Another Look at the Relative Performance Evaluation Hypothesis

In spite of strong theoretical predictions, empirical researchers have found little support for the relative performance evaluation (RPE) hypothesis in studies of executive compensation. Some evidence supports a weak form of the RPE hypothesis that executive pay is positively related to firm performance and negatively related to peergroup performance. But, there is almost no evidence supporting a strong form of the RPE hypothesis that performance shocks that are common to a firm and its peers are completely backed out when evaluating executive performance for compensation purposes. Whether the weakness of the RPE evidence is due to limited use of RPE in executive compensation or misspecification of empirical analyses of RPE is an unresolved research issue. Previous studies of RPE have not recognized the two-way relations between pay and performance that are fundamental to the agency models – performance affects pay and pay affects performance. In this study, we estimate models of RPE that recognize this simultaneity between pay and performance. In contrast to previous findings, our results support strong and weak form RPE with respect to both accounting and stock returns for a large cross-section of firms.