Assessing Pay for Performance

This paper explores five interpretations of “pay for performance”, presents a practical way to measure pay for performance and shows the extent of pay for performance at S&P 1500 companies. The paper argues that pay for performance has three dimensions: the sensitivity of relative pay to relative performance (“pay leverage”), the correlation of relative pay and relative performance (“pay alignment”) and the pay premium at industry average performance, and shows how to measure the three dimensions using a regression of relative pay on relative performance. The paper discusses four measures of pay and argues that the most useful measures are “mark to market” pay, which captures the incentive provided by changes in the value of unvested equity compensation, and grant date pay, which reflects the expected value of equity compensation at the time of grant. The paper shows that top management at the median S&P 1500 company has pay leverage of 0.55, i.e., a 1% increase in relative shareholder wealth increases relative mark to market pay by 0.55%, and that relative performance explains 33% of the variation relative mark to market pay.