The Advisors' Blog

– Liz Dunshee

I have a toddler at home. I’ve noticed that when I “motivate performance” by taking away toys, I may get the result that I want in the moment. But in the long-term, I’m just teaching him to do the bare minimum to regain his prize – not the result I’m going for. This “Harvard Law” blog suggests that the same logic might apply to CEOs. Here’s an excerpt:

Boards often cut CEO pay following poor performance. These pay cuts can go beyond the general pay-for-performance relation. Agency theory suggests that such pay cuts can act as a disciplining mechanism against the CEO and, therefore, can lead to better performance in subsequent periods. Consistent with this line of reasoning, there is some empirical evidence that firm performance improves following a CEO pay cut.

The article – “Accounting & Economic Consequences of CEO Paycuts” – examines the possibility that cutting the pay of an incumbent CEO might also induce an adverse response. Specifically, whether – in response to pay cuts – CEOs actually increase their efforts to improve the underlying economic performance of the firm, or simply resort to managing measured performance through activities such as accruals manipulation and real activities management. These latter activities may be designed to boost reported earnings in the short-run at the expense of long-term shareholder value. Since CEO pay is often linked to reported earnings performance, CEOs have incentives to engage in earnings management after a pay cut because such activities can lead to faster improvement in reported performance – and hence to speedier restoration of their pay to prior levels. Thus, the efficacy of a CEO pay cut as a disciplining mechanism is unclear.