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Explaining executive pay:
The roles of managerial power and complexity
D I S S E R T A T I O N
of the University of St. Gallen,
Graduate School of Business Administration,
Economics, Law and Social Sciences (HSG)
to obtain the title of
Doctor of Business Administration
submitted by
Lukas Hengartner
from
Waldkirch (St. Gallen)
Approved on the application of
Prof. Winfried Ruigrok, PhD
and
Prof. Simon Peck, PhD
Dissertation no. 3217
Publisher: Deutscher Universitts-Verlag, Wiesbaden 2006
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The University of St. Gallen, Graduate School of Business Administration, Economics, Law and
Social Sciences (HSG) hereby consents to the printing of the present dissertation, without hereby
expressing any opinion on the views herein expressed.
St. Gallen, June 12, 2006
The President:
Prof. Ernst Mohr, PhD
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PREFACE V
Preface
The idea of studying executive pay was born in a lecture on option valuation in spring
2002 at the Norwegian School of Economics and Business Administration NHH. At that
time, I started wondering how companies that had granted large amounts of stock
options to their executives would react to the sharp decreases in share prices that could
be observed since 2000. Based on this interest, I wrote my NHH master thesis about
Employee stock options and falling share prices investigating a sample of Norwegian
IT companies. These companies were especially likely to both have granted substantial
amounts of options and suffered from severe declines in share prices. The topic of
executive pay continued to attract my interest, mainly because I felt that it offered
opportunities to make a real contribution to academic researchers and policy makers
alike. In summer 2002, I wrote my master thesis at the University of St. Gallen HSG. I
investigated the determinants of executive stock option plan adoptions of Swiss stock-
listed companies. Major results were that both large outside shareholders and CEO
duality influenced whether companies would adopt stock option plans. At that time, very
little information about executive pay was disclosed in Switzerland. However, the SwissStock Exchange SWX issued new listing guidelines that required companies to disclose
detailed information on Corporate Governance starting from the annual report 2002 to be
published in 2003. Part of this information was the total compensation of the highest-
paid member of the board of directors and the total compensation for the top
management team. With these guidelines, the way was open to empirical studies on
executive pay in Switzerland, a topic that had received much attention in the US for a
long time.
The goal of this dissertation was twofold. On one hand, I wanted to make a contribution
to the international research community interested in top executive pay. By developing
and testing an innovative and broad measure of the link between managerial power and
pay as well as complexity and pay, I am confident to have made such a contribution. On
the other hand, this work should provide a detailed and comprehensive overview of the
executive pay in Switzerland. By presenting an extensive and updated review of the
literature and detailed statistical data, I hope to provide valuable input for compensation
consultants, HR managers and policy makers on this highly contentious issue.
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PREFACEVI
I am indebted to my interview partners and all participants of the survey used in this
work. Interview partners were Gary Steel, Head of HR and secretary to the compensation
committee ofABB, David Tankel, Managing Director ofNew Bridge Street Consultants,
Hanspeter Fssler, member of the compensation committee ofDaetwyler, and Prof. Dr.
Rolf Dubs, chairman of the compensation committee ofSchindler.
Further, I would like to thank all persons who supported me in writing this study. My
special thanks go to my academic advisors, Prof. Dr. Winfried Ruigrok and Prof. Dr.
Simon Peck, for their valuable guidance and suggestions as well as for the academic
freedom I was granted during the preparation of this paper. I also appreciated the
instructive comments of Elin Therese Dahl and Peder Greve, who reviewed drafts of the
manuscript.
Zurich, June 15, 2006 Lukas Hengartner
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OVERVIEW VII
Overview
Preface ..............................................................................................................................V
Overview.........................................................................................................................VII
Table of Contents............................................................................................................ IX
List of tables................................................................................................................ XVII
List of figures................................................................................................................XIX
List of abbreviations .....................................................................................................XXI
Summary....................................................................................................................XXIII
1 Introduction...............................................................................................................1
2 The compensation setting process ............................................................................9
3 Research review on executive pay...........................................................................13
4 Research review on director pay.............................................................................48
5 Are executives paid for the complexity of the job they have?................................53
6 Can powerful managers extract rents? ..................................................................66
7 Research methods..................................................................................................102
8 Research results.....................................................................................................119
9 Discussion..............................................................................................................159
10 Conclusions ...........................................................................................................169
Appendix - questionnaire ..............................................................................................179
References......................................................................................................................183
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VIII
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TABLE OF CONTENTS IX
Table of Contents
Preface ..............................................................................................................................V
Overview.........................................................................................................................VII
Table of Contents............................................................................................................ IX
List of tables................................................................................................................ XVII
List of figures................................................................................................................XIX
List of abbreviations .....................................................................................................XXI
Summary....................................................................................................................XXIII
1 Introduction...............................................................................................................1
1.1 Why study executive pay?...............................................................................1
1.2 The evolution of executive compensation research.......................................2
1.3 Literature gap and research questions ..........................................................4
1.4 Overview of the paper .....................................................................................6
2 The compensation setting process ............................................................................9
2.1 Purpose of compensation policies ...................................................................9
2.2 Roles and responsibilities ................................................................................9
2.3 Organization of the compensation committee .............................................10
2.4 Elements and allocation of executive pay ....................................................10
2.5 The influence of executives on their compensation.....................................11
3 Research review on executive pay...........................................................................13
3.1 The relationship between pay and performance.........................................14
3.1.1 The debate over size versus profits..............................................................14
3.1.2 Agency theory and optimal contracting.......................................................15
3.1.3 The pay-for-performance sensitivity ...........................................................16
3.1.4 Relative performance evaluation .................................................................21
3.1.5 Non-financial firm performance and pay ....................................................22
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TABLE OF CONTENTSX
3.1.6 Pay structure and subsequent performance..................................................23
3.1.7 The certainty-equivalent approach ..............................................................26
3.2 Other determinants of executive pay ...........................................................273.2.1 Economic explanations................................................................................27
Complexity...........................................................................................................27
The influence of risk in optimal contracting........................................................27
Managerial labor market ......................................................................................29
Investment opportunities......................................................................................30
Managerial discretion...........................................................................................31
Human capital ......................................................................................................33
Market forces .......................................................................................................34
Executives personal characteristics ....................................................................34
Stewardship theory...............................................................................................35
3.2.2 Political explanations...................................................................................35
Managerial power ................................................................................................35
Impression management ......................................................................................35
3.2.3 Social explanations ......................................................................................36
Social comparison................................................................................................36Isomorphism ........................................................................................................36
3.3 Other effects of executive pay .......................................................................37
3.3.1 Stock options, dividend payments and share repurchases ...........................37
3.3.2 Unvested stock options, restricted stock and manager retention.................37
3.3.3 Equity incentives and risk............................................................................37
3.3.4 Compensation, M&A and divestitures ........................................................39
3.3.5 Long-term compensation and capital investments ......................................40
3.3.6 Contingent pay and expectations management............................................40
3.3.7 Incentive compensation and earnings management.....................................41
3.3.8 Stock options and litigation .........................................................................41
3.3.9 Crowding out ...............................................................................................41
3.4 Determinants and consequences of pay differentials..................................42
3.4.1 Explaining pay differentials tournament theory .......................................42
3.4.2 Pay differentials and performance...............................................................43
3.4.3 Other determinants and consequences of pay differentials .........................44
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TABLE OF CONTENTS XI
3.5 Stock option repricing ...................................................................................44
3.6 Stock options versus stock grants.................................................................46
3.7 International comparison of pay levels and mix .........................................47
4 Research review on director pay.............................................................................48
4.1 Directors as the shareholders agents ..........................................................48
4.2 Overview of outside director compensation ................................................49
4.3 Determinants and consequences of director compensation .......................49
4.4 Summary of director pay studies .................................................................51
5 Are executives paid for the complexity of the job they have?................................53
5.1 Towards a framework of complexity and pay.............................................53
5.1.1 Defining complexity ....................................................................................53
5.1.2 Complexity as a determinant of pay level and structure..............................53
5.1.3 Prior operationalizations of complexity.......................................................54
5.1.4 Conceptual framework of complexity and executive pay ...........................55
5.2 Firm internationalization and executive pay...............................................56
5.3 Firm diversification and executive pay ........................................................58
5.4 Firm size and executive pay ..........................................................................59
5.5 Market uncertainty and executive pay ........................................................61
5.6 Politicized environment and executive pay..................................................62
5.7 Summary of the literature on complexity-pay relation..............................63
5.8 Literature gap and complexity hypotheses..................................................656 Can powerful managers extract rents? ..................................................................66
6.1 Towards a framework of power and pay.....................................................67
6.1.1 Defining executive power............................................................................67
6.1.2 Executive pay theories and executive power...............................................69
6.1.3 Prior studies on the link between executive power and pay........................70
6.1.4 Related studies on CEO power ....................................................................72
6.1.5 Conceptual framework of executive power and compensation...................74
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TABLE OF CONTENTSXII
6.2 Ownership power and executive compensation ..........................................76
6.2.1 Executive ownership....................................................................................76
6.2.2 Non-executive directors ownership............................................................78
6.2.3 Shareholder concentration ...........................................................................79
6.3 Structural power and compensation ............................................................81
6.3.1 Non-executive and independent directors ...................................................81
6.3.2 CEO duality .................................................................................................83
6.3.3 Presence of a compensation committee .......................................................84
6.3.4 Composition of the compensation committee .............................................86
6.3.5 Board size ....................................................................................................87
6.4 Tenure power and executive compensation.................................................88
6.4.1 CEO tenure ..................................................................................................88
6.4.2 Interdependent directors ..............................................................................90
6.5 Network power and executive compensation ..............................................91
6.5.1 Executive board memberships.....................................................................92
6.5.2 Reciprocal and social interlocks ..................................................................93
6.5.3 Non-executive board memberships .............................................................94
6.6 Credibility power and executive compensation ..........................................94
6.6.1 CEO celebrity status ....................................................................................94
6.6.2 Prior firm performance ................................................................................95
6.6.3 Expertise ......................................................................................................97
6.7 Summary of the literature on power pay relation ...................................97
6.8 Literature gap and power hypotheses........................................................100
7 Research methods..................................................................................................102
7.1 Development of hypotheses.........................................................................102
7.2 Sample and data...........................................................................................102
7.2.1 Archival data..............................................................................................102
7.2.2 Survey........................................................................................................104
7.3 Model specification ......................................................................................105
7.3.1 Regression analysis....................................................................................105
7.3.2 Unit of analysis..........................................................................................106
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TABLE OF CONTENTS XIII
7.4 Measuring executive compensation............................................................107
7.4.1 Cash compensation ....................................................................................108
7.4.2 Share awards..............................................................................................108
7.4.3 Stock options .............................................................................................108
7.5 Measuring complexity .................................................................................109
7.5.1 Archival data..............................................................................................109
7.5.2 Survey data ................................................................................................110
7.6 Measuring executive power.........................................................................111
7.6.1 Ownership power.......................................................................................111
7.6.2 Structural power.........................................................................................112
7.6.3 Tenure power.............................................................................................113
7.6.4 Network power ..........................................................................................113
7.6.5 Credibility power .......................................................................................114
7.6.6 Survey data ................................................................................................114
7.7 Other variables.............................................................................................115
7.7.1 Firm financial performance .......................................................................115
7.7.2 Firm risk ....................................................................................................116
7.7.3 CEO age.....................................................................................................116
7.7.4 Anglo-American board members and top managers .................................116
7.7.5 Disclosure effects.......................................................................................117
7.7.6 Industry effects ..........................................................................................117
7.7.7 Consultants ................................................................................................118
8 Research results.....................................................................................................119
8.1 Descriptive statistics ....................................................................................119
8.1.1 Overview of the Swiss pay scene ..............................................................119
CEO compensation ............................................................................................119
Top management compensation.........................................................................120
Non-executive compensation.............................................................................122
8.1.2 Evidence on complexity variables .............................................................123
8.1.3 Evidence on managerial power variables ..................................................124
8.1.4 Other variables...........................................................................................126
8.2 Basic determinants of executive pay ..........................................................127
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TABLE OF CONTENTSXIV
8.2.1 The determinants of the level of executive pay.........................................127
8.2.2 The determinants of equity-compensation mix .........................................130
8.3 The influence of complexity on executive pay ...........................................1318.3.1 The influence of individual complexity variables on pay levels ...............131
8.3.2 The influence of individual complexity variables on pay mix ..................134
8.3.3 Survey measures of complexity and pay levels and mix...........................135
8.3.4 The complexity construct and executive pay.............................................137
8.4 The influence of power on executive pay ...................................................140
8.4.1 The influence of individual power variables on pay levels .......................140
8.4.2 The influence of individual power variables on pay mix ..........................143
8.4.3 Survey measures of power.........................................................................145
8.4.4 The power construct and executive pay.....................................................147
8.5 The overall influence of power and complexity on executive pay ...........150
8.6 Sensitivity analysis .......................................................................................155
8.6.1 Does the composition of the compensation committee matter? ................155
8.6.2 Alternative measures for complexity variables .........................................156
8.6.3 Alternative measures for power variables .................................................157
8.6.4 Alternative measure of firm performance..................................................157
9 Discussion..............................................................................................................159
9.1 Complexity and executive pay ....................................................................159
9.2 The incremental contribution of firm size .................................................160
9.3 Technological complexity and executive pay.............................................160
9.4
The components of complexity ...................................................................161
9.5 The components of managerial power .......................................................162
9.6 Interdependent directors and executive pay .............................................162
9.7 Compensation committee existence and executive pay ............................163
9.8 Managerial power and pay structure.........................................................164
9.9 CEO duality as a self-serving opportunity? ..............................................166
9.10 Board size and executive pay ......................................................................167
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TABLE OF CONTENTS XV
9.11 The influence of Anglo-Americans.............................................................167
10 Conclusions ...........................................................................................................169
10.1 Contributions to the literature....................................................................169
10.2 Summary of results......................................................................................170
10.2.1 Overview of executive and director compensation ...............................170
10.2.2 Basic determinants of executive pay .....................................................171
10.2.3 Complexity and executive pay ..............................................................172
10.2.4 Power and executive pay .......................................................................173
10.3 Implications for policy makers and practitioners .....................................175
10.4 Limitations....................................................................................................176
10.5 Future research............................................................................................177
Appendix - questionnaire ..............................................................................................179
References......................................................................................................................183
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XVI
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LIST OF TABLES XVII
List of tables
Table 1: Empirical studies on the pay-performance relation. ................................................ 20
Table 2: Overview of studies on directors pay....................................................................... 52
Table 3: Empirical studies on complexity-CEO pay level relation........................................ 64
Table 4: Empirical studies on complexity executive pay mix relation. .............................. 65
Table 5: Major empirical studies on the CEO/board power variables and CEO pay level.... 97
Table 6: Empirical studies on CEO power pay mix relation............................................... 99
Table 7: Descriptive statistics on CEO compensation. ........................................................ 120
Table 8: Descriptive statistics on top management compensation....................................... 121
Table 9: Descriptive statistics on non-executive director compensation. ............................ 122
Table 10: Descriptive statistics on complexity variables. .................................................... 124
Table 11: Descriptive statistics of executive power variables. ............................................ 125
Table 12: Summary statistics of other variables. ................................................................. 127
Table 13: Correlation matrix of basic determinants............................................................. 128
Table 14: OLS estimation of common determinants on total executive compensation....... 129
Table 15: Tobit model estimates of common determinants on equity-pay mix................... 130
Table 16: Correlation matrix based on individual complexity variables. ............................ 131
Table 17: OLS estimation of individual complexity variables on compensation levels. ..... 133
Table 18: Tobit estimates of individual complexity variables on compensation mix.......... 135
Table 19: Descriptive statistics on survey complexity measures......................................... 136
Table 20: Univariate estimates of surveyed complexity on CEO compensation. ................ 136
Table 21: Univariate Tobit estimates of CEO equity-based compensation on survey
complexity variables. ........................................................................................................... 137
Table 22: Correlation matrix of archival complexity variables. .......................................... 138
Table 23: Principal component analysis and scoring coefficients of archival
complexity construct............................................................................................................ 138
Table 24: Principal component analysis and scoring coefficients of survey
complexity construct............................................................................................................ 139
Table 25: Relationship between complexity constructs and CEO compensation. ............... 140
Table 26: OLS estimation of individual power variables on compensation level................ 142
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LIST OF TABLESXVIII
Table 27: Tobit estimates of individual power variables on executive compensation mix.. 144
Table 28: Descriptive statistics on survey power measures................................................. 146
Table 29: Univariate estimates of survey power variables on CEO compensation. ............ 147
Table 30: Principal component analysis of archival power construct.................................. 148
Table 31: Scoring coefficients of archival power construct................................................. 149
Table 32: Principal component analysis on survey power measures. .................................. 150
Table 33: Scoring coefficients of survey power construct................................................... 150
Table 34: Regressions of the archival complexity and power constructs on executive pay. 152
Table 35: Tobit regressions of the complexity and power constructs on executive pay
structure................................................................................................................................ 154
Table 36: Regressions of the survey complexity and power constructs on CEO
compensation. ...................................................................................................................... 155
Table 37: OLS estimation of the composition of the compensation committee on TMT
compensation. ...................................................................................................................... 156
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LIST OF FIGURES XIX
List of figures
Figure 1: Dissertation overview............................................................................................... 7
Figure 2: Determinants and consequences of executive compensation. ................................ 13
Figure 3: Conceptual framework of complexity and executive compensation. ..................... 55
Figure 4: Conceptual framework of executive power and compensation. ............................. 75
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XX
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LIST OF ABBREVIATIONS XXI
List of abbreviations
CEO Chief Executive Officer
DOI Degree of internationalization
EJPD Eidgenssisches Justiz- und Polizeidepartement
FASB Financial Accounting Standards Board
FETE Foreign employees total employees
FSTS Foreign sales total sales
GBP British Pound
Ln Natural logarithm
LTIP Long-term incentive plan
M & A Mergers & acquisitions
MCHF Million Swiss Francs
MUSD Million US Dollar
R & D Research & Development
SIC Standard Industry Classification
UK United Kingdom
US United States
USD US Dollar
S & P 500 Standard & Poors 500
SWX Swiss Stock Exchange
TMT Top management team
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XXII
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SUMMARY XXIII
Summary
This paper examines the roles of complexity and power as explanations for executive
pay level and mix. It is hypothesized that complexity and power are positively associated
with the level of compensation. Further, I hypothesize that complexity is positively and
executive power negatively related to the proportion of executive compensation that is
based on stock options and restricted stock. Despite numerous research articles
investigating variables associated with complexity and executive power and their effect
on executive pay, a broad conceptualization of both complexity and power with respect
to the setting of executive pay is missing. This dissertation attempts to close this gap. For
a sample of 199 Swiss stock-listed companies in 2002-2003, I collect a large number of
archival variables to empirically test the effects of complexity and power constructs on
executive compensation. I augment these results with a sample of 47 survey-based
responses to obtain a richer conceptualization of executive power and firm complexity.
Multiple regressions are run on an individual variables basis as well as on factor-
analyzed categories. Results are broadly consistent with hypotheses. Complexity is
positively associated with CEO and top management team compensation levels andequity-pay mix. Managerial power is generally positively associated with pay levels.
Contrary to my hypothesis, I also find evidence that some dimensions of executive
power are positively related to the proportion of equity in total compensation.
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XXIV
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INTRODUCTION 1
1 Introduction
1.1 Why study executive pay?
Executive compensation has attracted widespread attention in recent years and has
become one of the focus topics in corporate governance (Felton, 2004). At least three
reasons have contributed to this increased attention on executive compensation for
academics and practitioners alike: A fascination with and sometimes lack of
understanding for the high levels of CEO compensation, the importance of the CEO as
the main strategic decision maker and the increased transparency of executive
compensation data in many countries.
First, the pay of corporate leaders has undisputedly escalated in the last few decades,
while workers pay has stagnated. The average real pay for chief executive officers of
S&P 500 firms increased significantly during the 1990s, growing from 3.5 MUSD in
1992 to 14.7 MUSD in 2000. Most of this increase reflects the escalation in stock
options valued at the time of grant, which now constitute the single largest component of
executive pay (Hall and Murphy, 2003). Average real CEO pay in the S&P 500
decreased again to 9.4 MUSD in 2002.1 Even for large stock-listed companies, these
amounts are substantial. Average CEO compensation now constitutes around 8% of
corporate profits for US firms (Balsam, 2002: 262; Bebchuk and Fried, 2003). Over the
same period, the pay of most employees has increased only marginally, increasing the
ratio of CEO pay to the average factory workers pay from 1:42 in 1980 to 1:531 in 2000
(Felton, 2004) and 1:431 in 2004 (Economist, 2005a). In Switzerland, some CEOs seem
to have multiplied their total compensation in recent years, in spite of modest stock
market developments (Schtz, 2005). At UBS, a large bank, top executives now earn 230times the average pay of low-paid employees (Wittwer, 2005a: 27). The rapid increase in
CEO compensation is difficult to comprehend for many people, given simultaneous
corporate downsizing, employee layoffs, plant closings (Abowd and Kaplan, 1999; Dial
and Murphy, 1995; Murphy, 1999; Murphy, 1997) and poor financial performance (e.g.
1 At the same time as average pay decreased, median pay rose, indicating that the declining averagewas the result of a significant fall in the earnings of a few extremely highly compensated executives(Useem, 2003).
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CHAPTER 12
Krauer, 2004). In short, there is a widely held belief that top executives are overpaid
(Gomez-Mejia, 1994). Anecdotal evidence indicates that CEOs of large Swiss
corporations are the best paid in Europe (Schtz, 2005: 73).
A second reason for the high attention paid to CEO compensation by practitioners and
academics is the CEOs position at the apex of the firm. As the main strategist for the
firm, his or her compensation may have a direct bearing on business decisions affecting
the future of the entire organization. How a firms top managers are compensated and
how much equity of their firm they hold has a significant impact on corporate strategic
decisions (Sanders, 2001a; Datta et al., 2001; Bliss and Rosen, 2001), the value
development of the firm (Morck et al., 1988; McConnell and Servaes, 1990) or the
compensation policies for middle and lower-level managers (Gomez-Mejia, 1994).
Furthermore, the structure of executive compensation mainly the large option grants
has been linked to recent corporate collapses in the US. With large stock options payoffs
in view, executives manipulated their books and inflated stated earnings in the search for
higher share prices (Hall and Murphy, 2003; Bebchuk et al., 2001; Bolton et al., 2002;
Felton, 2004; Frey, 2004; Hambrick et al., 2005). This has led experts to conclude that
much may be wrong with executive compensation (Elson, 2003) and stock options in
particular (Hall and Murphy, 2003) today.Third, executive pay is increasingly transparent, as companies are required to publish
increasing details of remuneration data in various countries (e.g. Schildknecht, 2004:
140). The Swiss Stock Exchange SWX required its listed companies to disclose the
compensation of the top management team and the board of directors in 2002.
Subsequently, interest in top management pay rapidly increased and has been a regular
topic in news publications. An amendment of the law to make more detailed disclosure
mandatory is under way (Gerny, 2004; EJPD, 2003).
1.2 The evolution of executive compensation research
Along with the increase in executive compensation levels, the volume of related research
papers has soared. Over the last several decades, hundreds of studies have been
conducted on the determinants and to a lesser degree the consequences of executive
compensation. Already more than a decade ago, Gomez-Mejia (1994) stated that
probably no other single variable had received as much empirical attention across
different business fields and related social sciences as executive compensation.
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INTRODUCTION 3
Spurred by the separation of ownership and control (Berle and Means, 1932; Fama and
Jensen, 1983) and agency theory (Jensen and Meckling, 1976), research has mainly
focused on the strength of the relationship between pay and firm performance (e.g.
Lewellen and Huntsman, 1970; Murphy, 1985). Conversely, managerialists (Tosi et
al., 2000) were interested in whether pay was related to firm size and sales growth rather
than financial performance (Baumol, 1959; Ciscel, 1974). This started the sales versus
profit debate originally tested by McGuire et al. (1962), which returned inconsistent
results.
In a seminal study, Jensen and Murphy (1990a) showed that a change in total
shareholder wealth of 1,000 dollars was associated with a change of 3.25 dollars of total
CEO wealth, and concluded that the size of the relationship is too weak to provide useful
incentives. Since then, numerous studies have replicated such investigations of the pay-
performance relationship (e.g. Lippert and More, 1994; Hall and Liebman, 1998;
Murphy, 1999; Brunello et al., 2001). However, little consistency has been found for the
relationship between pay and performance, partly due to differences in sample periods,
methods applied, different performance measures and control variables included (Joskow
and Rose, 1994). In a meta-analysis of 137 CEO pay studies, Tosi et al. (2000)
documented that firm performance accounts for less than 5% of the variance, while firmsize accounts for more than 40% of the variance in total CEO pay. The same authors
noted that the findings of studies on executive pay as a control mechanism are
remarkably inconsistent not only with theory but with each other (Tosi et al., 2000:
305).
Due to these discouraging results, recent work has begun to move beyond the pay-
performance framework to suggest other potential factors influencing executive
compensation (Barkema and Gomez-Mejia, 1998). These factors include the role of risk
(Gray and Cannella, 1997; Carpenter, 2000; Aggrawal and Samwick, 1999; Miller et al.,
2002), human capital (Harris and Helfat, 1997; Combs and Skill, 2003; Sanders et al.,
2001), skill (Kornhauser et al., 2005), social similarity (Belliveau et al., 1996), power
(Sridharan, 1996; Barkema and Pennings, 1998), CEO reputation (Milbourn, 2003),
symbolism and impression management (Zajac and Westphal, 1995; Siegel and
Brockner, 2005), the role of managerial discretion (Finkelstein and Boyd, 1998) and
stakeholder management (Coombs and Gilley, 2005). Overall, these advances have
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CHAPTER 14
shown that executive pay levels and structure are the consequence of the interplay
between various firm- and CEO-specific factors.
Economists and financial scholars have turned their focus towards design specificationsof stock option plans (Brenner et al., 2000; Hall and Murphy, 2000; Johnson and Tian,
2000a; Archarya et al., 2000; Bettis et al., 2005), stock option repricing (Chen, 2004;
Carter and Lynch, 2001; Chance et al., 2000; Challaghan et al., 2004; Chidambaran and
Prabhala, 2003) and the valuation of executive stock options (Carpenter, 1998; Hall and
Murphy, 2002; Johnson and Tian, 2000b; Cuny and Jorion, 1995).
Furthermore, researchers have increasingly become interested in the consequences of
compensation. They have studied how compensation policy affects managerial decisions
such as investment and debt policy (Coles et al., 2002), risk taking (Carpenter, 2000) or
corporate acquisition decisions (Datta et al., 2001) and how compensation is related to
future firm performance (Sanders, 2001b; Hanlon et al., 2003).
1.3 Literature gap and research questions
This work moves beyond the basic agency-theoretic hypothesis of linking pay to firm
performance. It extends the existing literature by investigating the concepts of
complexity and power in the design of executive compensation contracts.
Some CEOs have more complex and demanding jobs than others, and these CEOs may
command a pay premium in the managerial labor market. Although complexity was
early on suggested as an important determinant of CEO pay (Finkelstein and Hambrick,
1989), it has received very little theoretical and empirical attention in prior research on
executive compensation. Few studies have explicitly invoked a complexity explanation
for CEO pay. Moreover, operationalization of complexity has by and large been limited
to firm diversification (Finkelstein and Hambrick, 1989) or a firms degree ofinternationalization (Sanders and Carpenter, 1998). Much remains unclear on how the
notion of complexity affects executive compensation. Are executives really paid for the
complexity they manage? What kind of complexity are executives paid for? Does
complexity affect the structure of executive pay contracts?
This dissertation attempts to shed more light on how complexity influences executive
pay:
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INTRODUCTION 5
What is the role of complexity in the determination of executive compensation level and
structure?
To answer this research question, I developed an integrative concept of complexity. Thisconcept models complexity along different dimensions based on a large set of variables.
The variables were collected through archival and survey data collection methods to
capture both objective and subjective notions of complexity. Applying this thorough
method, I have attempted to give a more comprehensive account of how complexity
affects compensation level and structure.
Power stands at the heart of agency theory (Fama, 1980; Jensen and Meckling, 1976).
According to the agency perspective, the evolution of the public corporation has
dispersed corporate ownership. This has created a separation between ownership and
control and an opportunity for CEOs to maximize their personal wealth at the expense of
shareholders (Berle and Means, 1932; Jensen and Meckling, 1976). To empirically test
this basic agency assumption, researchers focused almost exclusively on the magnitude
of interest alignment in terms of the pay-performance sensitivity. A significant and high
pay-performance sensitivity would indicate that agency problems are effectively
mitigated. The level of compensation, arguably an important indication of a CEOs
pursuit of self-interest, has traditionally played a minor role, as agency theorists advocatethat it is not how much you pay but how you pay (Jensen and Murphy, 1990b). The
relatively scarce empirical literature on power has yielded ambiguous results. This is
mainly due to insufficient operationalization of power variables (Grabke-Rundell and
Gomez-Mejia, 2002) rather than poor theoretical ground. Better constructs and
operationalization of variables are necessary to capture the full picture of how more
powerful CEOs, as opposed to less powerful ones, manage to extract rents. Bebchuk and
Fried (2003; 2004) argue that managerial power is the reason for the extraction of rent in
recent years and decades. However, a valid construct measuring cross-sectional
differences in managerial power and its influence on compensation is still missing. A
call by Hambrick and Finkelstein (1996: 281) that a broader conceptualization of power
is needed in the context of executive compensation is still unanswered.
This dissertation attempts to close this gap by answering the following question:
What is the role of executive power in the determination of executive compensation?
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CHAPTER 16
I developed a conceptualization of board-CEO power grounded in theory and earlier
empirical results and created a measurement method that adequately captures the
multiple dimensions of executive power and its relation to compensation level and mix. I
also augmented archival data with survey data, as archival data cannot adequately
capture the nuances underlying executive compensation decisions (Gomez-Mejia, 1994).
1.4 Overview of the paper
The paper is structured as follows. In chapter 2, I describe the process of executive pay
setting in Switzerland. Today, many Swiss companies have established a compensation
committee. This committee is the body of the board mainly responsible for setting
executive compensation. The influence of executive management on pay determinationmay vary substantially across companies.
The vast literature on top management compensation is reviewed in chapter 3. Major
streams of research are discussed. The most influential concept in studying executive
compensation is agency theory. Due to the non-alignment of interests between
shareholders and managers, performance-based compensation helps reduce agency costs.
Researchers have focused on measuring how executive pay and wealth responds to
concurrent changes in firm performance in determining the extent of reductions inagency costs. While significant relations between pay and performance have been
detected, results were generally disappointingly low. As a result, other concepts have
been studied to increase the understanding of executive pay. Human capital, risk,
discretion, or managerial power have all been invoked and partially confirmed as
determinants of executive pay. Academic research also investigated the effects of
compensation structure and level on a firms strategic behavior.
Chapter 4 contains a review of the literature on director pay. Closely linked to executivepay, non-executive director pay has only recently received more attention by academics.
One reason for this lack of interest may be the implicit assumption of most studies on
executive pay that the board of directors acts in the interests of shareholders. Empirical
results show that the determinants of executive and director pay are remarkably similar.
In Chapter 5, the notion of complexity and its application to executive compensation are
discussed. Research hypotheses are formulated. While complexity has been examined as
a determinant of CEO pay in earlier studies, operationalization has generally remained
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INTRODUCTION 7
weak. Prior studies used proxies such as firm size and firm diversification to gauge the
extent of complexity. This chapter develops a broad concept of complexity related to a
CEOs job. In this respect, complexity is multidimensional. Firm size, diversification,
internationalization, a politicized environment and market uncertainty are identified as
different dimensions of complexity. It is hypothesized that complexity is associated with
higher levels of pay and a higher proportion of equity-based pay out of total pay.
Figure 1: Dissertation overview
9. Discussion
10. Conclusions
1. Introduction
2. Compensationsetting process
3. Literature reviewon executive pay
5. Are executives paid for thecomplexity of the job they have?
7. Research methods
8. Research results
6. Can more powerful managersextract rents?
4. Literature reviewon director pay
Chapter 6 contains the literature review and the development of the research gap and
hypotheses with respect to managerial power. Notions of power have been frequently
studied in executive compensation research. Agency theory, the dominant theoreticalapproach, argues that the separation of ownership and control in a large organization
creates a power base for executive management. However, most prior studies have
applied single measures of power, and results are often inconsistent and ambiguous. A
more complete concept of power is developed.
Research methods used to test the hypotheses developed in chapters 5 and 6 are
discussed in chapter 7. The hypotheses are tested applying both archival data and survey
data to capture a broad concept of power and complexity. I collected compensation data
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CHAPTER 18
for 199 Swiss stock-listed companies in 2002 and 2003, resulting in a dataset of 398
firm-year observations. Both CEO compensation and top management team
compensation are investigated. A large number of complexity and power variables were
also collected for these years. In addition, I conducted a survey among compensation
committee chairmen to capture more subtle and subjective elements of power and
complexity. This second data set consists of 47 observations in 2004. To reduce the
number of variables in regression analysis, I apply principal components factor analysis.
Research results are provided in chapter 8. In general, results confirm that several
dimensions of complexity are significantly associated with executive compensation
levels and mix. The individual complexity dimensions size, internationalization, and
politicized environment are all related to executive pay, while diversification and market
uncertainty show no significant association with pay. Further, the subjective measure
perceived complexity is significantly related to CEO pay. Results based on variables
transformed by factor analysis show that these dimensions all load on one principal
component and confirm a strong association between complexity and compensation. The
fifteen power variables sort into six principal components. Several of these components,
such as outside ownership power and structural power, are associated with executive
compensation levels.
I discuss the results in chapter 9. For instance, several dimensions of managerial power
are significantly associated with compensation mix. However, the sign of the results is
not consistent with the idea that more powerful managers prefer cash over equity-based
compensation. One explanation may be that internal and external political constraints
restrict the amount of cash compensation, and that stock options and share awards
provide better opportunities for managers to extract rents. Conclusions are provided in
chapter 10.
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THE COMPENSATION SETTING PROCESS 9
2 The compensation setting process
The general roles of the board of directors are to set the companys strategic direction, to
advise and monitor top management and to otherwise protect the interests of
shareholders (e.g. Styles and Taylor, 2003; Hilb, 2005). Determining executive pay is an
important task in fulfilling the boards duties (Finkelstein and Hambrick, 1996). This
chapter describes institutional details of the executive pay setting process.
2.1 Purpose of compensation policies
Many companies have a charter for the board of directors and their committees. Thesecharters outline in detail the purpose, tasks and responsibilities of the board and its
committees. The purpose of compensation policies as frequently stated is that executive
compensation is set such as to retain and attract executives who are needed to ensure the
competitiveness and long-term success of the business. Most companies publishing a
charter for the compensation committee further state the goal of establishing a link
between pay and performance. For instance, the charter for the compensation committee
of the UBS Board of Directors states that the compensation committee will support
policies and practices to attract, motivate and retain executives, ensure competitiveness,
long-term business success, shareholder interests and a strong pay-performance link.
While other companies use a different wording, the contents largely remain the same.
Companies that do not have or do not disclose a compensation committee charter often
state the same purpose in their annual reports. This would imply that compensation
committees only pay as much as needed to attract and retain the necessary individuals at
the top and that they aim at establishing a strong link between pay and performance.
Some companies further mention that the value of the position or individual qualificationrequired for that position play a role in determining compensation levels. This indicates
that complexity influences executive pay.
2.2 Roles and responsibilities
The compensation committees role is to either determine executive compensation or to
make recommendations to the full board of directors. The board expects to adopt the
compensation committees recommendations with possible modest modifications
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CHAPTER 210
(Newman and Mozes, 1999). The compensation committee typically surveys market
compensation levels, establishes performance benchmarks and salary policies, and
evaluates managements performance against financial and non-financial goals. These
activities, however, often depend on managements cooperation in providing background
information and advice (Crystal, 1991). Even though the CEO usually is not a member
of the compensation committee, he may sometimes attend its meetings. In companies
that do not have a compensation committee, the full board assumes the role of
determining executive pay. This is especially the case in small boards where all tasks are
fulfilled by the combined board. Some Swiss companies further combine the specific
responsibilities of nomination and compensation in a nomination & compensation
committee. Many compensation committees use external compensation consultants toestablish market conditions. These consultants typically compare the pay levels and
structure of firms in the same industry and of similar size and make recommendations to
the board of directors on how to compensate the CEO and his top management team. In
some companies, the internal audit function regularly reviews the compensation setting
process and submits a report to the board of directors.
2.3 Organization of the compensation committee
The compensation committee typically consists of three to four members of the board of
directors, who are appointed for one year. A majority and sometimes all of its
members are non-executive and independent. This should ensure that the objectivity
required to perform their duties is not impaired. However, it is not uncommon that the
CEO and other executives attend the meeting of the compensation committee without
formal voting power. The head of HR occasionally functions as the secretary to the
compensation committee. Furthermore, internal or external specialists may be invited to
hold presentations if deemed necessary. Meeting minutes are usually made available toall members of the board of directors. Compensation committees meet less frequently
than the full board, typically twice or three times a year, if circumstances do not require
otherwise.
2.4 Elements and allocation of executive pay
Compensation is largely made up of five components: Salary, bonus, option grants, share
grants and benefits. Salary and bonus are usually paid in cash. Bonuses are typically
awarded for achievement of accounting-based performance targets of the prior year and
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THE COMPENSATION SETTING PROCESS 11
are awarded once a year. Benefits include additional cash contributions to companies
pension funds, company cars or other perquisites. Not all companies make use of equity-
based option or shares grants. Similar to bonus payments, option and restricted stock
grants are usually made once a year. Only a small minority of companies has an award-
frequency that is higher than that. The adjustment of the strike price of options, called
repricing, is possible. However, little is known about repricing practice in Switzerland.
Interestingly, a few companies explicitly mention that the board considers the awards
given to the CEO and other top executives in past years when it determines current-year
compensation. While it remains unclear what elements of compensation that would
include, it indicates a certain slack in compensation levels. This suggests that once a
certain level of CEO compensation has been established, for instance after a period of
strong growth or profitability, a later significant downward adjustment seems unlikely.
In Switzerland, employee options of stock-listed companies are taxed at grant. The
taxable income is determined by the fair value of options at the time of grant adjusted for
the vesting period. The fair market value is usually determined by the Black-Scholes
option-pricing formula (Black and Scholes, 1973). For each year that the options are
blocked for exercise, the tax value is reduced by roughly 6%. Taxation at grant means
that employees are taxed for a potential benefit they may never actually be able to cashin.
2.5 The influence of executives on their compensation
Sections on executive compensation in annual reports revealed numerous instances
where CEOs appeared to have direct or indirect influence upon the contracting process
for their own pay. Some companies openly acknowledge in annual reports that CEOs
and other corporate executives such as the head of HR helped structure their own
compensation with the role of board committees potentially limited to ratifying
management proposals. For example, Tamedias 2004 annual report states that the
remuneration of the top management team is determined based on the proposal of the
CEO to the Board of Directors. Similarly, Kaba described the role of its board of
directors by writing in its 2004 annual report, it is the task of the compensation
committee todetermine the compensation policies for the top management team upon
proposal of the delegate to the board of directors and to approve the emoluments of the
top management team... Even when CEOs cannot directly influence their own pay, they
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often propose the pay of their immediate subordinates, which in turn may influence their
own pay, because paying regular members of the top management team more necessarily
reduces the gap between the CEO and the average TMT member. This, in turn, provides
a legitimate reason to increase CEO compensation to ensure internal fairness. For
instance, SIGs 2004 annual report states that the level of compensation for the other
members of the Group Executive Committee is setby the Nomination &
Compensation Committee, based on the proposal of the CEO.
In addition to these acknowledgments of direct management participation in setting the
terms of compensation, many annual reports suggested the presence of conflicts of
interests in the contracting process. As discussed above, a few Swiss stock-listed
companies reported having CEOs or other executives who served as members of their
own compensation committee. Other companies reported that non-executive directors
benefited from personal consulting contracts or from diversion of company business to
their principal employers. In addition to these channels for CEOs to grant favors to the
directors who set their compensation, the process for recruiting and reappointing
members of the board itself had long been understood to be influenced by the CEO in
most companies. A central tenet of this paper is that CEOs exert influence over their
board of directors and compensation committees in these and other ways, and that theyexploit this power to increase the value and lower the riskiness of their compensation.
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RESEARCH REVIEW ON EXECUTIVE PAY 13
3 Research review on executive pay
The number of research papers on executive pay has increased dramatically over the last
few decades. Academics of such diverse fields as accounting (e.g. Antle and Smith,
1986), economics (e.g. Jensen and Murphy, 1990a), finance (e.g. Baker et al., 1988;
Carpenter, 2000), human resources (e.g. Kostiuk, 1990), management (e.g. Barkema and
Gomez-Mejia, 1998), industrial relations (e.g. Agarwal, 1981) and sociology (e.g. Allen,
1981a) have published studies on the determinants and effects of executive
compensation.
Figure 2: Determinants and consequences of executive compensation.
Economic
explanations Performance
Complexity
Risk
Managerial labor market
Investment opportunities
Managerial discretion
Human capital
Market forces
Executives personal
characteristics
Stewardship theory
Executivecompensation
Cash compensation
Equity-based
compensation
Total compensationPolitical
explanations Managerial power
Impression management
Social explanations
Social comparison Isomorphism
Performance
Dividend payments
Stock repurchases
Managerial retention Risk
Mergers, acquisitions and
divestitures
Capital investments
Expectations
management
Earnings management
Litigation
This vast body of literature has generated not only useful insights, but also many
contradictory findings. Any review on executive pay will therefore have to remain
incomplete. Good general reviews are provided by Gomez-Mejia (1994), Finkelstein and
Hambrick (1996), Gomez-Mejia and Wiseman (1997) or Murphy (1999). Core and Guay
(2003) review the literature on equity-based executive pay. Balsam (2002) provides a
good introduction into and overview of executive pay. Figure 2 presents an overview of
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CHAPTER 314
the determinants and consequences of executive compensation level and structure, as
discussed in this and subsequent chapters.
3.1 The relationship between pay and performance
3.1.1 The debate over size versus profits
Prior to 1980, only a handful of studies of executive compensation were published. Most
of these studies focused on whether pay was more closely tied to company size or
company profits. Economists were interested in examining hypotheses derived from the
traditional theory of the firm that top managers operate to maximize profits. It was
contended that executive compensation (i.e. salary and bonus2) would be closely linked
with profitability (e.g. Lewellen and Huntsman, 1970). According to this view,
competition in the managerial labor market (Fama, 1980) and the structure of the
managers compensation contracts unite managerial interests with shareholder interests.
Consequently, managers act to maximize profits and shareholder wealth.
To recognize elements of oligopolistic competition, an alternative managerialist
hypothesis was introduced. Due to the separation of ownership in large firms, managers
seek their own personal goals, such as maximization of perquisites, power and control,
and they achieve these goals by maximizing sales and not profits or shareholder wealth.The managerialist hypothesis therefore stated that compensation would be more closely
related to sales revenues subject to a minimum profit constraint (Baumol, 1959). This
alternative view was also termed sales-maximization hypothesis.
This started the sales versus profit debate. Researchers examined whether changes in
executive pay were more closely related to changes in sales revenues or changes in
profits. For instance, McGuire et al. (1962), Ciscel (1974) and Schmidt and Fowler
(1990) among others concluded that top executive compensation appears to be drivenmore by organization size than performance. At the other extreme, Deckop (1988),
Lewellen and Huntsman (1970) and Masson (1971) accorded firm performance a
stronger role than size. These early studies suffered from severe methodological
problems. For example, collinearity can make a difference in how one interprets
regression coefficients, if both firm size and profits are correlated (Ciscel and Carroll,
2 At that time, the award of equity-based pay was still rare.
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RESEARCH REVIEW ON EXECUTIVE PAY 15
1980). Also the type of firm performance measure used affects the results (Masson,
1971).
3.1.2
Agency theory and optimal contractingSince the late 1970s, agency theory has emerged as the major theoretical approach to
studying executive pay. The original foundation of agency theory, however, goes back to
the early 1930s. At that time, Berle and Means (1932) argued that the owners of a
company usually do not have the power to place important pressure upon management,
since individual ownership interests are very small. They built their arguments on three
propositions: First, economic power is concentrated with a few large corporations in
each industry. Second, stock ownership of these corporations is dispersed. And third,
executives manage companies without owning them.
The relationship between shareholders of a publicly owned corporation and the
corporations executives is a classic example of a principal-agent problem. Jensen and
Meckling (1976: 308) define an agency relationship as a contract under which one or
more persons (the principal(s)) engage another person (the agent) to perform some
service on their behalf, which involves delegating some decision-making authority to the
agent. Agency theory assumes that the agent is a self-interested rational individual and
seeks to pursue personal value maximization, which may not necessarily be aligned with
shareholder value maximization. There is goal incongruence between managers and
shareholders. For instance, building a diversified and large company may reduce the
managers risk of unemployment and increase his compensation (Murphy, 1999).
However, shareholder value may not necessarily be maximized with such a strategy.
Another example of agency cost is the purchase of a corporate jet or a luxury office
building. Both of these actions are unlikely to result in a net increase in shareholder
wealth.A further building block of agency theory is information asymmetry. If shareholders had
complete information regarding the CEOs activities and the firms investment
opportunities, they could design a contract specifying and enforcing the managerial
action to be taken in each state of the world. In most cases, however, shareholders do not
know what actions the CEO can take and they cannot perfectly observe managerial
actions and investment opportunities. Therefore, information asymmetry excludes the
design of a detailed action plan to be implemented by the CEO.
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Agency theorists argue that a compensation contract can be written that alleviates
problems associated with goal incongruence and information asymmetry between
managers and shareholders. The traditional agency-framework defines an optimal or
efficient contract as one that maximizes the net expected economic value to shareholders
after transaction costs (such as contracting costs) and payments to employees (Core et
al., 2003). In this view, the board of directors sets executive pay to minimize agency
costs. Compensation policy will be designed to give the manager incentives to select and
implement actions that increase shareholder wealth. As actions cannot be directly
specified in the compensation contract, the principal will negotiate outcome-based
elements of compensation in the form of bonus payments, stock options and restricted
stock awards (Eisenhardt, 1989). Equity-based compensation is a particularly effectivemeans to solve the agency problem (Haugen and Senbet, 1981), especially as it is hard in
practice to use salary and bonus to reward and penalize CEOs (Hall and Liebman, 1998).
Agency theory further predicts that variable pay and equity holdings are used as
complementary sources of pecuniary incentives, where their relative importance varies
across firms and industries, depending on the relative costs and gains (Lambert and
Larcker, 1987).
3.1.3
The pay-for-performance sensitivityOptimal contracting suggests the alignment of shareholders and managers interests
through the provision of salary revisions, bonus compensation, and equity-based
compensation.3 As a measure of agency costs reduction, the sensitivity between pay and
performance has developed as the most studied phenomenon in executive compensation
research. Pay-performance sensitivity is defined as the dollar change in the CEOs pay or
wealth associated with a dollar change in the wealth of shareholders. The underlying
idea is that the existence of competition in capital markets makes the survival of the firm
depend on the provision of incentive compensation, which encourages the CEO to act in
the shareholders interest. Firms which fail to compensate managers in this way will face
higher costs and thus will not compete successfully with firms whose managers act in the
shareholders interest. Pay performance sensitivity is typically measured by tracking
3 Supporting incentive effects of equity compensation, the announcements of proposed changes inequity-based managerial compensation packages have been met with positive stock market reactions(Brickley et al., 1985; Larcker, 1983).
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RESEARCH REVIEW ON EXECUTIVE PAY 17
current changes of firm financial performance (typically total shareholder return) to
changes in CEO compensation or wealth.
Murphy (1985) and Coughlan and Schmidt (1985) document that changes in executivecash compensation are positively related to current year stock price changes. While the
relation between changes in executive cash pay and changes in shareholder wealth is
statistically significant, the effect is small and explains little of the variance in executive
compensation (Jensen and Zimmerman, 1985). Bentson (1985) establishes the
importance shares and option holdings have in calculating the appropriate pay-
performance sensitivity. He investigates CEO wealth effects of 29 large conglomerates
between 1970 and 1975 and finds that managers tend to gain and lose along with
shareholders, if the changes in value in CEO share- and option holdings are included in
the calculations.
In a seminal article, Jensen and Murphy (1990a) provide estimates for the total wealth-
performance sensitivity for a large sample of US companies between 1974 and 1986.
Jensen and Murphy estimate the value-enhancing magnitude of different compensation
elements such as salary revisions, cash bonus, stock options, stock ownership, and
dismissal decisions. Both cash compensation and total compensation (including stock
option grants and gains from exercising stock options) are positively related to firmperformance. However, the authors argue that the economic significance of these
compensation and wealth changes is low. The CEO receives an additional 1.35 cents of
cash and 3.3 cents of total compensation for each 1,000 USD increase in shareholder
wealth respectively. Their estimates of the total CEO pay-performance relation including
pay, options, stockholdings and dismissal indicates that CEO wealth changes 3.25 USD
for every 1,000 USD change in shareholder wealth. The results further demonstrate that
the incentives generated by stock ownership are large relative to direct pay incentives.
Showing a decline in real executive compensation since the 1930s and a decreased
sensitivity in the pay-performance relation since then, Jensen and Murphy (1990a) use
their findings to challenge the principal-agent paradigm. They conclude that these values
are too low, and that boards of directors should seek to increase equity-based
compensation and CEO shareholdings. In a related article, Jensen and Murphy (1990b)
argue that, from a shareholder perspective, the level of compensation is of secondary
importance to the appropriate mix of compensation. Compensation would be too low to
attract the highly-talented individuals necessary to run big companies: The very best
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lawyers or investment bankers can earn substantially more than the very best corporate
executives. Highly talented people who would succeed in any field are likely to shun the
corporate sector, where pay and performance are weakly related, in favor of
organizations where pay is more strongly related to performance and the prospect of
big financial rewards more favorable (Jensen and Murphy, 1990b: 149). They further
write that the resulting general absence of management incentives in public
corporations presents a challenge for social scientists and compensation practitioners
(Jensen and Murphy, 1990a: 262). By proposing incentive compensation, these
contributions greatly influence companies adopting equity-based compensation plans,
which consequently increased total executive pay.4
In the academic field, the contribution of Jensen and Murphy has spurred a vast amount
of literature investigating the size of the pay-performance sensitivity. Lippert and More
(1994) confirm Jensen and Murphys (1990a) results for a sample of 310 US firms
between 1974 and 1988. Their total pay-performance sensitivity is 0.0035 or 3.5 USD
CEO pay-change per 1,000 USD change in shareholder wealth. Haubrich (1994) studies
whether principal-agent and optimal contracting theory is indeed inconsistent with the
low value of pay-performance sensitivity reported by Jensen and Murphy (1990a) by
calculating numerical solutions to agency models developed by Grossman and Hart(1983) and Holmstrom and Milgrom (1987). He concludes using reasonable
assumptions about executive risk aversion, CEO effort and other variables, principal-
agent theory can yield quantitative solutions in line with the empirical results of Jensen
and Murphy (Haubrich, 1994: 259). Hall and Liebman (1998) study 478 US large
companies between 1980 and 1994. Investigating changes in total CEO wealth
including holdings of stock and stock options they argue that there is a strong link
between the fortunes of CEOs and the fortunes of the companies they manage (Hall and
Liebman, 1998: 654). As changes in firm market value are often extremely large in
absolute terms, even relatively low wealth-performance sensitivities may lead to very
large dollar rewards and punishments for CEOs. Applying the Jensen/Murphy (1990a)
statistic of CEO wealth changes, they estimate a change of 6.00 USD for every 1,000
USD change in firm value for 1994. Adjusting for increasing firm size over the
4 A further reason for the explosion of option grants is the 1994 reform that limited tax deductibility ofexecutive cash pay to 1 MUSD. Options turned into an alternative form of tax-favored compensation.
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RESEARCH REVIEW ON EXECUTIVE PAY 19
investigation period and the corresponding natural tendency for the Jensen/Murphy
statistic to fall over time, they find that sensitivities increased fourfold between 1980 and
1994 to 12 USD. The inclusion of stock and stock option revaluations in addition to
changes in direct pay increases compensation sensitivities by a factor of about 30
compared with direct pay-performance sensitivity. Murphy (1999) tests both cash pay-
performance sensitivity and elasticity for a sample of 500 US firms between 1990 and
1996 and reports an average sensitivity of 14 USD and elasticity of 0.263.
In the UK, pay-performance sensitivities are lower than in the US. Conyon and Murphy
(2000) report an average pay-performance sensitivity of 2.33 GBP per 1,000 GBP in the
largest 510 UK companies. Buck et al. (2003) report a sensitivity of 1.55 GBP of CEO
rewards per 1,000 GBP increase in shareholder value.
Very few studies on the pay-performance relationship exist outside the US and the UK.
For a sample of 48 German firms between 1968 and 1994, Conyon and Schwalbach
(2000) find a cash pay-performance elasticity of 0.071. Their pay measure is per capita
income of the top management team. Brunello et al. (2001) use survey data from 106
Italian companies and find a significant pay-performance sensitivity for upper- and
middle-level managers. However, their estimate is considerably lower than the ones
based on US data. In addition to cross-national differences, the lower sensitivity may bea result of including middle-level managers. The authors further report that the pay-
performance sensitivity is higher in foreign-owned firms, in listed firms, and in firms
affiliated with a multinational group. Table 1 summarizes a selection of studies
estimating cross-sectional differences in the pay-performance relation.
These studies of the pay-performance link suffer from two major methodological
weaknesses. First, there is no ex ante certainty on the time-lag of the pay-performance
relationship. The arbitrary research design of regressing current-year changes inexecutive pay on current year shareholder wealth need not necessarily be the appropriate
agency-theoretic proposition. Boschen and Smith (1995) show that CEO compensation
responds to changes in firm performance over the next 4-5 years, with the cumulative
response of pay to performanceroughly 10 times that of the contemporaneous
response (p. 577). Second, relying on shareholder return or accounting performance
measures provides an incomplete picture of how the board of directors evaluates CEO
performance. Hayes and Schaefer (2000) investigate the proposition that employment
contracts may be based on performance measures that are observable only to the parties
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of the contract (but not to the researcher). They show that unexplained variation in
current compensation is positively related to future performance and that this
relationship is stronger when there is more noise in the firms market and accounting
returns. These results suggest that compensation is informative regarding future
performance and that the board of directors takes into account subjective performance
measures when setting executive pay. Together, both articles demonstrate that examining
the contemporaneous relationship between pay and observable financial performance
underestimates the strength of the pay-performance relationship. In short, the total pay-
performance relationship may be high enough to elicit suitable incentives for executives,
especially when variations in equity holdings are considered.
Table 1: Empirical studies on the pay-performance relation.
STUDYSAMPLE(FIRMS)
COUNTRY TIME PERIODCOMPENSATION
VARIABLESP-PSENSITIVITY/
ELASTICITYA
Murphy (1985) 73 US 1964-1981 CEO totalcompensation
= 0.12
Coughlan andSchmidt (1985)
149 US 1977-1980CEO cash
compensation= 0.14
Jensen and Murphy(1990a)
430 US 1974-1986CEO total
compensation= 0.0033
Lippert and More
(1994) 310 US 1974-1988
CEO total
compensation = 0.0035
Hall and Liebman(1998)
478 US 1980-1994CEO total
compensation= 0.0060
Murphy (1999) 500 US 1990-1996CEO cash
compensation= 0.0138
= 0.263
Conyon andSchwalbach (2000)
102
48
UK
Germany
1969-1995
1968-1994
HPD* cashcompensation
TMT cashcompensation
= 0.067
= 0.071
Brunello et al(2001)
106 Italy 1993-1996Managerial cashcompensation
= 0.00024
Buck et al. (2003) 287 UK 1996-1997CEO total
compensation= 0.0016
AMeasuring pay and performance in absolute values leads to interpreting the regression coefficients as
sensitivities, while measuring pay in logarithms and performance in rates of return leads to interpreting the
regression coefficients as elasticities. An advantage of the elasticity approach is that it is relatively invariant to
firm size (Gibbons and Murphy, 1992). The primary advantage of the sensitivity approach is that sensitivities
have a more natural economic interpretation. The pay-performance sensitivity represents the executives share of
value creation. This sharing rate seems a natural m