CEOs' Outside Employment Opportunities and the Lack of Relative Performance Evaluation in Compensation Contracts

Although agency theory suggests that firms should index executive compensation to remove market-wide effects (i.e., RPE), there is little evidence to support this theory. Oyer (2004, Journal of Finance 59, 1619-1649) posits that an absence of RPE is optimal if the CEO's reservation wages from outside employment opportunities vary with the economy's fortunes. We directly test and find support for Oyer's (2004) theory. We argue that the CEO's outside opportunities depend on his talent, as prox- ied by the CEO's financial press visibility and his firm's industry-adjusted ROA. Our results are robust to alternate explanations such as managerial skimming, oligopoly, and asymmetric benchmarking. AGENCY THEORY PREDICTS THAT THE MARKET-WIDE COMPONENT of a firm's returns should be removed from the compensation package since executives cannot affect the overall market by their actions and it is costly for an executive to bear the relative risks. Such market indexing of compensation is also referred to as relative performance evaluation (RPE). However, there is little empir- ical evidence in the literature of RPE (e.g., Antle and Smith (1986), Janaki- raman, Lambert, and Larcker (1992)). In fact, a widespread feature of CEO pay packages, especially those which include stock option plans, is that they reward managers for stock price increases due to general market trends. Pro- ponents of the optimal contracting view argue that rewarding chief executive officers (CEOs) for riding a bull market is optimal if the CEO's reservation wage stemming from outside employment opportunities varies with the econ- omy's fortunes (Oyer (2004), Himmelberg and Hubbard (2000)). Assuming that CEO talent is scarce, demand for talented CEOs rises as the economy booms, in which case firms must pay CEOs more to retain them. In other words, allowing pay to increase with rising market levels during boom periods potentially en- ables firms to retain talented executives. A direct empirical test of the outside