The use of nonfinancial performance measures in CEO bonus compensation

Abstract Research Question/Issue In this study, we explore the relationship between the use of nonfinancial performance measures in Chief Executive Officer (CEO) bonus plans and CEO power, moderated by compensation committee monitoring. Furthermore, we investigate whether the inclusion of nonfinancial performance measures is associated with higher CEO bonus pay sensitivity to shareholder returns. Research Findings/Insights Using a sample of FTSE 350 firms during the period 2007–2013, we find that CEO power is significantly negatively related to the propensity of using nonfinancial performance measures. This negative relationship, however, is moderated by higher levels of compensation committee monitoring. We also find that firms combining nonfinancial and financial performance measures in CEO bonus plans tend to have stronger CEO bonus pay sensitivity to shareholder returns than firms using financial measures alone. Thus, our results suggest that boards of directors adopting nonfinancial performance measures are able to better align CEO incentives with shareholder interests. We find similar results when using the weight of nonfinancial performance measures in the bonus plan in our analyses. Theoretical/Academic Implications This study empirically supports the managerial power theory whereby powerful CEOs influence the choice of performance measures in their bonus plans. However, effective compensation committees are found to attenuate the influence of powerful CEOs and to better align their interests with those of shareholders. Our result of stronger bonus pay sensitivity to shareholder returns for firms combining nonfinancial with financial performance measures implies that the informativeness of these measures enhances the firm's ability to tie CEO bonus compensation to shareholder wealth. Practitioner/Policy Implications This study offers insights to members of boards of directors, especially compensation committee members, who are interested in improving the design of executive incentive contracts to better align managerial incentives to shareholder interests. Furthermore, the findings inform regulators about the importance of alternative performance measures in pay‐performance sensitivity and may warrant increased firm disclosure of the details of the pay structure.