Document Type

Article

Abstract

CEO compensation varies widely, even within industries. In this paper, we investigate whether differences in skill explain these differences in CEO pay. Using the notion that skilled CEOs are more likely to continue prior good performance and to reverse prior poor performance, we develop a new methodology to detect if skill is related to pay. We find that highly paid CEOs are more skilled than their industry counterparts when firms are small, especially when there is a large shareholder and the CEO has high incentives, or when firms face few environmental constraints on managerial discretion. By contrast, pay is negatively related to skill in firms constrained by environmental conditions, especially when there is no large shareholder to monitor management or the firm is large. We also examine CEO turnovers and show that the firm’s post-turnover performance is related to differences between the two CEO’s pay levels. Finally, we find that a portfolio that invests in firms managed by highly paid CEOs and sells firms managed by poorly paid CEOs generates an annualized abnormal return of 8% between 1994 and 2001, but only in conditions when pay and skill are related.

Date of Authorship for this Version

January 2005

Keywords

law and economics

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