CEO Compensation and Firm Performance: An Empirical Investigation of UK Panel Data

This paper examines the link between CEO pay and performance employing a unique, hand-collected panel data set of 390 UK non-financial firms from the FTSE All Share Index for the period 1999-2005. We include both cash (salary and bonus) and equity-based (stock options and long-term incentive plans) components of CEO compensation in our analysis of a dynamic CEO compensation model. Different from previous studies, we use GMM-system estimation method, which controls for the presence of unobserved firm-specific effects and for the endogeneity of explanatory variables. In addition, we control for a comprehensive set of corporate governance variables. The empirical results indicate that there is a positive and significant relationship between firm performance and the level of CEO cash compensation while the relationship is positive but not significant for total compensation. This finding suggests that corporate governance reports in the UK, such as Greenbury Report (1995) that proposed CEO compensation be more closely linked to performance, have not been totally effective. We also find that proportion of non-executive directors on board does not have a significant impact on CEO cash compensation, while non-executive directors’ share ownership has a nonlinear and significant impact suggesting that ownership can provide incentives for non-executive directors to be more active in monitoring for CEO compensation packages. Our results also indicate that institutional ownership has a positive and significant influence on CEO pay-for-performance sensitivity of option grants. Finally, we find that longer CEO tenure is associated with lower pay-for-performance sensitivity of option grants suggesting the entrenchment effect of CEO tenure. JEL classification: G3