90 Cents of Every 'Pay-For-Performance' Dollar Are Paid for Luck

We empirically estimate that approximately 90% of standard option-based compensation constitutes pay-for-luck. This value is very robust, and stems from the inherent fact that chance plays a dominant role in determining firm performance. The impact of a manager on her expected compensation via the improvement of firm performance is low, hence, in contrast to common wisdom, standard option-based compensation does not constitute a strong motivating force for rational managers. Indexing and a high strike price can double an option’s motivational power.