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Table of Contents
Abstract.......................................................................................................................................................1
Introduction.................................................................................................................................................2
Research Questions.....................................................................................................................................4
Part 1: The level of Executive compensation...............................................................................................4
The level of Executive Pay......................................................................................................................4
Part 2: The Relationship..............................................................................................................................6
The relationship between CEO compensation and the organization’s performance.................................6
Measuring managerial incentives............................................................................................................7
Part 3: Reasons behind the pay rise.............................................................................................................8
Theoretical arguments for the increase of CEO pay................................................................................8
Part 4: The relationship..............................................................................................................................11
Relationship between CEO pay and company’s value...........................................................................11
Future Research.........................................................................................................................................11
Conclusion.................................................................................................................................................12
Works Cited...............................................................................................................................................13
Abstract
In recent years, the CEOs’ compensation has seen a rapid rise. As a result, the rise has set
the tremendous debate on the pay-fixing process. Most people view the increased compensation
as a self-induced pay by the powerful managers. The power they accumulate in firms over time
enables them to set their salaries and other perks (O'Reilly et al. 231). Other people see this as a
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reward for the high competition that companies exhibit in acquiring these top-level managers.
Most global companies go to the extent of poaching these managers from other well-performing
companies (O'Reilly et al. 201). The competition is evidence of how firms are desperate to
acquire their services. With this kind of competition, the managers can negotiate their pay due
the management gifts and experience they have (Gopalan et al. 124). In some instances, the
boards of management continue raising pay for their CEOs to deter any poachers who may be
interested in acquiring the services of their managers (Bettis et al. 34). The gradual increase will
ultimately lead to a staggering pay for these individuals. The paper seeks to analyze the rapid
evolution of the high salaries and their relationship to companies’ performance. The paper will
discuss the two fronts according to the people of why the executive pay is high. The first front is
the competition by firms to acquire these CEOs, and the other is the pay rise brought about by
accumulated managerial power (Bolton et al. 178). It will also show possible future directions for
Introduction
USA, the rise in CEO salaries has set the ground for intense debate about how the pay-fixing
process (O'Reilly et al. 175). The debate is also about the effects of such high executive pay.
Some people state that the powerful managers who have accumulated immense power to
themselves set the high pay for themselves (Edmans et al. 68). Still, others see this as a deserved
reward for the managerial skills and talent that these CEOs exhibit (Bolton et al. 156). The term
paper shows great analysis on the high executive pay and gives forth arguments supporting and
opposing the trend. The paper suggests that both competition by firms and accumulated
managerial power are two crucial factors influencing the executive compensation, but also
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suggests that neither factor is consistent when applied alone (Gopalan et al. 87). When we look at
the evolution of the executive pay, we have two historical timelines. One timeline falls before the
1970s where there was low pay, and the performance was not so great (Dittmann and Zhang
183). Also, movement by the managers was not very common. Most would stick to a certain firm
for a long period (O'Reilly et al. 106). After the 1970s, the pay rose rapidly, the range between
firms also grew, and the wealth accumulated by the manager shows the firm performance
(Conyon 56). The existing literature does not show the sudden change from low pay to high pay
in the transition period. Also, the literature does not show cause for the discrepancies across the
firms. Most of the existing theoretical studies analyze how the compensation with optimal
contracting (Edmans et al. 49). However, the studies do not show that optimal contracting always
achieve maximum efficiency (Bolton et al. 261). Many factors may derail the performance of a
CEO despite the high competition to acquire his managerial skills (Gillan et al. 34). Therefore,
The new interest depicted in this paper will provide enough evidence to resolve the CEO
pay debate. Recent studies have analyzed the consequences of changes in the optimal contracting
scene on the executive pay, firm’s behavior, and the relationship. For instance, regulations in the
industries show CEO pay lead to strong board oversights (Edmans et al. 56). Strengthened
boards mean that some powers of the managers are taken away hence low pay for fewer duties
and responsibilities (Dittmann and Zhang 150). On the other hand, deregulations suggest higher
pay showing that increased demand for the executives results in their high pay (Bolton et al.
210). Whenever the CEO has many self-accumulated duties, the pay must rise to compensate the
duties the manager performs (Gillan et al. 38). The literature on CEO pay is wide, and this paper
attempts to carry out comprehensive research. However, the paper puts deep emphasis on recent
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literature and focuses more on empirical analysis as opposed to theoretical work. The paper also
The paper comprises of five major sections as follows. Part 1 highlights evidence about
the level of the executive pay. Part 2 shows the relationship exhibited between executive
compensation and the firm’s performance. The second part also shows different pay process
measures. Part 3 gives and discusses the reasons behind the pay rise. In part 4, the pay shows the
results of CEO compensation on the firm’s behavior and ultimate value. In the last part, the paper
Research Questions
The rise in CEO compensation after the 1970s and specifically its rapid acceleration over
the last twenty years has been researched, discussed and debated by various people. The research
continues without bringing the debate to an end. In fact, it seems the debate also escalates as the
research continues. Slow and rapid evolution. Looking at some of the highest paid executives in
the US, we will get a perspective on the rapid evolution of executive compensation. Datta and
Iskandar‐Datta (235) identifies the fifty largest firms in the USA in three different years and
periods. The specifically chosen years are 1940, 1960 and 1990. The year’s show periods of both
slow and rapid evolution of executive compensation. According to Datta and Iskandar‐Datta
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(301), total compensation refers to the salary, the bonuses, and payouts from incentives
During the World War II, there was a very sharp decline in the executive compensation
and experienced slow reduction in 1940s. However, from the 1950s, the level of CEO pay rose
slowly up to 1970s. On average, the rise was around 0.8% per year. From there, the pay
experienced rapid acceleration up to around 2005. According to Dittmann and Zhang (233), the
rise was most felt during the 1990s where the average growth was around 10% per year. For the
CEO, the pay was rising more rapidly than for other executives. Of worthy to note is that the
executive pay increased for all firms mindless of their sizes (Gillan et al. 66). Another thing to
note is that, despite firms of all sizes increasing the executive pay, there exist very interesting
differences. In large firms, the increase in pay has been very steep. In return, managing these
large firms have been every CEO’s wish. Interestingly, the difference in firms applies to both the
Despite great variations in pay modules across firms, in addition to salaries and bonuses
most CEO pay packages have other components: incentive plans’ payouts, stock grants, and
option grants. In addition to these packages, CEOs also earn pension plans and severance
payments whenever they leave a certain firm. The stock grants, option grants, and other
incentives are emerging trends in the executive compensation. Initially, the CEOs used to earn
salaries and annual bonuses only. The bonuses were based on the annual performance of the
firms (Datta and Iskandar‐Datta 236). However, the current long-term incentives are based on
multiyear firm performances. The more a firm performs, the more the payouts to the CEO.
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At the turn of the 20th century, separation of corporate control and corporate ownership
brought many principal-agent problems (Denis and Xu 112). The problems continue to rage up to
date. The problem arises if the executive is self-centered and want to take actions without
considering the shareholders’ value. During such an occurrence, the shareholders are unable to
monitor them, or sometimes they don’t know what to do. Also, there may be actions that the
executive may make that are well-intentioned but the shareholders are suspicious of them (Bettis
et al. 67). That influences the progress of the firm negatively. In such instances, executive
compensation may be applied to solve the problem arising from agency. The problem’s solution
is through aligning the shareholders’ interests with those of the executive. In principle, the
manager’s compensation should be calculated based on the value of the shareholders. The
executive will take actions that will maximize the value of the shareholders since their interests
become intertwined. However, the reality is a bit different. The shareholders might not always
know which actions are taken to maximize their value (Conyon 98). In that case, the executive
must undertake actions that will ultimately realize the shareholders’ primary objective which is
increasing their value. The executive acquires a stake in the firm, and thus he will take actions
that benefit all the shareholders including him. The objective is to do the executive work for
something that partially belongs to him. It also prevents well-performing CEOs to keep on
moving to different firms as their stake is secure. The relationship between executive wealth and
the performance was well visible in the 1990s (Denis and Xu 97). That further explains the rapid
Since the twentieth century, there has been much research to measure the effects of the
incentives offered to the CEOs. The early researchers focused on measuring the firm’s
performance like the market capitalization, sales, and profits. Those scales best explain the
difference in executive pay across different firms. The following generation of researchers
studied the relationship between executive incentives and the changes to the stock performance.
The researchers realized the positive forecast relationship between shareholder value and
executive pay. However, they undermined the level of manager incentives by basing their
research on the current pay. Many executives own a considerable amount of stock holdings in
their employer (Denis and Xu 101). The ownership ties their cumulative package to their
employer’s share performance (Gillan et al. 40). For most executives, the compensation from a
high return on the stock is usually higher than the salary package (Pepper and Gore 291). With
that in mind, the executives always strive to ensure that the firm is performing well. If the firm’s
stock underperforms in a particular year, then the annual total package for the executive also
reduces. Even with shareholders who cannot monitor the actions taken by the executive, the
A complete measure of executive bonuses should analyze all the possible connections
between performance of the firm and executive pay into account. Research in the US shows that
firms pay 3.25 dollars per 1,000 dollars increase in value earned by the firm (Gillan et al. 129).
The combination of these effects shows the relationship between incentives and the firm’s
performance. According to the research above, the executive’s pay increase as the firm’s stock
value increase.
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According to Dittmann and Zhang (302), executive incentives are good on two fronts.
One, the increased stock compensation since the late 1980s strengthened the connection between
CEO compensation and performance. Two, they state that the variations in compensation caused
by the variations in the company’s value are large. Even though the executive’s equity holdings
may seem negligible, but the values of their equity share holdings are not. Consequently, the
CEO stands to gain so much wealth from raising the company’s performance. For instance, the
3.25 per 1,000 dollars may seem a small fraction, but when the firm rakes in millions of dollars,
the small fraction translates into much wealth for the executives.
The rapid increase in manager compensation over the last 20 years or so has set off a
vigorous argument about the main factors leading to executive pay. On one side of the divide,
people view the increased levels of executive pay as a result of the CEOs’ capability to change
and increase their pay. On the other side of the divide, people see CEO compensation as the
expected effect of a labor market where companies compete for the managerial skills and talent
(Pepper and Gore 201). In recent years, different people give many explanations, and every
proponent wants his reason to prevail. The emerging reasons continue to add flavor to an already
tremendous debate. Instead, the paper will analyze the theories in two parts. The theories that
view increased pay as a form of rent extraction phenomenon and those theories that see it as an
The view of rent extraction states that acquiescent boards of management and
weak corporate governance are partially responsible for allowing CEOs to set their pay. They
state that the weak boards are the cause of the high levels of CEOs pay. Researchers refer to this
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theory as the managerial power hypothesis. The theory further alleges that much of the
compensation occurs through less visible forms such as pensions, severance pay, perquisites and
stock options. This theory, however, leaves a lot of questions. Its critics say that inefficient high
pay will result in the dismissal of the CEO whether the package is visible or not visible (Pepper
and Gore 146). If the CEO set an unsustainable pay for himself, he will be pushed out by the
shareholders due to the economic variables in the industry. However, cunning CEOs can avoid
ousting since dismissing them is expensive and also hiring a new CEO also extracts rent (Pepper
and Gore 56). Weak firms with high compensation paint the theory in a bad light even to firms
that are performing well. It is also becoming hard for firms that are not performing well to attract
CEOs from well-performing firms since they ask for high equity in the firm. Therefore, this leads
In contrast to this theory, there is literature that states that CEO compensation is as a
result of high demand for the skills and talent for these managers who are scarce to find.
One theory in this spectrum connects the increase in CEO compensation to rising scale effects
and firm sizes. According to De Jong (46), if the executive talent is valuable in large firms, then
these firms should give greater levels of compensation. Very little increase in this talent imply
increments very much in the firm’s value and pay due to the increased operations under the
CEO’s management. The theory provides further evidence of the increased pay (Pepper and Gore
243). It says that the six times increment since 1980- 2003 is equal to the way firms’ value has
grown six times (De Young 157). The proponents see no worry in raising the pay as long as the
The second theory proposes that changes in technology, product markets and the firm’s
characteristics in the recent past have raised the efforts of the CEO on the firm value. Therefore,
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this leads to increased level of pay and incentives. Entry by foreign firms has also led to
increased pay as they seek to move to the top and be market leaders (Pepper and Gore 450). In
their endeavors, they give high incentives to CEOs with already high pay. When these CEOs
agree to jump ship, it means the compensation is an expanded package with more incentives than
in the previous firms. To catch the eyes of the new firms, it means that the CEO’s talent and
skills are top notches. It is these talents that this theory seeks to defend. The rules of nature
further show us that we cannot cap talents on those who have them. Also, deregulation in the
industry has been the cause of increased perks as the weak boards lay all their trust on the actions
of the CEO (De Young 123). They believe in his management skills and know their shareholder
value will ultimately increase. With this trust, they have no qualms about increased incentives
The third theory is a market-based explanation for the rise in CEO compensation.
According to this theory, the shift from specific to general management skills demanded by the
firms cause the rise. The shift increases the competition by firms for the available talents (Pepper
and Gore 456). The competition, in turn, allows the managers to take a bigger fraction of their
firm’s stake. The theory further explains the increase in pay, why firms hire more executives
outside the firm and also the growing inequality within the firm and across different firms and
industries.
Lastly, the final market-based theory states that the rise in CEO compensation is the
effect of better corporate governance and close supervising by boards than before (Pepper and
Gore 367). The more the monitoring by boards becomes intense, the more the possibility of a pay
rise (De Young 197). The rise prevents the CEO from moving away from the firm despite
increased monitoring (Pepper and Gore 674). Further, the close monitoring means that the CEO
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performs well and the overall performance of the firm increases (Carberry and Edward 29).
However, if the monitoring does not bring the expected results, it might not necessarily bring an
increase in the compensation. Also, the boards monitor their market share and stock value and
compare it with their rivals in the industry (Conyon 122). In case their rivals are paying lower
compensation than them and performing well, then the CEO should not expect any pay rise.
The raging debate on the pay‐fixing process has irked curiosity in the consequences of
pay on the executives’ behavior and the company’s performance. The major issues about this
would be swept away if higher CEO compensation meant better firm performance and increased
stock values (De Jong 46). However, trying to find such convincing evidence is extremely
difficult even for seasoned researchers and economists. The available literature offers adequate
evidence that CEO pay and incentives have a connection to a variety of corporate behaviors. In
any case, if CEO pay did not affect corporate behavior, then it would not make any sense to use
incentives (Carberry and Edward 35). The main problem is the identification of the correlation
Future Research
Future researchers should concentrate on both the private and public firms. They should
also expand their scope outside the United States. They should even research the results of CEO
Conclusion
in recent years. With expanded literature and information, our knowledge of payment practices
has also improved. However, despite the available literature. There exist very many important
questions that lack answers yet. For instance, the causes of the changes that occurred in
executive compensation in the 1990s remain unknown (Carberry and Edward 45). The
importance of optimal contracting and rent extraction is still not determined. Researchers still
don’t know the exact effects of CEO compensation on firm value and behavior. If we are to find
answers to these issues, we require more research and data from other nations (Dittmann and
Zhang 408). Also, research should be open to both public and private entities. However, all the
research so far is not in vain. The research in this paper shows that the answers are attainable and
probably shortly.
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Works Cited
after Enron: Substance and Symbol." Academy of Management Proceedings. Vol. 2017.
(2014): 1853-1866.
De Jong, René-Paul. "The Relation between Executive Compensation and Voluntary Disclosure."
(2017).
De Young, Robert, Emma Y. Peng, and Meng Yan. "Executive compensation and business policy
(2013): 165-196.
Denis, David J., and Jin Xu. "Insider trading restrictions and top executive
Pepper, Alexander, and Julie Gore. "Behavioral agency theory: New foundations for theorizing