CEO compensation packages are becoming increasingly standardized, for various reasons, including the growing influence of external bodies on company boards of directors. A study of US CEOs over a 7-year period, which examined the relationship between CEO compensation effectiveness and their tenure, found that the motivation inducing effects of different compensation components differed depending on how long CEOs had been in their role. The results suggest that standardization of CEO compensation is not an optimal compensation strategy for companies to follow.
Key Topics: CEO tenure; CEO compensation; Shareholder returns; Performance-based compensation
Title of Reviewed Article: Does One Size Fit All? Investigating Pay–Future Performance Relationships Over the “Seasons” of CEO Tenure
Researchers: Wanrong Hou (University of Texas-Pan American), Richard L. Priem (Texas Christian University), and Maria Goranova (University of Wisconsin-Milwaukee).
Publication: Journal of Management, 2017, Vol. 43 No. 3, pp. 864 –891.
Setting the Scene
In recent years, CEO compensation has become increasingly standardized, as shareholders, advisory services, and regulators have exerted greater influence over the determination of executive pay, and boards of directors look to follow recommended best practice (Ertimur, Ferri, & Muslu, 2011; Kaplan, 2013). Research by Core and Guay (2010), among others, indicates very similar CEO compensation packages, across salary and variable compensation components, in Standard & Poor’s 500 firms.
While it is unsurprising that there is consistency in CEO compensation given the external pressures on boards of directors, it begs the question as to whether this ‘one-size-fits-all’ approach is an effective way in motivating CEOs, particularly as research suggests that CEOs have varying values and beliefs which affect their motivations and behaviours in relation to compensation (e.g. Finkelstein, Hambrick, & Cannella, 2009).
The current study looked to examine the role of different compensation elements in CEO performance across different tenure stages, namely early, mid, and late CEO tenures. CEO tenure has been shown to relate to various company outcomes, such as invention (Wu, Levitas, & Priem, 2005), performance (Henderson, Miller, & Hambrick, 2006), and strategic change (Boeker, 1997).
Tenure is also likely to relate to compensation in different ways. For example, new CEOs, who are often under more pressure to provide results in the short term and prove themselves, are likely to be more motivated by short term bonuses that provide that short-term feedback on their performance (Devers et al., 2008; Vancil, 1987), while salary is likely to have less of a motivating effect.
The researchers proposed the following hypotheses for examination:
Hypothesis 1 – “CEO tenure will moderate the effect of CEO pay on performance, such that long-term, performance-based pay will affect shareholder returns positively in the earlier stages of CEO tenure, but negatively in the later stages of CEO tenure.”
Hypothesis 2 – “CEO tenure will moderate the effect of CEO pay on performance, such that short-term, performance-based pay will affect shareholder returns positively in the early stages of CEO tenure, but negatively in the later stages of CEO tenure.”
Hypothesis 3 – “CEO tenure will moderate the effect of CEO pay on performance, such that non-performance-based pay will affect shareholder returns negatively in the early stages of CEO tenure, but positively in the later stages of CEO tenure.”
How the research was conducted
This study collected data on Standard & Poor’s 500 companies for the 1998-2005 period. The data sample included 1,558 company-year observations from 299 companies.
CEO data was sourced from Execucomp and company financial data was collected from Compustat.
Using the data collected, the researchers measured the following primary factors: CEO compensation components, including Salary, Long-term- and Short-term performance-based compensation; total return to shareholders (TRS); CEO tenure, including seasons of CEO tenure, as classified as early tenure (CEOs that have been in their job for up to 3 years) and late tenure (CEOs that have been in their job for 9 years or longer).
Data was also collected on factors such as CEO age, CEO gender, CEO duality (i.e. if they were also the company chairman), level of CEO ownership of the company, company size, stock price volatility, CEO compensation industry norms.
Key Research Findings
CEOs, on average, earned an annual salary of $870,000, stock options of $5.74m, and annual bonus of $1.38m. On average, companies had 48,900 employees and CEO compensation levels correlated positively with company size.
CEOs had an average tenure of 6.4 years and an average age of 56, while 76% of CEOs also held the position of chairman of the board.
CEO tenure was found to negatively moderate the effect of long term performance based pay on shareholder returns, and as such Hypothesis 1 was supported. CEO stock options were found to positively affect shareholder returns in the early stages of CEO tenure, but to have a negative effect in later stages of CEO tenure.
Hypothesis 2 was also supported by the results, with the positive effect of CEO bonus on shareholder returns generally decreasing as CEO tenure increased and becoming negative in later tenure stages. However, support for Hypothesis 2 was only partial, as CEOs with high bonuses outperformed CEOs receiving low bonuses during early and late tenure.
The effect of salary on shareholder returns was found to be increasingly positive as CEO tenure increased. For CEOs with tenure of 8 years or less, salary and shareholder returns were negatively related, however, when CEOs had tenure of 12 years or more salary had a positive effect on shareholder returns. These results support Hypothesis 3.
The results confirm that the effect of CEO compensation components on performance differs depending on the length of tenure and that CEOs view compensation components differently depending on tenure. There appears to be a reducing benefit to short- and long-term variable compensation as CEO tenure increases, while the opposite is the case for salary. This suggests that, rather than optimizing CEO performance, the standardization of CEO compensation packages may be a barrier to optimal CEO performance.
Organizational and Reward Implications
This study has important practical implications. The results suggest that, while well meaning, the raft of external interest in CEO compensation determination may be creating a sub-optimal compensation environment for CEOs to operate in, and that when it comes to designing CEO compensation packages, company boards should consider ‘best fit’, not just ‘best practice’.
The results offer encouragement for boards of directors to consider deviating from the status quo when it comes to CEO compensation packages, and resist the urge to create a CEO compensation package that appears robust but is not appropriate for the CEO in question. Rather, boards should consider the unique profile of their own CEO in determining their bespoke compensation package. Furthermore, boards should not lose sight of the fact that they are typically best informed about their CEO’s values, aspirations, and motivators, and should utilize this information in determining compensation.
This study highlights the importance of tenure in determining an optimal compensation package for CEOs, which offers important insight, particularly given that the standardization of CEO compensation packages is becoming more prevalent. Aside from the merits of its own results, this study given cause to consider that other trait factors, such as CEO aspirations, are likely to impact on CEOs’ relationship with their compensation, and it is hoped that this is examined in future studies.
Source Article: Hou, W., Priem, R. L., & Goranova, M. (2017). Does One Size Fit All? Investigating Pay–Future Performance Relationships Over the “Seasons” of CEO Tenure. Journal of Management, 43(3), 864 –891.
Published by: Sage Publishing
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