Ideas for Leaders #469

High CEO Pay Leads to Overconfidence and Poor Results

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Key Concept

A new study shows a negative correlation between high executive incentive pay and company performance: the higher the pay, the worse the future results. This study also pinpoints the culprit behind the negative correlation: CEO overconfidence. The overconfidence of higher-paid CEOs leads to poor investment decisions and unsuccessful M&A initiatives. 

Idea Summary

Previous studies have explored the link between CEO pay and future business performance with mixed results. In some cases, higher CEO pay is linked to better results; other studies show the opposite: the companies of the highest paid CEOs perform less well, on average, than their more moderately paid counterparts.

A research team from the UK and the U.S. expanded on previous pay/performance studies in two ways. First, the team expanded the base of their data. While previous studies focused on a small group of executives over a short period of time, the new study used the extensive database of New York Stock Exchange, American Stock Exchange, and NASDAQ companies listed in the Compustat Execucomp database from 1994 - 2011. Adjusting for size and industry, the researchers divided the companies into 10 ‘deciles’, the lower deciles representing the firms with lower compensation, while the upper deciles consisted of companies that offered more generous CEOs compensation packages. The team then compared the performance of these companies in the one to three years following the year a company first reached the decile.

The results of the analysis are compelling. The results for companies in the very bottom decile matched other companies in their industries. Companies in the top decile, however, earned results that, in the year after they moved into the top category, were nearly 5% to 6% lower than expected. And the figures only get worse over time; within three years of being classified in the top decile, companies earned abnormal returns (that is the difference between earned results and expected results) of -8% to nearly -11% (depending on how the portfolios are weighted).

The data also shows that the impact is not linear. There is little negative correlation between higher pay and performance for the bottom seven deciles; for the top three deciles of CEO pay, however, there is a significant negative impact on the bottom line.

What causes this negative correlation between pay and performance? In addition to examining a significantly larger pool of companies for a significantly longer period of time, the second way that this study differed from previous studies is that the team introduced manager style effects, and primarily overconfidence, into the analysis of the data. Overconfidence has been shown to impact CEO choices of pay structures — overconfident CEOs choose riskier incentive compensation packages, for example. Overconfidence has also been shown to impact future performance: overconfident CEOs engage in wasteful capital expenditures and make other decisions that reduce shareholder value and firm results. The team therefore studied whether overconfidence might explain the negative correlation.

The results were unequivocal. First, the researchers found that there were more overconfident CEOs in firms with high compensation levels than in firms that paid less. They also found that among companies with high compensation, it was the firms with overconfident CEOs who fared the worst in business performance. Specifically, firms with CEOs in the highest decile earned abnormal returns of -9.38% over three years; those in the highest decile with overconfident CEOs earned abnormal returns of – 15.15% abnormal return; those in the highest decile with overconfident CEOs with longer tenure earned abnormal returns of -22.4% abnormal return. Since longer tenure only reinforces the confidence of the CEO, these results emphasize that the more confident the CEO, the worse the three-year performance of the company.

Business Application

This research has important implications concerning optimal compensation structures for CEOs. Incentive pay, particular through options, is intended to incentivize the CEO to ensure greater shareholder value and better results. However, generous pay packages including options can lead to less cautionary behaviour because the CEO’s ego has, in the mind of the CEO, been affirmed. Highly paid CEOs believe they can take risks, even though bad risks impact their options, because they are overly confident about success. As a result, they invest more and engage in less successful M&A activity than less paid CEOs. In addition, if these CEOs have been in their positions for any length of time, this overconfidence is only magnified by their entrenchment and probably less rigorous board oversight.

In short, compensation plans that include such elements as restricted stock, options, and long-term incentive payouts may backfire unless you pay attention to the relation between pay and managerial style. Look at your CEO’s record: do his or her decisions indicate unwarranted overconfidence? If so, don’t restructure the CEO pay package to create long-term incentive effects: those effects will not occur. The first step to maximizing shareholder value with overconfident CEOs is to ensure rigorous corporate governance. Only CEOs who have demonstrated the confidence required for leadership but not the overconfidence that leads to high-risk decisions should be rewarded with incentive-driven compensation plans.

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