Executive pay is one of the most hotly debated topics around. Are executives being fairly compensated for their contributions to firm and shareholder value, or are they overpaid? One of the obstacles to finding the answer has been the difficulty in measuring pay versus contribution, but now Bang Dang Nguyen and Kasper Meisner Nielsen have come up with an intriguing proxy. They have looked at the stock price reaction to the sudden death of a top executive, and correlated that with executive compensation.

“The intuition behind this approach is that the stock price reaction to sudden deaths equals the expected value of the deceased executive’s contribution, net of compensation relative to the expected replacement,” they said. The authors compared those stock moves with the deceased executive’s abnormal compensation, measured as the excess compensation relative to peer firms of similar type and size.

They identified 149 sudden deaths of CEOs and top executives (presidents, chairmen, chief financial officers, chief operating officers and vice-presidents) in the United States between 1991 and 2008. While there were large variations in compensation packages, ages, and other characteristics, a clear trend emerged.

“There was a negative and significant relationship between the stock price reaction to sudden deaths and the deceased executive’s expected abnormal compensation. Executives who receive large compensation are perceived to be more valuable to shareholders, and the relationship is stronger for professional executives and executives at the top of the distribution of pay, which is consistent with a labour market driven by rare managerial talent,” they said.

On the other hand, 42% of sudden deaths (63 of the 149) resulted in a positive stock price reaction. This indicates that these executives were receiving more than 100% of the total rents and were overpaid, a factor that may have influenced another area that the authors looked at, the sharing of rents between executives and shareholders.

The average executive kept 71% of the marginal rent and the average CEO 65%. The higher level for professional managers indicated that managers who made higher contributions to shareholder value received higher compensation – a point strengthened when the authors excluded founders and managers with large ownership who would have the opportunity to manipulate their compensation.

Nonetheless, “the fraction of 71% appears large and is subject to debate and discussion. On the one hand, this rent share might reflect the prospect of the scarcity of managerial talent. On the other hand, as our estimates show, some executives extract more rent than they create,” they said.

The authors also considered whether executives mattered for value creation. “Our approach suggests that differences in skills across executives equal 5.1 to 6.4% of firm value. This indicates that executives do matter for firm value,” they said.

The data were subjected to various tests and measures and the results still held up, giving added weight to the findings. “Overall, the stability of the estimated rent sharing across empirical specifications bolsters our approach of eliciting an estimate of rent sharing from the relationship between stock price reactions to sudden deaths and executive compensation, and is informative for the ongoing discussions about the level of compensation,” they said.

There is a caveat in that the study relies on market perceptions of managerial contributions to shareholder value. “To the extent this differs from true value, our contribution is in showing that boards pay more to executives whom they think are better,” they added.

Story based on the article, “​What Death Can Tell: Are Executives Paid for Their Contributions to Firm Value?” originally published in Management Science, Vol. 60, No. 12, December 2014