The Impact of the Likelihood of Turnover on Executive Compensation

Abstract

This study analyzes the role of three incentive devices in managerial compensation: pay for performance, termination, and career concerns. A model is derived which shows that the three incentives are substitutes; where the termination (or career concerns) incentive is low, the optimal contract contains stronger pay-for-performance incentives. The empirical implication, then, is that the pay-for-performance sensitivity of managers should be decreasing (increasing) in the probability of termination (retirement). To test the model’s predictions, I first use a sample of CEOs to estimate the probabilities of forced and voluntary turnover. Then, these estimated probabilities are compared to the CEOs’ estimated pay-for-performance sensitivity. The evidence is consistent with the hypothesis that boards consider the likelihood of termination when setting the compensation contract; the relationship between changes in CEO compensation and firm performance is decreasing in the estimated probability of forced turnover. While CEOs nearing retirement do not appear to have compensation that is increasingly sensitive to performance, their wealth does have increased sensitivity. Consistent with the model’s intuition, the sensitivity of total CEO firm-related wealth to performance is positively related to the probability of voluntary turnover.