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Executive Compensation and Firm Performance: Big Carrot, Small Stick

Mar 2000
Working Paper
By  Scott Wallsten
The statistical link between executive compensation and firm performance is well established. I explore two features of the relationship that have not yet been addressed empirically. First, does the relationship itself change depending on firm performance? I find that, on average, executives are rewarded in good years but are not punished in bad years. This result is consistent with a model that attempts to induce risk-taking behavior by rewarding good performance and limiting downside punishment. Second, does the relationship change with the executive’s rank in the company? I find that the top executive’s compensation is most strongly linked with performance, the second-highest ranking executive less so, and the third-highest even less. This result is consistent with linking compensation to performance only to the extent that the employee has some direct influence on it.