Incentive pay sensitivity to firm performance prior to anticipated CEO turnover

This study explores whether the sensitivity of CEO compensation to changes in firm performance depends on the CEO's likelihood of leaving the position. In a sample of 3180 US publicly-traded firms, we find that the sensitivity of bonus pay to firm performance is enhanced for a CEO who has reached retirement age. Further, we find that the sensitivity of bonus pay to firm performance is greater when there is evidence of a planned CEO turnover within a two-year window. We show that these findings are consistent with a principal-agent model in which firms who anticipate a greater likelihood of CEO departure find it advantageous to enhance the link between bonus pay and concurrent performance measures to compensate for the lowering of incentives that rely on the manager being employed long-term. The results provide a rationale for including bonus pay in the overall executive compensation package. •Firm-CEO fixed effects results confirm a direct link between firm performance and CEO bonus pay.•When CEO turnover is anticipated there is an increase in sensitivity of bonus pay to performance.•Firms appear to increase bonus pay sensitivity to compensate for incentives lost with CEO turnover.•Increased pay-performance sensitivity is observed only for bonus, not for salary or equity pay.