 854 1,774 2 140 346 755 13,199 Tenure 6,683 7.2 6.2 0.5 2.8 5.5 9.5 36.0

Panel B. Incentive Lab Firms with Calculable Bonus Delta Variable N Mean SD Min P25 Median P75 Max Firm characteristics MVE ($ millions) 2,841 10,828 24,733 19 2,390 4,675 11,177 626,550 Idiosyncratic Volatility 2,841 0.28 0.16 0.13 0.17 0.23 0.33 2.10 Book–to–Market Assets 2,841 1.20 1.24 0.13 0.59 0.90 1.27 9.16 Free Cash Flow 2,841 0.08 0.07 –0.31 0.05 0.08 0.12 0.34 Earnings 2,841 0.02 0.24 –3.29 0.03 0.05 0.07 0.27 CEO characteristics Salary 2,841 974 282 1 800 971 1,116 1,950 Bonus 2,841 1,734 1,553 0 766 1,350 2,210 7,863 Total Compensation 2,841 7,546 5,300 198 4,207 6,285 9,285 31,994 Portfolio Delta 2,841 743 1,629 2 132 305 667 13,199 Tenure 2,841 6.8 5.6 0.5 2.9 5.4 8.8 36.0

Panel C. Execucomp Sample Variable N Mean SD Min P25 Median P75 Max Firm characteristics MVE ($ millions) 15,066 8,426 26,369 2 654 1,760 5,280 626,550 Idiosyncratic Volatility 15,066 0.34 0.21 0.13 0.20 0.29 0.41 2.10 Book–to–Market Assets 15,066 1.21 1.23 0.09 0.57 0.87 1.29 9.16 Free Cash Flow 15,066 0.08 0.09 –0.86 0.03 0.08 0.13 0.34 Earnings 15,066 –0.01 0.34 –3.29 0.02 0.05 0.07 0.27 CEO characteristics Salary 15,066 779 346 1 530 747 989 1,950 Bonus 15,066 1,208 1,485 0 250 737 1,592 7,863 Total Compensation 15,066 5,272 5,345 198 1,721 3,583 6,818 31,994 Portfolio Delta 15,066 647 1,564 2 73 196 539 13,199 Tenure 15,066 8.1 7.1 0.5 3.0 6.0 10.8 36.0

- 45 -

Table 3. Descriptive Statistics: Estimated Bonus Sensitivities

This table presents descriptive statistics for our estimated bonus sensitivities. Panel A presents estimates of the sensitivity of the CEO’s bonus payout i) per $1,000,000 of net income, ii) for net income equal to 1% of market capitalization, and iii) for net income necessary to increase market capitalization by 1%. Our figures and regression analyses assume a fixed 17× P/E ratio (the median in our sample) to compare the sensitivity of CEO’s bonus and equity portfolio sensitivities to a 1% change in stock price (i.e. the third row). We also estimate CEO bonus sensitivities assuming a firm-year specific P/E (i.e. the fourth row) calculated as the bonus for income equal to 1% of market capitalization, scaled by net income for the year (only for firms with positive net income). Panel B presents descriptive statistics for the sensitivities of CEO bonuses to common non-earnings based measure (Cash Flow and Sales). We estimate the sensitivity of the CEO’s bonus payout i) per $1,000,000 of Cash Flow or Sales, and ii) for Cash Flow or Sales equal to 1% of market capitalization.

Panel A. Earnings Metrics Variable N Mean SD Min P25 Med P75 Max Bonus Sensitivity per $1,000,000 Income 3,327 22,134 30,484 433 5,120 11,944 26,402 196,499 (i.e., the median firm pays a bonus of $11,944 per $1,000,000 of net income) Bonus payment (in $000s) for income equal to 1% of market capitalization Income 3,327 1,207 1,891 10.84 232 592 1,341 12,574 (i.e., the median firm pays a bonus of $592,000 for income equal to 1% of market capitalization) Bonus payment sensitivity (in $000s) to earnings necessary to increase market 1% increase in market capitalization Income (assuming firm-year specific P/E) 3,327 66.66 101.92 0.39 12.85 31.56 74.90 662.75 Income (assuming fixed 17× P/E) 3,327 71.00 111.26 0.64 13.65 34.82 78.86 739.64

(i.e., the median firm pays a bonus of $31,560 for a 1% increase of equity value)

Panel B. Cash Flow and Sales Metrics Variable N Mean SD Min P25 Med P75 Max Bonus Sensitivity per $1,000,000 Cash Flow 641 8,590 14,734 159 1,688 3,926 10,000 134,834 Sales 789 5,972 18,763 34 563 1,685 4,138 203,125 (i.e., the median firm pays a bonus of $3,926 per $1,000,000 of cash flow) Bonus payment (in $000s) for cash flow/sales equal to 1% of market capitalization Cash Flow 641 430 632 7 102 223 487 5,178 Sales 789 260 585 2 25 80 211 4,792 (i.e., the median firm pays a bonus of $223,000 for cash flow equal to 1% of market capitalization)

- 46 -

Table 4. Realized Bonus Payouts

This table presents descriptive statistics for actual CEO bonus metric performance and payouts. Pretax metrics include all pretax performance measures (e.g., EBIT, Operating Income). Earnings metrics include all after-tax earnings-based performance measures (e.g., net income, economic value added). EPS metrics include all per share earnings-based performance measures. Margin metrics include all return- or margin-based performance measures (e.g., profit margin, ROA, ROE). Panel A presents the distribution of realized bonus payouts (at the underlying performance metric level) for the CEOs in our sample, as a percentage of the underlying target (e.g., CEO salary). Panel B presents the proportion of realized bonus performance measures that were above or below the threshold, target, and maximum performance goals for the fiscal year.

Panel A. Payout as % of Underlying Target

Earnings metric N Mean SD Min 25th Median 75th Max Pretax 1,431 103% 67% 0% 62% 103% 150% 375% Earnings 461 118% 71% 0% 74% 123% 179% 300% EPS 901 111% 69% 0% 74% 115% 158% 500% Margin 468 111% 71% 0% 65% 113% 167% 300% Total 3,261 108% 69% 0% 66% 111% 158% 500%

Panel B. Earnings Metric Actual Performance Relative to Benchmarks (N=3,414)

Earnings metric Below

Threshold

Between Threshold and

Target Between Target and Maximum

Above Maximum

Pretax 17% 31% 33% 19% Earnings 15% 21% 40% 23% EPS 17% 22% 42% 20% Margin 15% 28% 31% 26% Total 16% 27% 36% 21%

- 47 -

Table 5. Pay-Performance Sensitivities

This table reports results from estimating the association between pay and performance for our sample with and without calculable Bonus Delta. This table estimates the following OLS regression models:

, , , 1

, , , 2

where GAAP Earnings is either Earnings as defined in Appendix C or Earnings – Goal Threshold. Panel A presents results from estimating Eq. (1), and Panel B presents results from estimating Eq. (2). Column 1 of each panel estimates the relevant specification for all firms with calculable Bonus Delta from 2006 through 2014, as these firms explicitly tie the CEO’s bonus to earnings. Column 2 of each panel estimates the regression for firm-year observations with a calculable Bonus Delta and we further restrict the sample to observations where actual earnings fall between the specified “threshold” and “maximum” earnings benchmarks. Columns 3 and 4 of each panel re-estimate the specifications from Columns 1 and 2, respectively, measuring the relevant earnings number as earnings in excess of the goal threshold. For parsimony we do not tabulate coefficients for our estimated fixed effects. All variables are defined in Appendix C. Standard errors are calculated based on clustering by firm. *, **, *** indicate statistical significance (two-sided) at the 0.1, 0.05, and 0.01 levels, respectively.

Panel A. Pay-Performance Sensitivities Dependent variable: Bonust (1) (2) (3) (4) GAAP Earningst 460.264*** 209.505

(4.95) (1.56)

(GAAP Earnings – Goal Threshold)t 454.608*** 176.949

(4.92) (1.46) Sample requirement(s) Non-missing

Bonus Delta Non-missing Bonus Delta;

Incentive Zone = 1

Non-missing Bonus Delta

Non-missing Bonus Delta;

Incentive Zone = 1

Firm Fixed Effects Yes Yes Yes Yes Observations 3,003 1,676 2,885 1,676

R2 0.715 0.811 0.721 0.811

Panel B. Bonus Earnings Pay-Performance Sensitivity

Dependent variable: Bonust (1) (2) (3) (4) Bonus Earningst –73.144 97.348

(–0.29) (0.30) (Bonus Earnings – Goal Threshold)t 3,215.637*** 2,624.011**

(5.54) (2.29) Sample requirement(s)



Incentive Zone = 1



Incentive Zone = 1

Firm Fixed Effects Yes Yes Yes Yes Observations 2,593 1,676 2,504 1,676 R2 0.718 0.811 0.738 0.813

- 48 -

Table 6. Contracting Over CEO Incentive-Compensation

This table examines the relation between CEO bonus sensitivity (Bonus Delta) and the CEO’s equity holdings. Specifically, this table reports results from estimating the following OLS regression models:

, , Γ ,

where Delta is either the CEO’s stock and option portfolio delta computed following Core and Guay (2002), Constrained Delta, Unconstrained Delta, Annual Delta, or a vector including Constrained Delta, Unconstrained Delta, and Annual Delta. For parsimony we do not tabulate coefficients for our estimated fixed effects. All variables are defined in Appendix C. Standard errors are calculated based on clustering by firm. *, **, *** indicate statistical significance (two-sided) at the 0.1, 0.05, and 0.01 levels, respectively.

Dependent variable: Log(Bonus Delta)t (1) (2) (3) (4) (5) (6) (7) Log(Delta)t-1 –0.028 –0.027 (–0.86) (–0.86) Log(Constrained Delta)t-1 –0.016 –0.015 –0.019 (–0.63) (–0.63) (–0.75) Log(Unconstrained Delta)t-1 0.013 0.013 0.012 (0.78) (0.77) (0.70) Log(Annual Delta)t 0.070*** 0.070*** 0.071*** (3.51) (3.50) (3.56) Log(MVE)t-1 0.201*** 0.189*** 0.166** 0.177** 0.172** 0.194*** 0.174**

(2.78) (2.79) (2.35) (2.51) (2.57) (2.72) (2.49) Idiosyncratic Volatilityt-1 –0.432** –0.431** –0.440** –0.431** –0.437** –0.429** –0.426**

(–2.53) (–2.52) (–2.53) (–2.50) (–2.49) (–2.47) (–2.44) Book–to–Market Assetst-1 –0.157*** –0.155*** –0.151*** –0.153*** –0.150*** –0.154*** –0.150***

(–2.81) (–2.78) (–2.72) (–2.75) (–2.65) (–2.71) (–2.66) Tenuret 0.014* 0.012 0.009 0.010 0.011 0.013* 0.009

(1.72) (1.58) (1.20) (1.24) (1.49) (1.67) (1.21) Free Cash Flowt-1 0.581 0.575 0.564 0.567 0.532 0.541 0.527

(1.34) (1.33) (1.32) (1.32) (1.25) (1.26) (1.24) Firm & Year Fixed Effects Yes Yes Yes Yes Yes Yes Yes Observations 2,506 2,506 2,506 2,506 2,506 2,506 2,506 R2 0.132 0.132 0.132 0.133 0.139 0.140 0.140

- 49 -

Table 7. Contracting Over Liquidity Preferences

This tables examines the relation between CEO bonus compensation (Bonus Mix) and several CEO- and firm-specific characteristics. Specifically, this table reports results from estimating the following OLS regression models:

, , Γ , 1

, , Γ , 2

where CEO Liquidity Preference is either No Deferred Compensation, Executive Age, or High Hire Date Cash Mix (Industry). Columns 1 through 3 present results from estimating Eq. (1) using each of the different CEO Liquidity Preference measures. Column 4 presents results from estimating Eq. (2) using a firm-level liquidity characteristic, Stock Illiquidity. Column 5 presents results from including all measures of CEO- and firm-specific liquidity preference measures in the same model. For parsimony we do not tabulate coefficients for our estimated fixed effects. All variables are defined in Appendix C. Standard errors are calculated based on clustering by firm. *, **, *** indicate statistical significance (two-sided) at the 0.1, 0.05, and 0.01 levels, respectively.

Dependent variable: Bonus Mixt (1) (2) (3) (4) (5) CEO-specific liquidity preference High Hire Date Cash Mix (Industry)t 0.023** 0.023** (2.23) (2.29) No Deferred Compensationt 0.004*** 0.004*** (3.41) (3.04) Executive Aget 0.046*** 0.043*** (3.36) (3.20) Firm-level liquidity preference Stock Illiquidityt 0.030** 0.029** (2.37) (2.44) Log(MVE)t-1 –0.046*** –0.047*** –0.046*** –0.046*** –0.045***

(–4.01) (–4.10) (–4.00) (–3.94) (–3.96) Idiosyncratic Volatilityt-1 –0.018 –0.011 –0.014 0.014 0.014

(–0.37) (–0.23) (–0.30) (0.28) (0.28) Book–to–Market Assetst-1 0.008 0.007 0.008 0.010 0.010

(0.69) (0.58) (0.74) (0.89) (0.92) Tenuret –0.001 –0.003** –0.001 –0.001 –0.003**

(–0.59) (–2.57) (–0.71) (–0.60) (–2.45) Free Cash Flowt-1 0.174** 0.172** 0.171** 0.203** 0.208***

(2.07) (2.11) (2.09) (2.45) (2.66) Firm & Year Fixed Effects Yes Yes Yes Yes Yes Observations 2,870 2,870 2,870 2,870 2,870 R2 0.046 0.051 0.050 0.048 0.063

- 50 -

Table 8. External Pressure and Shareholder Monitoring

This table examines the relation between CEO bonus sensitivity (Bonus Delta) and measures of external pressure and shareholder monitoring. Specifically, this table reports results from estimating the following OLS regression models:

, , Γ , 1

, , , Γ , 2

, , Γ , 3

where Median Peer Bonus Delta is the median Bonus Delta for the firm’s peer group as identified in its proxy statement. ISS Rec is either Cumulative ISS Recommendation, or Current ISS Against Recommendation. Monitoring is either S&P 500, % Institutional Ownership, or Number of Blockholders. Column 1 of Panel A presents results from estimating Eq. (1). Columns 2 and 3 of Panel A present results from estimating Eq. (2). Panel B presents results from estimating Eq. (3). Columns 1, 2, and 3 of Panel B present results including measures of Shareholder Monitoring individually in each specification, whereas Column 4 presents results from estimating Eq. (3) using all three measures of Shareholder Monitoring simultaneously. For parsimony we do not tabulate coefficients for our estimated fixed effects. All variables are defined in Appendix C. Standard errors are calculated based on clustering by firm. *, **, *** indicate statistical significance (two-sided) at the 0.1, 0.05, and 0.01 levels, respectively.

Panel A. External Pressure

Dependent variable: Log(Bonus Delta)t (1) (2) (3) (4) (5) Median Peer Bonus Deltat-1 0.185*** 0.185*** 0.184*** (6.20) (6.20) (6.16) Compensation Votet-1 0.017 0.014 0.014 0.012 (0.36) (0.29) (0.29) (0.25) Cumulative ISS Recommendationst-1

–0.061 –0.061

(–1.07) (–1.05) Current ISS Recommendationt-1 0.068 0.051 (0.86) (0.64) Log(MVE )t-1 0.099 0.130** 0.144** 0.091 0.103*

(1.59) (2.00) (2.23) (1.44) (1.66) Idiosyncratic Volatilityt-1 –0.316** –0.245 –0.233 –0.324** –0.312**

(–2.13) (–1.54) (–1.46) (–2.17) (–2.10) Book–to–Market Assetst-1 –0.133** –0.173*** –0.171*** –0.135** –0.133**

(–2.36) (–3.05) (–2.96) (–2.41) (–2.35) Tenuret 0.019*** 0.019*** 0.019*** 0.019*** 0.019***

(2.94) (2.90) (2.93) (2.92) (2.94) Free Cash Flowt-1 0.398 0.559 0.569 0.393 0.402

(1.09) (1.50) (1.52) (1.07) (1.10) Firm & Year Fixed Effects Yes Yes Yes Yes Yes Observations 2,419 2,419 2,419 2,419 2,419 R2 0.169 0.135 0.135 0.170 0.169

- 51 -

Table 8. External Pressure and Shareholder Monitoring (continued)

Panel B. Shareholder Monitoring

Dependent variable: Log(Bonus Delta)t

(1) (2) (3) (4) S&P 500t-1 0.011 0.012 (0.12) (0.13) % Institutional Ownershipt-1 0.002 –0.098 (0.01) (–0.41) Number of Blockholderst-1 0.003 0.005 (0.66) (0.86) Log(MVE)t-1 0.150** 0.152** 0.149** 0.150**

(2.42) (2.48) (2.45) (2.39) Idiosyncratic Volatilityt-1 –0.430*** –0.430*** –0.426*** –0.424***

(–2.89) (–2.89) (–2.88) (–2.87) Book–to–Market Assetst-1 –0.166*** –0.166*** –0.168*** –0.166***

(–3.09) (–3.07) (–3.11) (–3.06) Tenuret 0.019*** 0.018*** 0.019*** 0.019***

(3.55) (3.53) (3.54) (3.55) Free Cash Flowt-1 0.744* 0.743* 0.727* 0.737*

(1.95) (1.95) (1.91) (1.94) Firm & Year Fixed Effects Yes Yes Yes Yes Observations 2,897 2,897 2,897 2,897 R2 0.142 0.142 0.143 0.143

- 52 -

Table 9. Top Management Team Synergies

This table reports results from estimating the relation between CEO incentives and the incentives of each firm’s lowest-paid executive. Panel A presents descriptive statistics for cash and equity incentive measures of firms’ lowest-paid executives as well as the firm’s CEO, for only those observations with a calculable Bonus Delta for the lowest-level executive and the CEO Panel B presents descriptive statistics for the similarity between the number of different types of performance measures used in the CEO’s and lowest-paid executive’s bonus contracts. Panels C and D report results from estimating the following models, respectively:

∆ , , Γ , 1

, , Γ , 2

where the dependent variable in Eq. (1), Δ Plan Characteristic is one of several measures of changes in the bonus plan characteristics for the CEO, and CEO Turnover is an indicator for years of CEO turnover. The dependent variable in Eq. (2), Bonus Delta is calculated for the CEO, and Lowest Paid Bonus Delta is the corresponding Bonus Delta for the lowest-paid executive at the firm, as identified in its proxy statement. For parsimony we do not tabulate coefficients for our estimated fixed effects. All variables are defined in Appendix C. Standard errors are calculated based on clustering by firm. *, **, *** indicate statistical significance (two-sided) at the 0.1, 0.05, and 0.01 levels, respectively.

Panel A. Descriptive Statistics for Lowest-Paid Executive

Variable N Mean SD Min P25 Median P75 Max

Lowest-Paid Executive Incentives Bonus Delta 2,155 20.81 36.29 0 3 9 20 203 Portfolio Delta 2,155 83.23 216.27 0 16 38 83 2,723 Bonus-Equity Delta Ratio 2,155 0.66 1.23 0.00 0.08 0.23 0.60 6.58 CEO Incentives Bonus Delta 2,155 71.62 111.33 1 14 36 80 740 Portfolio Delta 2,155 728.62 1,588.40 2 136 306 662 13,199 Bonus-Equity Delta Ratio 2,155 0.28 0.52 0.00 0.05 0.11 0.27 4.12

Panel B. Descriptive Statistics for Congruity between CEO and Lowest-Paid Executive Variable N Mean SD Min P25 Median P75 Max Number of CEO Measures 7,299 2.88 2.07 1 2 2 4 12 Number of Lowest-Paid Executive Measures 7,299 2.98 2.10 1 2 2 4 12 Measure Spread 7,299 –0.10 1.03 –4 0 0 0 4 Congruity 7,299 0.89 0.23 0 1 1 1 1 Perfect Congruity 7,299 0.72 0.45 0 0 1 1 1

- 53 -

Table 9. Top Management Team Synergies (continued)

Panel C. Changes in Bonus Contracts Around CEO Turnover

Dependent variable: Δ Log(Bonus

Delta)t |Δ Log(Bonus

Delta)|t Added Measurest Removed Measurest Δ Congruityt

Δ Measure Spreadt

(1) (2) (3) (4) (5) (6) CEO Turnovert-1 –0.072 0.187*** 0.298*** 0.359*** 0.023 0.104 (–0.89) (3.58) (3.00) (3.72) (1.31) (1.09) Log(MVE)t-1 –0.509*** 0.066 –0.169** –0.084 0.013 0.016

(–6.34) (1.06) (–2.10) (–0.84) (1.09) (0.23) Idiosyncratic Volatilityt-1 –0.085 –0.203 –0.028 –0.133 0.012 0.237

(–0.34) (–1.22) (–0.11) (–0.58) (0.29) (1.06) Book–to–Market Assetst-1 0.114** 0.068 0.012 –0.051 0.010 –0.060

(2.17) (1.57) (0.13) (–0.47) (0.73) (–0.72) Tenuret –0.003 0.000 0.008 0.015** 0.000 0.004

(–0.42) (0.08) (1.08) (2.15) (0.37) (0.71) Free Cash Flowt-1 0.523 0.068 –0.172 –0.841** –0.050 0.221

(1.00) (0.19) (–0.38) (–2.09) (–0.41) (0.70) Firm & Year Fixed Effects Yes Yes Yes Yes Yes Yes Observations 2,077 2,077 4,806 4,806 4,806 4,806 R2 0.137 0.055 0.013 0.009 0.004 0.006

- 54 -

Table 9. Top Management Team Synergies (continued)

Panel D. Cross Sectional and Within-Firm Regressions

Dependent variable: Log(Bonus Delta)t (1) (2) Log(Lowest Paid Bonus Delta)t 0.490*** 0.249*** (5.77) (3.71) Log(MVE)t-1 0.202*** 0.084

(4.67) (1.56) Idiosyncratic Volatilityt-1 –0.722*** –0.374**

(–3.67) (–2.19) Book–to–Market Assetst-1 –0.025 –0.140***

(–0.92) (–2.82) Tenuret 0.014** 0.014***

(2.57) (2.88) Free Cash Flowt-1 0.277 0.560*

(0.76) (1.73) Firm & Year Fixed Effects No Yes Observations 2,605 2,605 R2 0.547 0.306

Documents

Do CEO Bonus Plans Serve a Purpose?