The other side of the trade-off: The impact of risk on executive compensation

The principal-agent model of executive compensation is of central importanc e to the modern theory of the firm and corporate governance, yet the existi ng empirical evidence supporting it is quite weak. The key prediction of th e model is that the executive's pay-performance sensitivity is decreasing i n the variance of the firm's performance. We demonstrate strong empirical c onfirmation of this prediction using a comprehensive sample of executives a t large corporations. In general, the pay-performance sensitivity for execu tives at firms with the least volatile stock prices is an order of magnitud e greater than the pay-performance sensitivity for executives at firms with the most volatile stock prices. This result holds for both chief executive officers and other highly compensated executives es. We further show that estimates of the pay-performance sensitivity that do not explicitly account for the effect of the variance of firm performance are biased toward zero. We also test fur relative performance evaluation of executives against the performance of other firms. We find little support for the relative perfor mance evaluation model. Our findings suggest that executive compensation co ntracts incorporate the benefits of risk sharing but do not incorporate the potential informational advantages of relative performance evaluation.