Definition of pay-performance sensitivity

This is a measure to find out if a chief executive is compensated appropriately according to how well s/he runs the company. Pay-performance sensitivity is the change in a chief executive's payoff that is associated with a given performance of the company that s/he leads.

In its simplest incarnation, the pay-performance sensitivity is the correlation between a chief executive pay and stock return a cross a large number of chief executives and their companies.

Pay-performance sensitivity is measured in a variety of ways. One is the dollar increase in a chief executive's wealth associated with a 1,000 dollar increase in the firm’s market capitalisation. Another is the dollar increase or the percentage increase in a chief executive's wealth associated with a 1% equity return or stock return.

Pay-performance sensitivity measures are used as indicators of the quality of corporate governance.  Everything else equal, a larger sensitivity is sign of a better alignment between the chief executive incentives and the interest of his/ her shareholders.  Sensitivity is larger when the pay responds more to changes in performance.

Example
In their research paper "Executive Compensation: Facts", Gian Luca Clementi and Thomas Cooley, at NYU Stern School of Business, carried out calculations on compensation data for chief executives of US publicly traded companies.

Over the period between 1993 to 2008, a 1% increase in market capitalisation was associated with a 1.14% median increase in a chief executive's wealth.

Reference
Clementi, Gian Luca and Cooley, Thomas F., Executive Compensation: Facts (October 6, 2009). FEEM Working Paper No. 89.2010.

Source: Gian Luca Clementi, assistant professor of economics, NYU Stern School of Business

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