Definition of performance-related pay

Performance-related pay involves linking the pay executives get with their performance on the job.

Typically, it involves solving a problem in economics called moral-hazard. Once a contract has been agreed, the company runs the risk that a high-paid worker will shirk on the job. Therefore companies typically tie the pay of the manager with the performance of the company by paying the manager with restricted stock or options. If the pay of the manager drops (through the drop in the share price) when he shirks relative to when he works hard, he will be motivated to work hard.

This solution does not solve a second problem in economics called adverse selection. Offering a contract with a high level of options will tend to attract optimistic candidates who are confident they can achieve an increase in share price. In many cases, these managers end up being too optimistic which might hurt shareholder value. [1]

Example

In their research paper The cross-section of stock returns and incentive pay, Mike Cooper, Huseyin Gulen and Raghavendra Rau show that firms that pay their CEOs in the top ten per cent of excess pay relative to their peers earn negative abnormal returns over the next three years of approximately -9 per cent. The effect is stronger for CEOs who receive higher incentive pay relative to their peers. They argue that their results are consistent with high-pay induced CEO overconfidence and investor overreaction towards firms with high paid CEOs.

 

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