Modeling executive pay as a barrier call

Abstract

Criticism by the Administration at the height of the global financial crisis of ‘excessive’ company bonuses rekindles debate on the link between executive pay and firm performance. We model the relationship between realized CEO pay and an earnings-adjusted barrier call as the dependent variable. We employ both externally- and internally-derived metrics of target financial performance. Pay components are found strongly interrelated. Salary sensitivities to the dependent variable are broadly consistent with determination of a reservation wage set by the executive labor market, while annual bonuses are paid for expected above-target performance, but are also capped. Long-term incentive plans are used to mitigate noise in earnings only when above-target performance is expected. Hence, we find no evidence of excessive’ bonuses, at least during the interval ending in fiscal 2005. Rather, we document evidence that the ‘excessiveness’ may in fact be present in salaries.