Rising Executive Pay Tied to Uncertainty of Joining New Firms

Everyone knows executive pay is rising. None of us can agree about why. Our forthcoming study in The Accounting Review, “Matching Premiums in the Executive Labor Market,” points to one reason—executives are being compensated for the risk they bear when leaving one firm for another. A company that wants to lure someone from another firm needs to bump up her compensation, as she’ll want a wage premium for sacrificing the comfortable fit with the current employer for the uncertainty of life at a new firm. This risk may be shared by both the company and the executive, but the executive still can command higher pay as a result. Tracking a sample of over 30,000 executives in S&P 1500 firms over 16 years, we show that executives receive about 15 percent higher pay when they jump to new companies.

What does this mean for firms? Hiring from outside, rather than promoting from within, requires firms to pay up. And, as executive tenures shorten, that entails more movement between firms—for which there must be more compensation. Simply put, greater mobility and risk have translated to higher pay. While critics of executive pay argue greed and nepotism explain rising pay levels, our study suggests a less nefarious explanation—the evolution of the labor market toward greater external hiring is at least partly boosting executive compensation.

Naturally, we strive to rule out other explanations for the increase. We control for factors shown to influence pay levels, including economic characteristics of the employers and individual characteristics of the executives, like their education, age, and work experience. And we control for characteristics of job-switching, such as how far the executive must move, whether she moved to a higher cost-of-living area, and whether she received a promotion with the move. Because we track the movement of executives across firms in the S&P 1500, we can control for an executive’s average compensation level across our sample period. This helps address concerns that talent or skill explain someone’s pay.

We also test whether the premium decreases with an executive’s tenure at a new firm. If what we document is rooted in the uncertainty of the match, and not some innate characteristic, we would expect such a decrease. After all, the longer she’s employed at the firm, the more confident she becomes about fitting in, as there’s more information to suggest the match will be a long-term success.  Our evidence supports this. Finally, we repeat the analysis using proxies that more directly capture the uncertainty of fit with a new firm: Whether the new firm is in a different industry from the prior employer and whether the executive has previous connections (through employment or board membership) with the new firm. These characteristics should influence the expected uncertainty of fit. As expected, we find that pay premiums at the new firms vary accordingly, consistent with our argument that executives receive higher pay for job hopping when the uncertainty of fit is greater.

This post comes to us from professors Mary Ellen Carter at Boston College’s Carroll School of Management and Francesca Franco and A. Irem Tuna at the London Business School. It is based on their recent article, “Matching Premiums in the Executive Labor Market,” available here.

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