Determining Executive Pay - Term Paper Example

Determining Executive Pay College Executive pay is a significant issue in current ongoing debate on corporate governance. Debate is still ongoing on how the various executive pay structures and levels can be explained and understood. This paper will provide an overview of the various theories and literature that have been used in trying to explain this phenomenon in the corporate scene. There are basically three types of approaches to this;- The agency approach The value approach The symbolic approach A keen examination of the various theories show that the use in the various literatures of the perfect contracting approach theory tends to neglect: the socially determined value that this pay should reflect as well as the prevailing contextual conditions in which this pay is set. A more effective approach in understanding this pay should be based on considering it as an outcome of socially developed arrangements of corporate governance whereby the parties involved possess relative discretion to affect the outcomes. Including such a view in an attempt to understand executive pay tends to provide a much more conclusive explanation of the ongoing debate about executive pay both in practice and in theory (Hengartner, 2006). Introduction The issue of executive pay is one of the aspects of business that has been generating newspaper headlines quite often in the recent past. The media tends to regularly display the public outrage on the extreme highs that executive bonuses, financial gratuities and salaries have reached. In the middle of all this turmoil, many company directors have found it difficult to explain why and how much they pay their various executives as they do. The field of determining and explaining executive pay is dominated by the agency theory’s perfect contracting approach (Jensen & Meckling, 1976). This theory on executive pay explains that this is a key instrument used in alleviating agency problems. In order to ensure the separation between firm control and firm ownership is harmless, the theory states that executive pay is a key instrument used in aligning the interests between management and shareholders (Fried and Bebchuk, 2004). Pay setting is often seen as an issue of optimal pay design that is based on risk preferences and market forces. (Wiseman and Gomez-Mejia, 1997) Market forces contribute to optimal pay structures and levels that compensate the concerned executives for the various risks they took in managing the corporation in the shareholders’ best interests. This is the reason that most of the literature and studies conducted on executive pay structures tends to focus on the relationships between firm performance and executive pay. The results of these often tend to range from negative, positive and to even no significant relationship at all. The overall literature consensus is that the performance-pay relationship is often not very strong. These results tend to weaken the common case for the frequent use of the perfect contracting approach for two main reasons. First of all, this theory can only provide a weak explanation of the prevailing pay arrangements in practice. The theory’s applicability is somehow limited in the sense that pay incentive usually leads to various other positive outcomes both in practice and/or theory. Secondly, the parties that are involved in the process of setting the pay may in practice decide not to follow the agency theory’s principles or may actually not be able to follow these principles. Theoretical approaches The main theories that are addressed here are divided into three main approaches. This classification is based on the role that remuneration plays in each theory as well as on the underlying discussions on pay in each theory. These three approaches are as follows;- The value approach This tends to focus on mostly how much should executives be paid. Pay in this case is set by market forces hence it is legitimized The agency approach This tends to consider pay as mainly an agency problems’ consequence and mainly focuses on the issue of how much should executives be paid. The pay levels are arrived at due to market forces as well as the risks that the executives expose themselves to The symbolic approach this actually considers pay as being a reflection of status, achievements, dignity or expectations and normally plays a much more secondary role in the motivation of executives ( Balsam, 2002). The Value Approach This approach mainly consists of five different theories which are; the efficiency wage theory, the marginal productivity theory, the human capital theory, and the opportunity cost theory as well as the super star theory. Of all these theories, the marginal productivity theory is normally considered as the most fundamental theory. The executives’ input i.e. the service which they provide for to provide for the company is usually treated as just any other factors of production. This means that the value of this is equated to the intersection of demand and supply on the executives’ labor market. This equilibrium dictates that pay is equal to the marginal revenue production of the executives. Marginal revenue productivity is defined as the firm’s observed performance without factoring in the firm’s production with the next better executive alternative at the company’s helm minus the cost of acquiring this executive’s services (Durai, 2010). Executive pay can be easily explained as the end result of the value of the marginal revenue productivity of the executive. This is equated to the intersection of demand and supply on the executives’ market. The human capital theory argues that the productivity of an executive is usually influenced by his accumulated skills and knowledge which is referred to as his human capital. The level of the human capital is determined by the amount of skills and knowledge that executive possesses. An executive is paid more due to having a higher level of skills and knowledge because his human capital will be more. The executives’ market usually determines the value of his human capital. The efficiency wage theory tends to argue that executives will usually put in an extra effort in the event that they are promised a wage that sits above the prevailing market level. This is because they will be less likely to leave the company or to be under motivated to perform since they feel that their skills are valued by the company. They have an added incentive to put in an extra effort thus reducing turnover of executives and raises productivity levels (Brink, 2011). The opportunity cost approach tends to argue that the transparency of available job openings in the executive job market tends to make it possible for them to easily switch their employers. The perspective of opportunity cost argues that in order to retain or hire a qualified executive, the salary level has to be at least equal to the level that would have been paid to his the next best available alternative. The superstar theory does not address the implications of this theory regarding to the prevailing skewness that is seen in the income distribution. The seen skewness in the distribution of executive pay could be explained by the available disproportionate premium levels that companies are often willing to for executives’ capabilities or talents for which there are not available any other suitable substitutes (Brink, 2011). The Agency Approach This approach tends to focus on how to pay executives rather than how much to pay them. The salary levels are assumed to be mainly based on the market value of these executives’ services. Pay is usually viewed as a consequence of agency problems and these theories usually address the issue of how to pay these executives. Agency problems normally exist in every situation whereby one party gives the responsibility of tasks to another third party. In this particular agency approach, a clear distinction can be drawn between two different groups. The first group is made up of theories that consider remuneration of executives as sort of partial solution in overcoming agency problems via risk transference as well as alignment of incentives. The second group is made up of theories that tend to consider pay as an end result of the discretionary powers of executives that result from agency problems. The theories that are contained in the first group are mainly the complete contract approach that is referred in this literature as prospect theory as well as agency theory. The group that follows is mainly made up of class hegemony theory and managerial power theory (Crotty & Bonorchis, 2006). Agency problems are usually key in any literature on corporate governance. There are three major assumptions as summed up by Wiseman and Gomez –Mejia (1997) when dealing with a simple agency model. The first assumption is that agents are usually risk averse; the second one is that they normally behave based on self-interest assumptions; the third one assumes that the interests of agents are not usually in line with the interests of the principles. These assumptions also clearly identify two significant cases. The first case deals with the complete information about the actions of the agents. In this situation, there is no information asymmetries that exists between agents and principles. In this circumstance, the principle is completely aware of the actions of the agent. This makes it unnecessary to provide the agent with extra incentive since the principal is completely aware of the how the results are achieved and this would needlessly transfer the available risk to an agent that is risk averse. The second case is when the principle party does not have complete information about the behavior of the agent. Under this circumstance, the principal is unaware if and when the agent deviates from the principal’s interests. Under this second case; problems of agency could arise due to two factors; The presence of a moral hazard like shirking as well as adverse selection like hubris action (Oxelheim & Wihlborg, 2008). Agents can be increasingly involved in going after their own interests which may contribute in them neglecting their duties to the principal as well as overestimating their own personal capabilities. The principal however has two options to his disposal in solving these problems that arise out of incomplete information. The principal may opt to obtain much more information on the efforts of the agent as well as his behavior. This can be done by improved monitoring or providing the agent with more incentives in a manner that the interests of the agent and principal become much more aligned. The risk of deviation from the principal’s interests is transferred to the agent when the principal provides incentives. The optimal pay level or package serves to minimize agency cost and is usually a tradeoff between incentives and additional costs (Thomas & Hill, 2012). 3.3 The Symbolic Approach Executive remuneration has a significant role in reflecting executive dignity, status as well as expectations and normally plays a much more secondary role in motivating the executive. These arguments are normally based on socio-economically constructed beliefs on executive roles in the company and how their pay has to reflect this aspect. This approach mainly consists of the following theories; tournament theory, figurehead theory, stewardship theory, crowding-out theory, psychology/implicit contract theory, social enacted theory as well as social comparison theory. Tournament theory tends to treat executive pay as prize in a contest. The first prize in this is the highest salary that is paid to the CEO who is the highest ranked executive in any given company. This incentive provides a reason for other officers to climb higher through hard work and gaining promotions which increases the company’s productivity. Figurehead theory is of the view that behavior reflects intention or purpose that a diversity of interests and goals co-exist within companies (Foulkes, 1991). Conclusion The value approach argument for the legitimization of executive pay is mainly based on market forces and mechanisms. The key contribution of this value approach is the insight that it provides into how economic theory contributes to an overall understanding of market inefficiencies in coming up with executive pay. However, this approach is less capable of providing proper explanations on executive pay when looking at the issue of how decisions on pay are arrived at. Reference List FERRACONE, R. A. (2013). Fair pay, fair play aligning executive performance and pay. San Francisco, Calif, Jossey-Bass. http://rbdigital.oneclickdigital.com. HENGARTNER, L. (2006). Explaining executive pay the roles of managerial power and complexity. Wiesbaden, Deutscher Universit̃ts-Verlag. http://public.eblib.com/EBLPublic/PublicView.do?ptiID=749118. BALSAM, S. (2002). An introduction to executive compensation. San Diego, Calif. [u.a.], Academic Press. DURAI, P. (2010). Human resource management. Chennai, Pearson. http://proquest.safaribooksonline.com/?fpi=9789332501393. BRINK, A. (2011). Corporate governance and business ethics. Dordrecht, Springer Verlag. GERARD, P. (2006). Performance and Reward: Managing Executive Pay to Deliver Shareholder Value. Leicester, Matador. CROTTY, A., & BONORCHIS, R. (2006). Executive pay in South Africa: who gets what and why. Cape Town [South Africa], Double Storey. OXELHEIM, L., & WIHLBORG, C. (2008). Markets and compensation for executives in Europe. Bingley, UK, Emerald. OXELHEIM, L., & WIHLBORG, C. (2008). Markets and compensation for executives in Europe. Bingley, UK, Emerald. THOMAS, R. S., & HILL, J. G. (2012). Research handbook on executive pay. Cheltenham, Edward Elgar Publishing. http://public.eblib.com/EBLPublic/PublicView.do?ptiID=950413. FOULKES, F. K. (1991). Executive compensation: a strategic guide for the 1990s. Boston, Mass, Harvard Business School Press. LIPMAN, F. D., & HALL, S. E. (2008). Executive compensation best practices. Hoboken, N.J., John Wiley & Sons. http://site.ebrary.com/id/10226749. GRAHAM, M. D., ROTH, T. A., & DUGAN, D. (2008). Effective executive compensation: creating a total rewards strategy for executives. New York, AMACOM/American Management Association. CHINGOS, P. T. (2002). Paying for Performance a Guide to Compensation Management. New York, John Wiley & Sons. http://public.eblib.com/EBLPublic/PublicView.do?ptiID=139940 Read More