The determination of CEO compensation is often a difficult and contentious one. A study at the University of Illinois looked into companies’ use of peer benchmarking information in determining the compensation of their CEO and explored the social-psychological mechanisms which can explain compensation adjustments. The results found that CEO power moderates the relationship between a CEO’s compensation and the compensation of their peers, with CEO with greater power better able to push for benchmarking and higher compensation. Pay inequality versus peers was also found to be a strong motivator for CEOs to restore compensation equity.
Key Topics: CEO compensation; Benchmarking; Managerial power
Title of Reviewed Article: Fair Pay or Power Play? Pay Equity, Managerial Power, and Compensation Adjustments for CEOs
Researchers: Taekjin Shin (University of Illinois) Publication: Journal of Management, 2016, Vol. 42 No. 2, pp. 419–448. __________________________________________________________________________ Setting the Scene Compensation benchmarking is a central part of CEO pay determination in most companies (Bizjak, Lemmon, & Naveen, 2008; Faulkender & Yang, 2010), with many large companies having a compensation committee who often use peer CEO data to set compensation (Bizjak, Lemmon, & Nguyen, 2011). Bannister and Newman (2003) in a review of 160 US proxy statements, found that 94% of companies used benchmarking to some degree in determining CEO compensation. While some have argued that benchmarking is used to maintain CEO compensation competitiveness (e.g. Bizjak et al., 2011), others have suggested that companies may use benchmarking to justify excessive compensation adjustments (Ceron, 2004). Equity theory (Adams, 1963) indicates that pay inequity leads to tensions within the individual which will motivate them to try to gain equity, and from a CEO compensation perspective it would suggest that motivation to be closer to peers would be greater in underpaid rather than overpaid CEOs. Ezzamel and Watson (1998) found support for this, finding that when companies determined executives to be under or overpaid then they typically adjusted the compensation of impacted executives in the following year either up or down. Consistent with equity theory, Fong et al. (2010) found underpaid CEOs to be more likely to increase their company size or leave their company than CEOs who were overpaid. While compensation inequality may be a strong motivator for CEOs to reduce inequality, their ability to effect change is likely to play a part. Research suggests that CEOs can use managerial power to exercise influence over the company’s board, resulting in more favourable compensation (e.g. Bebchuk & Fried, 2004). The managerial power of CEOs may be impacted by various factors, such as if they are also the chairman of the board and the composition of the board. In order to examine some of these relationships further, this study posited the following research questions: Hypothesis 1 – “The relationship between changes in a focal CEO’s pay and changes in peer CEOs’ pay is stronger when the CEO has been underpaid than when the CEO has been overpaid.” Hypothesis 2 – “For underpaid CEOs, the strength of the relationship between changes in the focal CEO’s pay and changes in peer CEOs’ pay is greater for CEOs who have more power over the board than for those who have less power over the board.” Hypothesis 3 – “For overpaid CEOs, the strength of the relationship between changes in the focal CEO’s pay and changes in peer CEOs’ pay is weaker for CEOs who have more power over the board than for those who have less power over the board.” How the research was conducted This study collected data from 1996 to 2006 on companies from the Standard and Poor’s ExecuComp database. From this database, a final sample of 1,211 companies in the S&P 1500 Index were selected, which included information on 1,555 CEOs. The study defined compensation as the sum of salary and bonuses, as research suggests these components are most typically used for peer benchmarking (Murphy, 1999). Consistent with prior research (e.g. Bizjak et al., 2008), this study used the two-digit Standard Industrial Classification (SIC) industry code to categorize peers appropriately. The average peer group size was 22 companies, and peer compensation was calculated as the average CEO compensation, excluding the compensation of the focal CEO i.e. the one being benchmarked. Various factors were used to determine CEO power, including the proportion of board hires made before and after the CEO’s appointment, the proportion of outside directors on the board, and whether the CEO was also the chairman of the board. This information was primarily sourced from the RiskMetrics Directors data and proxy statements. Key Research Findings Hypothesis 1 was not supported as no evidence was found to indicate that the effects of changes to peer compensation differed between under and overpaid CEOs. Results found that for underpaid CEOs the relationship between peer pay and CEO duality (i.e. they were also the chairman) was positive, which is consistent with Hypothesis 2 and suggests that the relationship is greater between CEO compensation and that of their peers when CEOs are also the board chair. On the other hand, for overpaid CEOs this duality was not significant, which is inconsistent with Hypothesis 3. When using the proportion of outside directors to determine CEO power, the results found that, for both under and overpaid CEOs, the interaction between CEO’s compensations and proportion of outside directors was not significant, thus Hypotheses 2 and 3 were not supported with this measure of power. When using the proportion of directors appointed after the CEO’s appointment to determine CEO power, the results found that, for underpaid CEOs, the interaction between CEO’s compensations and proportion of directors appointed after the CEO’s appointment was not significant, thus Hypotheses 2 was not supported with this measure of power. For overpaid CEOs, however, a relationship was found, which supported Hypothesis 3. Results Commentary The rejection of Hypothesis 1 indicates that changes in a CEO’s compensation and that of their peers does not vary as a result of pay inequality. The researcher suggests that lack of support for Hypothesis 1 could be due to managerial power not being included in the analysis of pay inequality effects for Hypothesis 1. A CEO’s power may have a bearing on whether they can address pay inequality issues or not, and therefore their power may moderate the relationship between a CEO’s compensation and that of their peers. This assertion was borne out in the findings relating to Hypotheses 2 and 3, which predicted that CEO power would have a moderating effect. For underpaid CEO’s with greater relative power, it appears from the results that peer benchmarking is utilised to a greater extent to make upward adjustments to CEO compensation. While for overpaid CEO’s with greater relative power, there is a weaker relationship between a CEO’s pay and their peers, which suggests that CEO may have greater influence to avoid using benchmarking and downward adjustments to their compensation. What the results suggest is that pay inequality is an important consideration for CEO’s, but their reaction to this inequality is likely to differ depending on the level of power they possess to do something about it, and the results show that desire alone of CEO’s to address their compensation is not enough to bring about a change. Organizational and Reward Implications This study highlights the appetite of CEO’s to have compensation that in line or above their peer group. This comes as little surprise, but what is interesting is the role that CEO power can apparently play in CEO benchmarking and compensation adjustments. The findings suggest that CEO power over the board enables them to influence determination of their own pay, and those with the necessary power can strategically promote benchmarking when they are underpaid, whilst avoiding benchmarking if overpaid. Knowledge of this behaviour should be of significant interest to board members, as well as Reward and HR practitioners, who should be mindful of this possibility for manipulation when determining and applying CEO compensation policies. This study also highlights the prevalence of peer benchmarking at CEO level, and practitioners should be cognizant of the effect this might have on ratcheting up compensation and companies being caught in a cycle self-perpetuating CEO pay inflation. Final Thoughts This study provides insight into some of the behavioural mechanism that can drive the determination of CEO compensation, and that have given rise to increases in CEO compensation in recent decades. Similar future research in a non-US context would be beneficial to further understand these mechanisms from an international perspective. __________________________________________________________________________ Source Article: Shin, T. (2016). Fair Pay or Power Play? Pay Equity, Managerial Power, and Compensation Adjustments for CEOs. Journal of Management, 42(2), 419-448. Published by: Sage Publishing For further details and access to the full journal article Click Here (subscription or payment may be required). __________________________________________________________________________ References: Adams, J. S. (1963). Wage inequities, productivity and work quality. Industrial Relations: A Journal of Economy and Society, 3(1), 9-16. Bebchuk, L., & Fried, J. M. (2004). Pay without performance: The unfulfilled promise of executive compensation. Cambridge, MA: Harvard University Press. Bizjak, J. M., Lemmon, M. L., & Naveen, L. (2008). Does the use of peer groups contribute to higher pay and less efficient compensation? Journal of Financial Economics, 90(2), 152-168. Bizjak, J., Lemmon, M., & Nguyen, T. (2011). Are all CEOs above average? An empirical analysis of compensation peer groups and pay design. Journal of Financial Economics, 100(3), 538-555. Ceron, G. F. (2004). The company we keep. Wall Street Journal. April 12: R4. Ezzamel, M., & Watson, R. (1998). Market comparison earnings and the bidding-up of executive cash compensation: Evidence from the United Kingdom. Academy of Management Journal, 41(2), 221-231. Faulkender, M., & Yang, J. (2010). Inside the black box: The role and composition of compensation peer groups. Journal of Financial Economics, 96(2), 257-270. Fong, E. A., Misangyi, V. F., & Tosi, H. L. (2010). The effect of CEO pay deviations on CEO withdrawal, firm size, and firm profits. Strategic Management Journal, 31(6), 629-651. Murphy, K. J. 1999. Executive compensation. In O. C. Ashenfelter & D. Card (Eds.), Handbook of labor economics: 2485-2563. New York, NY: Elsevier. Comments are closed.
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