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A TERM PAPER ON EXECUTIVE COMPENSATION

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

this fast-evolving trend to expand future research.

Introduction

Without doubts, executive compensation is a contentious and complex issue. In the

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 two approaches must provide evidence of relationship to firm performance.

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

lays great emphasis on public firms in the US.

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

has the conclusions.

Research Questions

1. What are the effects of CEO pay on the firm’s value?

2. What is the link between CEO pay and performance of the firm?
3. What are the reasons behind the executive pay rise?

Part 1: The level of Executive compensation

The level of Executive Pay

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

sometimes as cash or as stock.

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

CEOs and other top executives.

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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Part 2: The Relationship

The relationship between CEO compensation and the organization’s performance

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

rise of the compensation package in the 1990s.

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Measuring managerial incentives

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

executive’s stock does the monitoring for them.

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.

Part 3: Reasons behind the pay rise

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

efficient consequence of a market variable.

Theoretical arguments for the increase of CEO pay

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

to weak firms collapsing due to inefficient compensation.

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

firms are growing.

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

and pay to such talented CEOs.

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.

Part 4: The relationship

Relationship between CEO pay and company’s value

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

and the effect.

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

compensation on the company’s behavior and stock value.

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Conclusion

The executive compensation research has gone through tremendous growth

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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