CEOs Compensation as an Agency Problem - Literature review Example

Name Class Unit Abstract This literature review has been based on the intense debate surrounding the topic on what constitutes the optimal pay for the CEOs. The main aim of this literature review is to analyse literature on the optimal compensation for CEO based on current literature. This helps in filing the gap that exists on executive pay debate. The analysis of literature shows that it is possible to address agency problem through optimal pay for the CEOs. Through this, the management can work in maximising shareholders value. The literature shows that use of poor compensation model leads to an agency problem. Through analysing a proposed model, ways of avoiding overcompensating or under compensating the CEOs are identified. This is a model that makes CEOs to earn rents which are higher than the outside options. The pay should be justifiable and not promote inequality. Optimal and fair pay is attained when CEO is paid based performance with minimal monitoring as supported the by literature. Future research should focus on unanswered areas and the managerial power giving it more attention as given to optimal contracting model. Also there a need to focus on how appropriate compensation can be attained in a processes which is not corrupted. The literature review is very important to investors and financial analysts. This is due to fact that it shows how to come up with a fair compensation which maximises shareholders value through enhanced firm performance. It shows how to reward the top talent in executive and have a meaningful performance-based pay for the executives. Table of Contents Abstract 2 Introduction 3 CEOs compensation as an agency problem 5 Framework for compensation 5 Optimal Compensation Model 7 Justice and CEO compensation 9 Fair compensation 9 Conclusion 11 References 13 Introduction The issue of chief executive officer (CEO) compensation has been attracting a lot of attention from the financial economists (Mengistae and Xu, 2004). The main aim of this literature review is analyse literature on the optimal compensation for CEO based on executive pay debate. Most of the research in executive compensation has been focused on alleviating the agency problem in public companies through the compensation scheme (Bebchuk and Fried. 2003). The contention on the executive pay has risen especially due to recessions. The executive pay is made up of sum of the base pay, stock options and stock grants among other types of compensation and benefits. The executive pay has been on rise over the last decades where it has been argued that greedy executives have taken advantage of the pay system to reward them. Research has found out that CEO pay is high when the firm is performing well but does not go down when the firm has a negative performance (Brick, Palmon and Wald. 2006). The main problem that exists in this case is lack of an optimal compensation model. Compensation is one of the vital and flawed elements that make the firm to be exposed to huge risks on their balance sheets. Dyl (1988) asserts that when the compensation is high than the value being delivered, it is no longer a pay but a gift. The escalation of executive pay in relation to other production workers has made the researchers to take sides. This is with some of the researchers claiming that the pay is economically justified while others claim that the increase is as a result of the managerial influence on the executive pay determination. This raises the question on the basic framework which is used in viewing the executive pay. Another issue under the research is what just compensation for the executive is. This involves determining the guiding justice ideas in the CEO pay (Brick, Palmon and Wald. 2006). This is a situation where the high earning workers are few and concentrated at the top. A properly designed executive pay package has the ability to attract and retain a good CEO as well as senior management (Core, Holthausen, and Larcker. 1999). The issue identified in CEO compensation are highly related to the firm financial performance. CEOs that are not adequately compensated may lack motivation to ensure the firm has best financial performance to maximise shareholders value. Literature on executive pay and its relationship to financial performance is a major issue among the corporate leaders, managers, investors and industry regulators. This is due to fact that it affects the firm performance and the group is impacted (Mengistae and Xu, 2004). The literature review will start by discussing the analysing literature in executive compensation as an agency problem. The report will then look how executive compensation is set and framework that can help in setting the compensation. The optimal compensation model will be outlined and analysed critically. Literature on what constitutes a just compensation for CEO will be then analysed. Finally, the literature review will focus on what constitutes a fair executive compensation. CEOs compensation as an agency problem Framework for compensation The article by Bebchuk and Fried (2003) looks at the managerial compensation as an agency problem. This involves analysing managerial power and optimal contracting which both plays a vital role in executive compensation. Literature have shown that executive compensation have a link to the agency problem (Dyl, 1988). This is where the executive problem is looked as an instrument that can address the agency problem and also as part of the agency problem. It is clear that some forms of compensation arrangement are seen to reflect rent seeking by the management instead of efficient incentives. This is where the managerial influence in designing the compensation arrangement plays a major role. According to Dyl (1988), it is important to note that the managerial influence on their pay is a major problem and can lead to substantial costs to the shareholders. It is advisable that the compensation arrangement to be based on the market forces which are aimed at maximising the output (Bebchuk and Fried. 2003). Based on the optimal contracting, it is stated that the managers suffers from the agency problem and in cannot seek to maximise the shareholders’ value automatically (Bebchuk and Fried. 2003). This leads to the suggestion by the article that it is vital to give the managers adequate incentives. But it is important to make the incentives being given to managers cost effective (Dyl, 1988). The argument is that the fact that one cannot expect the managers to managers to automatically maximise shareholders value, one should also not expect the directors to do so. This is due to the fact that the directors’ behaviours are also prone to agency problem. According to Mengistae and Xu, (2004), this makes it hard for them to fully address the agency problems. Based on their attractive salary, the directors have a high incentive to favour the executive (Bebchuk and Fried. 2003). It is agreeable with the article that the market forces may not be powerful enough to ensure that there are optimal contracting outcomes. The research shows that managerial power has a great impact on the design of the executive salary (Brick, Palmon and Wald, 2006). This is well supported by theoretical and empirical reasons. This is in the companies that have separation of ownership and control. According to Bebchuk and Fried (2003), this is also an instrument that can be used in gaining knowledge on how the agency problem can be solved. One can agree with the author that managerial power and rent extraction have a great role in determining the executive compensation and also implications on governance (Dyl, 1988). Despite this, it is vital to ensure that the widespread recognition of this problem does not lead to its elevation. There is adequate research showing that the managerial influence has the ability to move the executive compensation arrangement away from the optimal contracting. This is agreeably dependent on the manner in which the problems arising from the managerial power are recognised by the market participants and investors (Bebchuk and Fried. 2003). The financial economists are capable of making analysis of the current practices and how they violate optimal contracting. Optimal Compensation Model It is important to note that the issue of executive pay becomes more contentious during the financial crisis (Edmans, Gabaix and Landier, 2009). This is especially due to the rise of executive compensation over the last decade. It is evident that selfish managers have used the pay-setting process for their own good. It is important to analyse whether the executive is paid based on their input. It is possible that the executive is pay is based on the performance which has been contributed by the entire sector and in some cases not even related to their input (Mengistae and Xu, 2004). Also, it is important to ask ourselves whether the executive pay is made low when the firm underperforms. All these are issues which occurs since there is poor model which can ensure optimal compensation. This model can serve a great purpose in firms where the principals are unable to see the firm business opportunities and cannot fully control the agents. The shareholders may in this case depend on the cash flow which is based on the managerial choices in order to come up with appropriate compensation based on these cash flows. As stated earlier, the cash flow may be unrelated to managerial decisions hence making it hard to come up with fair compensation. Despite this as claimed by Mengistae and Xu (2004), it is possible for the value maximising shareholders to come up with optimal contracts for the executive. Even when the CEO lacks bargaining power, the shareholders has the ability to come up with optimal contracts (Brick, Palmon and Wald. 2006). There are cases where the CEO compensation is high even in instances where the form stock price is falling. The model proposed by Edmans, Gabaix and Landier (2009) comes up with an optimal compensation. It allows the CEOs to earn rents which are higher than the outside options. In this case, the CEO is rewarded even in cases where the firm stock falls. This is a compensation model that can reward the CEO even in cases where the stock price has fallen (Edmans, Gabaix and Landier, 2009). Based on the article and other research, it is evident that CEO compensation should be given in such a way that the manager does not make choices which can destroy the firm value. It is advisable to come up with a compensation model where the manager is paid more than the outside option. This should be based on the manager marketable skills. The model is an effective way to ensure that the compensation for the executive does not harm the shareholders’ value and the executive is motivated (Mengistae and Xu, 2004). This is a compensation that is related to the firm performance and is based on an optimal contract. The model has a major weakness since it does not adequately reduce the executive pay when the firm underperforms. This may lead to instances where financial inequality is enhanced in a firm especially during financial crisis. The argument that underpaid CEO may take outside project which may harm shareholders value is not also well founded (Brick, Palmon and Wald. 2006). Despite this, taking Tim Cook as an example may justify the model. This is where Tim Cook was offered million shares of apple stock when he joined as CEO (Frydman and Jenter, 2010). The fact that he had equity at Apple may have made him to act in the best interest of the shareholders. Justice and CEO compensation When the executive salary is not well set, there is a problem of the wealth being concentrated at the top (Core, Holthausen, and Larcker. 1999). This where wealth and inequality leads to justice concerns. If injustice in pay is evidenced, there can be negative consequences in the society. In the society, the pay for the CEO is seen as high and unjustifiable in most cases (Edmans, Gabaix and Landier, 2009). It is common place for the CEOs to negotiate large compensations and using fraud and criminal means to misrepresent the organisation performance (Core, Holthausen, and Larcker. 1999). All this is done based on personal gain. It is important to note that justice does not always point on over rewarding for the executives. There have been cases where some of the CEOs are underpaid in the industry. For the CEOs compensation to be considered just, it should account for firm characteristics, size, CEO location, age, schooling and experience among others. A study done by (Edmans, Gabaix and Landier, 2009) utilises Rossi’s factorial survey method to make justice judgement on the executive pay. It is important to ensure that justice is followed when coming up with the CEO pay structure (Frydman & Jenter, 2010). From the justice viewpoint, compensation must be justified and should not enhance inequality. Fair compensation The executive pay is based on the principal agent model. This is where the firm is expected to come up with the most efficient compensation for the CEO with the aim of maintaining, retain and motivate them (Harris, 2009). It is evident from the literature that when the executive is well compensated, they are able to perform to thee best of the shareholders. This is due to fact that there exists a link between the firm financial performance and the executive pay. A fair compensation for the executive ensures that they are able to work for the shareholders’ interests. It is important in this case to note that when a misalignment exists between the shareholders and managers, agency problems can occur (Wade, O'Reilly and Pollock, 2006). This includes instances where the executive engages in actions which act for their own benefit instead of the shareholders. The right CEO compensation helps in solving the agency problem (Core, Holthausen, and Larcker. 1999). This is where the right design for the compensation comes into play. The use of effective compensation has the ability to maximise the shareholders wealth. It is recommendable that the CEOs pay is based on two polar positions (Wade, O'Reilly and Pollock, 2006). One of the positions is where the management is compensated on the basis of stock price changes. In this case, there are low agency costs hence benefiting the firm financially. The main problem with this approach is the fact that it will be difficult to get a talented manager under these conditions. This is because they will have their earnings affected by the economic conditions which the management cannot control (Core, Holthausen, and Larcker. 1999). Also, the stockholders can be used to monitor the management moves. This would be highly costly and ineffective. To come up with the optimal solution, the executive compensation should be based on their performance with minimal monitoring (Harris, 2009). This is a compensation method that does not inhibit the ability of the firm to attract talented executives. It is vital to note that equity-based pay for the executives is associated with economic value added performance in a positive way. The available research has in a great way supported the CEO pay and firm performance (Edmans, Gabaix and Landier, 2009). Despite the calls to lower the salary for the overpaid CEOs, no firm wants to have their CEOs pay lagging behind in the market. When CEOs are overpaid, they may become overconfident and start engaging in capital expenditure that is wasteful as well as empire building (Moriarty, 2005). For a firm that wants good future returns, it is important to avoid overpaying the CEOs. This is through giving optimal incentives to ensure managerial incentives are well aligned with maximisation of shareholders’ value (Core, Holthausen, and Larcker. 1999). Conclusion To sum up, the literature review has been able to critically look at the issue of CEO compensation and address the gap that exists in the debate. The review has looked at a framework which can be used in setting the executive compensation to ensure that it delivers value to shareholders. The model is applicable especially in the organisations where the principals cannot see the business opportunities and lacks control for the agents. The model analysed has the capability to give optimal compensation. This is where the CEO is able to earn rents which are higher than the alternative outside options. Through the proposed model, it is possible to come up with a compensation based on CEOs marketable skills. This model is supported by Apple CEO Tim Cook’s compensation package. When he joined Apple as the CEO, he was offered million shares of stock. The review has also looked at the issue of CEO compensation based the on lens of justice. There is a problem of the wealth being concentrated at the top if the CEO compensation is not well set. In this case, wealth and inequality leads to justice concerns in an organisation. Injustice is based on what people see as just and what is around them. When setting the executive pay, justice should be considered. For the CEOs compensation to be considered just, it should account for firm characteristics, size of the organisation, CEO location, age, schooling and experience among others. This is where the compensation package is set in relation to the organisation financial performance. The compensation package should be justified and not enhance the inequality that exists in a firm. When the salary is not fairly set, it may lead to discontent and hence affecting the firm performance. A fair CEO compensation should be able to maintaining, retain and motivate them the executive. When a misalignment exists between the shareholders and managers, agency problems can occur. It is recommendable that the CEOs pay is based on two polar positions. One of the positions is where the management is compensated on the basis of stock price changes. The other position is the optimal solution, where the executive compensation is based on their performance with minimal monitoring. The first position is highly costly and ineffective. CEOs should not be overpaid to avoid them becoming overconfident and start engaging in capital expenditure that is wasteful as well as empire building. The CEO should be given optimal incentives to ensure managerial incentives are well aligned with maximisation of shareholders value. Despite the research on executive compensation growing tremendously, several areas remain unanswered. This includes the importance of rent extraction and use of optimal contracting in determining CEOs pay and the impact of CEOs pay on firm behaviour. Future research should focus more on unanswered areas and the managerial power giving it more attention as given to optimal contracting model. Future research also needs to look at ways in which appropriate compensation can be attained in a processes which is not corrupted References Bebchuk, L. A., and Fried, J.M., (2003), Executive compensation as an Agency Problem. Working Paper. Brick, I. E., O. Palmon, and Wald, J.K. (2006) CEO compensation, director compensation, and firm performance: Evidence of cronyism? Journal of Corporate Finance 12(3): 403-423. Core, J. E., Holthausen, R.W. and Larcker, D.F., (1999), Corporate governance, chief executive officer compensation, and firm performance, Journal of Financial Economics 51: 371- 406. Dyl, E.A., (1988), Corporate control and management compensation: Evidence on the agency problem’, Managerial and Decision Economics, 9(1), 21-25. Edmans, A., Gabaix, X. and Landier, A., (2009), A multiplicative model of optimal CEO incentives in market equilibrium, Review of Financial Studies, 22(12), 4881-4917. Frydman, C., and Jenter, D. (2010), CEO compensation (No. w16585), National Bureau of Economic Research. Harris, J.D., (2009), What’s wrong with executive compensation? Journal of Business Ethics, 85(1), 147-156. Mengistae, T., and Xu. L.C., (2004), Agency Theory and Executive compensation: the case of Chinese State-Owned Enterprises, Journal of Labor Economics, 22 (3), 29-63. Moriarty, J., (2005), Do CEOs get paid too much? Business Ethics Quarterly, 15(02), 257- 281. Wade, J.B., O'Reilly III, C.A. and Pollock, T.G., (2006), Overpaid CEOs and underpaid managers: Fairness and executive compensation, Organization Science, 17(5) 527-544. Read More