Discussion and Analysis of Executive Compensation and Firm Performance

Discussion and Analysis of Executive Compensation and Firm Performance – Evidence From the United States

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nIntroduction

nOver the past few decades in the corporate world, the issue of executive pay has attracted attention. In the United States, the performance of the executives in the organization plays a role in the level of their compensation (Tung 2011). There is a wide range of factors that influence the association between compensation and performance of executives in an organization. Some of these include socio-cultural features, executive features, pay characteristics and organization characteristics. Most literatures indicate that compensation of top executives in a firm comprises four main constituents: incentive strategies, stock options, annual bonus and basic salary. Moreover, the executives have an opportunity to acquire unique benefits such as retirement plans, and life insurance (Matolcsy and Wright 2011). The chapter analyses and discusses the previous studies in order to examine the association between organizational performance and compensation of the executives.

nOrganizational characteristics

nMany researches have been conducted to examine the impacts of organizational feature such as ownership structure, organizational risk and size on the performance-compensation relationship of the executives (Lin, Kuo and Wang 2013). According to a study by Gregg, Jewell and Tonks (2012), organizational risks play a role in compensation of executives based on their performance. Based on the findings of this study, organizational risks contribute to negative effects on the compensation-performance relationships of the executives (Gregg, Jewell and Tonks 2012). In addition, other research by Graham, Li and Qiu (2012) noted that firm risks has a substantial effect on the overall compensation of the executives of the firm (Graham, Li and Qiu 2012).

nOrganizations size is also a major factor that affects the compensation of executives and companys performance. According to the Allocation theory of control, in the contemporary world, the largest companies hire highly brilliant executives for senior positions because the efficiency of their work is very crucial. Due to this fact, the study noted that the size of the organization is highly related to its performance (Cao, Lemmon, Pan, Qian and Tian 2014). In this regard, the compensation of executives working in large organizations is much higher as compared to those working in medium-sized companies. The findings of this research are consistent with Matolcsy and Wright (2011) study that suggested that executive pay increases depending on the size of the firm and their remuneration is also connected to the performance of the company (Matolcsy and Wright 2011).

nOwnership factors are also a major determinant of the executives pay based on the performance of the firm. Custódio, Ferreira and Matos (2013) argued that organizations that possess larger concentration of ownership, and occupied by shareholders from outside market plan to utilize less compensation based on equity (Custódio, Ferreira and Matos 2013). According to empirical evidence from Goergen and Renneboog (2011), concentration of ownership for executive shareholding is a reducing function of compensation of executives. The study noted that organizations that are controlled by huge shareholders are more likely to compensate a smaller salary to their executives. Similarly, the sensitivity of remuneration to the profitability of the organization is much smaller (Goergen and Renneboog 2011). Other researchers conducted in the United States indicated that there is a positive association between organizational structure and executive compensations. For instance, Cao, Lemmon, Pan, Qian and Tian (2014) explored the executive pay and structures of ownership among the US firm. The findings of this study noted that organizations applying concentrated ownership structure have a weaker association between firms performance and executive pay. Therefore, the compensation level is substantially lower in these firms (Cao, Lemmon, Pan, Qian and Tian 2014).

nCompensation characteristics

nMany researches have been conducted in order to analyse the association between firms performance and executive compensation. Nonetheless, there are limited researches on the impacts of diverse pay components and performance of companies. Review of literature indicated the effect of adoption of compensation plan as well as pay components on the organizational performance was conducted (Matolcsy and Wright 2011). Capezio, Shields and O’Donnell (2011) documented that components of compensation for executives is delivered in terms of fridge benefits, stock payment and cash payments. The study also noted that cash payments refer to the total amount of bonuses and salary to the executives (Capezio, Shields and O’Donnell 2011).

nThe performance of the company and stock alternatives

nA study by Lin, Kuo and Wang (2013) investigated approximately five hundred companies and noted that firms granting stock choices to their executives acquire huge returns in their stock markets (Lin, Kuo and Wang 2013). A similar research by Custódio, Ferreira and Matos (2013) established that the performance of an organization is directly associated to the equity rate possessed by executives. Additionally, the study investigated the effects of performance on the stock options of staff in 120 organizations (Custódio, Ferreira and Matos 2013). The findings of this research noted that compensation of executives based on equity is positively associated with the performance of the organization. Therefore, there is a robust association between stock remuneration and organizational performance. In most cases, interior stockholdings play a special role in compensation of executives because they serve as substitutes (Sigler and Carolina 2011). At this point, less motivational payments are required to optimize the value of stock. Matolcsy and Wright (2011) also found out that stock alternatives offer a positive association between appreciation of the share price and rewards of executives because the pay-out from other choices improves in value because of rise in the prices of stocks (Matolcsy and Wright 2011). The findings of this study are also consistent with Gregg, Jewell and Tonks (2012) arguments which documents that initiation of alternatives in the payment structures rises the association between the organizations performance and compensation structures of it executives (Gregg, Jewell and Tonks 2012).

nOrganizational performance and compensation of cash

nLarkin, Pierce and Gino (2012) noted that for firms in the United States, there is a substantial association between compensation of cash and performance measures such as stock returns and asset returns. The association was, however, not significant when it was determined via options of cash plus as measures of performance (Larkin, Pierce and Gino 2012). Tung (2011) also argued that there are firms that awarded their executives fixed salaries. In these cases, these executives did not have incentives to encourage them to enhance the performance of the organization since they could not obtain a share of the companys gains (Tung 2011). Besides, Lin, Kuo and Wang (2013) documented a positive association between the salaries of the executives and performance of an organization. However, the study proposed that compensation of executive in terms of bonus and salary are not dependent on the variation in terms of organization value (Lin, Kuo and Wang 2013). Literature from these studies indicate that firms in the United States use payment structures that have a substantial association between performance of the company and compensation of executives.

nStudies also revealed out that the compensations of CEOs are not negatively affected by poor performance of the organizations stock returns. Cao, Lemmon, Pan, Qian and Tian (2014) noted a positive association between lower performance of the firm and the bonuses awarded to their executives. In this regard, the bonus structure may not be applicable for huge organizations to optimize the wealth of their shareholders (Cao, Lemmon, Pan, Qian and Tian 2014). Nonetheless, a study conducted by Matolcsy and Wright (2011) did not establish a significant association between performance measures and compensation of salary especially during global economic crisis period in the United States. On the other hand, there was a positive association between performance measures of companies and compensation of salary at the time of growth of the global economy (Matolcsy and Wright 2011).

nCompensation strategy adoptions

nMost of the companies in the United States use the strategy of compensation for corporate performance because connecting performance to payment can inspire people to accomplish better organizations goals. In addition, it helps to maintain higher levels of performance in the company (Cao, Lemmon, Pan, Qian and Tian 2014). In this regard, a variety of compensation-for-performance strategies has been introduced. In addition, a wide range of companies in the United States uses this strategy to motivate their staff including firms executives. Studies have noted that performance-for-compensation strategies play a crucial role in enhancing achievements of required outcomes at both the corporate and personal level (Tung 2011). Nonetheless, some empirical findings suggest that performance-for-compensation strategies do not have an effect on the corporate performances.

nA research by Capezio, Shields and O’Donnell (2011) investigated the uses of residual income-based (RI) payment strategies. The study noted that RI strategies were positively associated to rise in the residual earnings. Nevertheless, they were not meaningfully associated with the increase in wealth of the shareholders (Capezio, Shields and O’Donnell 2011). Based on the findings of this study, it is evident that payment strategies affect the performance of the executives in an organization. Gregg, Jewell and Tonks (2012) studied the decisions on investment of companies utilizing the RI strategies. The findings showed that the residual income (RI) payment strategies contributed to rise of residual earnings awarded which suggested that a company is able to achieve its desired level of performance based on its strategies (Gregg, Jewell and Tonks 2012).

nFurthermore, a research by Larkin, Pierce and Gino (2012) explored the adoption of suggestions for compensation of executives for corporate performance strategies. The findings of this research indicated that strategy proposals were substantially related to rise in the wealth of the stakeholders, especially those strategies designed for executives (Larkin, Pierce and Gino 2012). Lin, Kuo and Wang (2013) also conducted a similar study on the impacts of ownership programs on the corporate performance. Through these programs, executives are encouraged to hold least possible levels of corporate stock. Their findings demonstrated that the equity of executive ownership rose considerably after two years from the time of adoption (Lin, Kuo and Wang 2013).

nIn another research that explored the impacts of economic profit plans (EPPs), which provided rewards to managers when their income surpassed the capital cost, on performance and plan (Balsam, Fernando and Tripathy 2011). The findings indicated that expected economic profit plans adopters benefited from efficient management of assets. In addition, the study noted that there was a higher rate of profitability (Tung 2011). Besides the EPPs played a crucial role in the establishment of higher rate of shareholders value in many companies, but other organizations that failed to adopt these strategies did not record such advantages (Kaplan 2012).

nExecutive features

nIn a firm, CEO characteristics play a huge role in determining the expectations of organization performance as well as his/her compensation. In this regard, features such as executive identity with the organization, academic background and his/her age have a critical association with company performance and compensation of executives (Bell and Van Reenen 2016).

nExecutive tenure and age

nA research by Cao, Lemmon, Pan, Qian and Tian (2014) documented findings related to the effects of executive features on his/her remuneration. With regard to executive characteristics, the results proposed a noteworthy, executive age profile that improves following fifty-five years of age for entire compensation and cash. More significantly, the study noted that executive features such tenure and age have a significant and positive effect on both entire compensation and cash (Cao, Lemmon, Pan, Qian and Tian 2014). In this regard, older executives receive higher compensation because they have more experience as compared to younger executives.

nSimilarly, executives with extensive tenure also receive higher remuneration because they are deemed to possess more knowledge concerning the business or organization. Additionally, these executives have more entrenchments. A study by Armstrong, Ittner and Larcker (2012) established that the association between executives compensation and stock earnings deteriorates with tenure (Armstrong, Ittner and Larcker 2012). Conversely, Capezio, Shields and O’Donnell (2011) research noted that the performance of an organization is a critical factor of salary remuneration for executives in the initial period of their function such as first three years. However, it becomes insignificant factor after 15 years of service at the executive position in the company (Capezio, Shields and O’Donnell 2011).

nBased on the correlation results, the measures of performance based on both accounting and market have negative correlations with executives total remunerations irrespective of the duration of experience. According to Tung (2011), there is a positive relationship between the levels of executives compensation and their tenure. Moreover, researches also indicated a similar positive association between the sensitivity of executives compensation-performance and their tenure (Tung 2011).

nExecutives education

nThe education level of an executive in a company such as CEO is a major determinant in his/her selection to that position. Balsam, Fernando and Tripathy (2011) in their study investigated how the compensation of a CEO was associated with his/her educational background such as schools attended. In addition, the study examined how the academic level affected the performance of the company (Balsam, Fernando and Tripathy 2011). In this regard, the findings demonstrated that the academic background of its executives does not affect the corporate performance. Similarly, the results showed substantial disparities between salaries earned by executives based on their academic backgrounds. A research by Sigler and Carolina (2011), noted that the academic years have a positive and significant association on executive compensations (Sigler and Carolina 2011).

nKaplan (2012) study investigated the association between executives academics and the corporate performance, and established that there was no empirical evidence that executives that attended prominent academic institutions did not indicate outstanding performance as compared to those from less prominent schools (Kaplan 2012). Similarly, there was no significant association of high levels of academic qualifications such as MBA and better performance. Nonetheless, the academic qualifications played a central role in hiring and selection of executives although it did not influence overall performances of these organizations.

nExecutives duality and ownership

nAccording to Armstrong, Ittner and Larcker (2012), executives in a company possessing huge proportion of the organizations equity contribute to demand decline for more stock depending on compensations. The research also documented that a fragile structure of board governance is related to huge remunerations of executives and poor performance of the company (Armstrong, Ittner and Larcker 2012). Similarly, Bell and Van Reenen (2016) argued that the extreme remuneration of executives is related to poor corporate performances. The study also demonstrated that CEOs who held large proportion of shares in the companies acquired marginally greater remunerations as compared to other staff (Bell and Van Reenen 2016). According to Kaplan (2012) when there is a higher rate of ownership, the executives receive lower compensation. In addition, in most firms in the US, the CEO influenced the information and agenda presented to the board, which means that he/she sometimes, take the role of the chairperson of the board (Gong, Li and Shin 2011).

nWhen the board chairperson also acts as a CEO, the companys performance declines because of his/her inability to handle all the functions. In addition, the internal systems of control are not effective in maintaining proper performance of the company. Cao, Lemmon, Pan, Qian and Tian (2014) noted that duality contributes to huge compensations of the executives. They also reported that when an executive combines the functions of a chairperson and CEO, the remuneration is likely to increase significantly (Cao, Lemmon, Pan, Qian and Tian 2014). A study by Sigler and Carolina (2011) examined the relationship between performance and the duality of executives. The study documented that there is a negative association between the performance of the company and duality of the executives (Sigler and Carolina 2011). In other words, the study failed to establish a significant association between the performance of the company and composition of committee on board audit.

nNonetheless, according to a research by Capezio, Shields and O’Donnell (2011), the closeness of executives to members of remuneration committee in the firm was found to contribute to higher compensation of CEOs (Capezio, Shields and O’Donnell 2011). However, this led to another negative effect on the performance of the company. Conversely, the study revealed a positive association between the company performance and participation of the management in the hiring process of directors (de Villiers, Naiker and van Staden 2011).

nSocio-cultural features

nSeveral studies have indicated that socio-cultural factors play a major role in determining the association between corporate performance and compensation of executives

nCapital and social connections

nAccording to a study by Kaplan (2012), executives networks establish an important company resource. Firms in the US demonstrated that networks have a positive association with executive remunerations and the future performance of the organizations. The firm pays these persons for efficient connections they present to the company. The research also examined the responsibility of the managers networks in the decision making process of the firm (Kaplan 2012). It revealed out robust evidence that in companies where executives played a critical role in the network, they benefited from higher compensation but the performance of the company is not considered (Balsam, Fernando and Tripathy 2011). According to the researchers, the centrality of CEO has a negative effect on the performance of the company.

nThe study also noted that social networks of the CEO negatively affect the organizational performance, especially in large companies (Gong, Li and Shin 2011). According to a research by Armstrong, Ittner and Larcker (2012), executive utilize their security and power they acquire from holding accessibility to form a huge social connection. At this point, the executives tend to use this social connection to serve their personal interests instead of promoting the interests of the company (Armstrong, Ittner and Larcker 2012). Other studies noted that in the US, some companies have higher compensation for executives with large social networks; hence, these companies did not consider their performance (Cao, Lemmon, Pan, Qian and Tian 2014). Therefore, the network of executives is an important factor in determining the compensation package.

nPolitical connections

nPolitical factors play an important role in defining the performance of the company since the policies of the government influence anticipated cash flows in the future. Therefore, the company should function within the environment of legislation constrains. According to Kaplan (2012), political networks in corporate governance are considered as a social capital. The political connections are considered a resource in corporate governances. In this regard, the executives can utilize the political connectedness to influence the kind of policies made by the government (Kaplan 2012). Moreover, they help to advance the interests of the organization, which can increase the chances of improving the performance of the company.

n A study conducted by Balsam, Fernando and Tripathy (2011) examined the effect of remuneration of firms executives based on incentives aiming to improve the companys performance (Balsam, Fernando and Tripathy 2011). Similarly, the study examined the effects of executives promotions as incentives to enhance companys performance in the United States firms. The researchers found out that in some states, political and monetary incentives are positively associated to the performance of some organizations. Cao, Lemmon, Pan, Qian and Tian (2014) also revealed out that political networks in an organization could also lead to negative effects especially in its performance. For instance, the study noted that organizations that had no political connections were performing better than those that had political connections (Cao, Lemmon, Pan, Qian and Tian 2014). In this regard, the findings of this study suggested that the cost of networks in politics of the executives counterbalances the benefits it produces.

nHowever, the research had some limitations because it failed to offer clear empirical evidence of ways in which connections in politics influenced the organizations performances (DeYoung, Peng and Yan 2013). A similar study by de Villiers, Naiker and van Staden (2011) revealed that political connections had positive associations to the degree of remunerations of executives. However, political networks of the executives had a negative relationship with regard to performance (de Villiers, Naiker and van Staden 2011). Precisely, the findings demonstrated that political networks could contribute to an increase of approximately 9 per cent of the total compensation of a CEO per year. Unfortunately, on the other hand, political networks can lead to an estimated decrease of 17 per cent in the performance rating of the executives leading to the downfall of the organization (Bell and Van Reenen 2016).

nSocial justice

nThe effects of social justice on organization performance have been through literatures that have examined it based on two opposing theories. The theories include Equity fairness and Tournament theory. Based on information from existing literature, there are limited studies on the tournament theory. According to Fernandes, Ferreira, Matos and Murphy (2012), the organizational performance is positively related to compensation dispersion of the executives. Additionally, they also noted that the disparity in remuneration of executives is not related to better performance of the organization (Fernandes, Ferreira, Matos and Murphy 2012).

nOn the other hand, equity fairness theory proposes an equitable salary distribution to promote pleasant social association at the labour force to boost the performance of the company. A research conducted by Hagendorff and Vallascas (2011) in the United States documented that higher salary dispersion among the executives contributed to a reduction in their work satisfaction, which affected their productivity. In addition, teamwork and efficient working relationship was negatively affected by these factors (Hagendorff and Vallascas 2011). Therefore, the research recommends use of the equity fairness when determining the compensation levels of the executives based on their performance rate in the company.

nConclusion

nBased on the arguments of the scholar on the issue of compensation of executives based on their performance, companies in the United States apply a wide range of models in their corporate governance. For instance, there is a theoretical and an empirical difference in terms of compensation-performance relationship. The analytical discussion of the association between compensation of executives and organization performance indicated that there are some quantifiable noticeable aspects, which influence this connection (Balsam, Fernando and Tripathy 2011). The review of literature revealed that some of these factors include organization features, compensation characteristics, executive features and socio-cultural factors in the United States.

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nReferences

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