The Relationship between Executive Remuneration and Corporate Performance - Literature review Example

? The relationship between executive remuneration and corporate performance Table of Contents Introduction 3 Executive Compensation and Firm performance 3 Reference List 8 Introduction Traditional theories of a firm revolve around the concept that entrepreneurs are the owners or the managers of the firm. However, the modern day corporations are characterised by the separation of management and ownership. The decision making power and the control of the firm remains with the management, whereas the stockholders are expected to be benefitted by the decision taken by the managers. At a normative level, the managers are expected to align their personal goals with that of the shareholders and aim toward maximising their values (Chaubey and Kulkarni, 1988). Many of the studies have identified that managerial compensation is linked with the firm’s performance, which is a critical factor in the maximization of shareholders value. The managerial compensation includes base salary, deferred compensation, perquisites and cash bonus. This paper deals with the literature review related to the relationship between compensation of the executives and the performance of the firm. Executive Compensation and Firm performance The advent of the “new economy” industries is a recent phenomenon and not much literature is available which concerns the relationship between performance and pay. Anderson, Banker and Ravindran (2000) have used simultaneous equation model for estimating the performance of the firm and compensation of the executives in the information technology industry and has found evidences that suggest that the share of both pay and bonus increases with the performance. Along with this, the study also suggested that the extent of incentive pay and the level of pay are responsible for positively affecting the performance of the firm. Ittner, Lambert and Larcker (2003) have conducted study based on the data of proprietary sample of firms between 1998 and 1999, which has proved that determinants of equity grants differs in case of old and new economy firms. The study of Ittner, Lambert and Larcker (2003) is complemented by the study of Murphy (2003), who had analyzed the data for much longer period of time starting from 1992 to 2001 and had recorded the effect of the market crash, in 2000, on stock based pay in the firms of “new economy”. The performance of the firm and its size serves as determinants of the pay, which has been suggested by a standard empirical model based on CEO compensation. The firm size is the component that measures the managerial discretion. The compatibility of managerial incentive is indicated by the performance of the firm. The literature related to the compensation of the CEO lacks consensus with respect to the appropriate functional specification. The research scholars like, Coughlan and Schmidt (1985), Hall and Liebman (1998), and Gibbons and Murphy (1992), prefer elasticity specification where the change in or level of the log of executive compensation is linked to the change in or level of log of the firm performance. A different approach has been taken by Jensen and Murphy (1990). They had used sensitivity approach that had linked the change in the compensation level with the change in the performance of the firm. These specifications imply that the relationship between the firm’s performance and the compensation of the employees is contemporaneous only. This signifies that one-time increase in the performance leads to an increase in the compensation of the executives within that period of time. These specifications help to remove the fixed effects related to the firm. In other words, it omits the consistent effect of the time invariant factors such as, the diverse personal characteristics of the CEO, which otherwise might have diverted the estimation of the pay related to performance relationship. A wide spread interest and media attention had thrown light on the pay packages of CEOs in United Kingdom (UK). Eruption of public indignation was seen for the first time in 1995 owing to the news of about 75 percent rise in the salary of Cedric Brown, who was the chief executive of British Gas. The second eruption took place in 1999 due to a compensation package of ?10 million which was awarded to the CEO of Vodafone, Chris Gent, as the firm had successfully taken over Mannesmann, a German mobile phone group. This has initiated several studies by the research scholars on the compensation of the CEOs of organizations based in UK. Girma, Thompson and Wright (2007), have investigated the effect of Cadbury reforms on the compensation packages of the CEOs of various companies in UK. The results of this investigation had suggested that the relationship between the pay and the performance was seen to be weak for the sample of firms that they had picked up for examining during the period of 1981-1996. Gregg, Jewell and Tonks (2005) had complemented the findings of Girma, Thompson and Wright (2007) by suggesting that even their research had found a weak link between the performance of the firm and the CEO pay. The weak statistical results can be due to the fact that the researchers might have heavily relied on the total cash pay, which is the sum of the annual bonuses and the salary in order to measure the compensation of the executives. They have excluded the equity based components of the compensation like, stock awards and stock options. This shortcoming was addressed by the research initiated by Ozkan (2006) where the researcher had included both equity based components and the cash within the compensation of the CEO. The analysis of the research scholar had suggested that there was no significant relationship between CEO performance and performance of the firm in case of a larger sample of companies in UK for the fiscal year 2003-04. The interpretations of these researches propose that the study to establish relationship between CEO compensation and firm’s performance is mixed and hard to interpret. Another study was initiated by Ozkan (2007) and even there, she had included both the cash and equity component while studying the compensation of CEOs for a panel of large firms in UK. In this study, the scholar has used GMM-system estimation method, which establishes a control over the endogeneity of exploratory variables and presence of unobserved firm-specific effects. The empirical results of the research indicate that there exists a significant positive relationship between the level of cash compensation for the CEO and performance of the firm. However, the relationship is positive and insignificant when the total compensation is considered. Gregg, Jewell and Tonks (2011), have examined the relationship between the cash compensation of the executives and the performance of the companies on a large sample of companies based in UK. Their study was strictly restricted to financial services industry, since misalignment of the incentives was considered to be one of the major reasons for the global financial crisis in the year 2007-08. The study suggested that even though the payment in the financial services sector is high, yet the cash pay-performance sensitivity of the banks and other financial firms are not high enough in comparison to the other sectors. The low sensitivity in pay to performance makes it less likely for the incentive structure to be held responsible for causing the bank executives to incline more towards the short-term profits. This study has found that the companies, who have relatively high stock return and high pay-performance elasticity, are seen to exhibit an asymmetric relationship between performance and pay. However, when the stock return is low, the pay of the executives is less sensitive to performance. Heimes and Seemann (2012) had initiated their study on compensation of the executives in firms which are based in Germany and United States (US). These research scholars through their study had analysed the impact of accounting based measures related to the performance of the firm and the performance of the stock market according to the different components of compensation. They found that the total compensation of the executives is dependent on the earnings of the firm in case of both the samples, but stock market performance is not. In case of German executives, the cash bonus payment is explained by the earnings of the firm and not by the stock returns. On the other hand, in case of US, the bonuses are explained by the stock return. Moreover, the study had also suggested that the impact of the cash bonuses on the performance is also dependent on the firm size and risks borne by the firm. Finally, they have concluded that the pay-performance sensitivity is higher is case of US firms as compared to the Germans. Another study conducted by Kaplan (2012) had suggested that the compensation of the CEO has increased substantially through 1990s, but they have declined since then. When the ratio of CEO pay of large companies to the market value of the firm in late 1970s is compared to that of the late 1960s, unlike the level of the former, the level of the later was seen to be lower. This pattern had implied that scale and technology have also played a significant role in driving the pay of the CEO and others. However, the CEOs are awarded for their good performance and penalised for their failures. The board of the company monitors the performance of the CEO. The researcher has also found that the pay policies of the top executives, in about 98 percent of Russell 3000 companies and S&P 500 companies, has received much support from majority of the shareholders. Reference List Anderson, M., Banker, R. and Ravindran, S., 2000. Executive compensation in the information technology industry. Management Science, 46(4), pp. 530-47. Chaubey, M.D. and Kulkarni, M.S., 1988. Executive compensation and performance of Firms. Managerial Finance, 14(4), pp. 14-18. Coughlan, A.T. and Schmidt, R.M., 1985. Executive compensation, management turnover, and firm performance. Journal of Accounting and Economics, 7(1-3), pp. 43-66. Gibbons, R. and Murphy, K.J., 1992. Optimal incentive contracts in the presence of career concerns: Theory and evidence. Journal of Political Economy, 100(3), pp. 468-505. Girma, S., Thompson, S. and Wright, P., 2007. Corporate governance reforms and executive compensation. Manchester: The Manchester School. Gregg, P., Jewell, S., and Tonks, I., 2005. Executive Pay and Performance in the UK 1994 – 2002. Working paper. Devon: XFi Centre for Finance and Investment. Gregg, P., Jewell, S., and Tonks, I., 2011. Executive Pay and Performance: Did Bankers’ Bonuses Cause the Crisis? [online] Available at < http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1815210> [Accessed 20 November 2013]. Hall, B. and Liebman, J., 1998. Are CEOs really paid like bureaucrats? Quarterly Journal of Economics, 113(3), pp. 653-91. Heimes, M. and Seemann, S., 2012. Which Pay for what Performance? Evidence from Executive Compensation in Germany and the United States [online] Available at < http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2084705> [Accessed 20 November 2013]. Ittner, C.D., Lambert, R.A. and Larcker, D.F., 2003. The structure and performance consequences of equity grants to employees of new economy firms. Journal of Accounting and Economics, 34(1-2-3), pp. 89-127. Jensen, M.C. and Murphy, K.J., 1990. Performance pay and top-management incentives. Journal of Political Economy, 98(2), pp. 225-64. Kaplan, S.N., 2012. Executive Compensation and Corporate Governance in the U.S.: Perceptions, Facts and Challenges [online] Available at < http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2134208> [Accessed 20 November 2013]. Murphy, K.J., 2003. Stock-based pay in new economy firms. Journal of Accounting and Economics, 34(1-2-3), pp. 129-47. Ozkan, N., 2006. Do corporate governance mechanisms influence CEO compensation? An empirical investigation of UK companies. Journal of Multinational Financial Management. Ozkan, N., 2007. CEO Compensation and Firm Performance: An Empirical Investigation of UK Panel Data [online] Available at < http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1102703> [Accessed 20 November 2013]. Read More