How Is CEO Compensation Determined? It's Complicated

CEOs of S&P 500 companies earned an average of $9.6 million a year in 2011. But what exactly did they do to warrant such hefty paychecks? The answer to that question is the subject of a new study that explores the connection between performance and compensation for top-tier CEOs.

The study, by researchers at Rice and Cornell universities, is based on CEO compensation information submitted to the U.S. Securities and Exchange Commission (SEC) by S&P 500 companies. The research focuses specifically on what measures companies use to assess CEO performance as it relates to compensation.

What the researchers found is a divided approach to measuring performance, one that is determined by the overall strategy and maturity of a company on the S&P 500.

Specifically, the authors found that mature firms, which have limited opportunities for growth, tend to rely more heavily on accounting-based measures to assess CEO performance than do companies still in "growth mode."

"On average, firms rely mostly on accounting-based performance measures, among which they put heavier weights on income measures, sales and accounting returns," said David De Angelis, an assistant professor of finance at Rice’s Jones Graduate School of Business.

Larger firms and firms with larger growth opportunities, on the other hand, tend to rely more heavily on market-based measures to assess the performance of their CEOs.

"In [growth] firms, stock price performance, which captures investors' perception regarding firms’ long-term growth opportunities, is a more informative measure," said De Angelis, who co-authored the study with Yaniv Grinstein, an associate professor of finance at Cornell's Johnson Graduate School of Management.

Companies still in growth mode were found to also use accounting measures in assessing CEO performance, but they tended to look at a different set of numbers than more established firms. Mature companies focus on end-of-year accounting numbers. Expanding firms focus on sales growth — a better indicator of how well a CEO's actions support continued growth of a company.

On average, the study found that accounting-based measures account for 79 percent of a CEO's performance assessment. Stock performance measures account for 13 percent of this assessment, and non-financial measures account for 8 percent of a CEO's performance assessment.

The 8 percent of a CEO's performance determined by non-financial measures was of particular interest to De Angelis and Grinstein, who believe this facet of their research deserves further investigation.

"A large portion of CEO awards is given at the discretion of the board," the authors said. "How exactly this portion of the awards is determined is an interesting topic for future research."

Originally published on Business News Daily.