Ceo Compensation Is A Economic Reward Commerce Essay

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CEO compensation is the economic reward given to an individual, measured by their basic pay, bonuses and stock options. According to Armstrong (2010) "no aspect of remuneration has attracted as much attention recently as that of the pay of directors and senior executives, especially since the 2008/09 banking crisis". One of the few things that anti-globalisation campaigners and most stock market investors agree upon is that executive pay is out of control. It is not hard to understand this shared outrage: executive pay has exploded since the 1980s and for most of the post war era, executives earned a few multiples of the median pay. However, thereafter, starting in America and slowly spreading to the rest of the world, the multiples increased exponentially. Today many American workers claim to earn in a year what their boss takes home in an evening. Isn't this a scandal that needs investigation? Critics of executive pay worry that even mediocre bosses are given outsized rewards. Example, Robert Nardelli received a $20m pay-off when he left Home Depot although the share price had fallen during his six-year tenure. Carly Fiorina was $180m better off when she left Hewlett-Packard despite an uninspiring tenure. Defenders of executive pay argue that great bosses such as Louis Gerstner, the former boss of IBM, and Jack Welch, the former boss of General Electric, are worth every penny because they create huge amounts of wealth for both shareholders and employees. The debate about executive pay, though never cool, is particularly hot at the moment were workers have been squeezed by the recession. Unemployment is high in a number of many countries and numerous governments are planning to deal with their rising deficits by freezing public-sector pay. Despite this, many bosses and bankers continue to make out like bandits-or so lots of people think.

The question remains however, "are top executives worth what they are paid?" This position paper focuses on whether these "top executives" are really worth their compensation packages and what has been used to determine such value to these individuals.

BACKGROUND ON EXECUTIVE COMPENSATION:

Chief executive officers are not the only highly paid people in today's economy, it's just their misfortune that, thanks to disclosure rules, they're among the most visible.

 In the past three decades, the difference between CEO's compensation and that owned by the average employee has increased dramatically. Prior to World War II, average compensation of top executives was about 63 times higher than average earnings and this ratio fell significantly during the war years, so that by 1945 the remuneration of top executives was 41 times average earnings (Rockoff 1984, Goldin and Margo 1992).

During the 1960's the average CEO earned some 40 times more than the average employee and by 1990 this figure had increased to 107 times. The New York Times has reported that these figures increased in the next decade to 525 times and by 2003, it was reported as 301:1. Still a very wide gap and opening many questions in terms of equality and ethical concerns, HR practitioners are faced with many questions in terms of controlling and managing executive compensation. Much research has been conducted on this area and has attempted to relate performance to compensation. According to Tosi & colleague (1989) about 250 studies on executive compensation and performance have been conducted during the last century but the outcomes of these studies are disappointing (Miller, 1995).

Many additional research has attempted to discover the determinants of CEO compensation using different methods however, the controversy still exists, regarding the most important determinant of CEO compensation, their attributes and how exactly do they influence executive compensation. Reliability of the sources used to acquire data on this topic by different research, has also proven to be controversial and still debatable. Many disagreements have arisen due to the different methods used in various researches to determine the relationship among various determinants of CEO compensation and since internationalization, workplace diversification, profit maximization and the demise of various large companies has strengthened the need for synthesis of determinants of CEO compensation globally. However, none has essentially settled on the views of whether CEO's are worth their exorbitant salaries or whether they are not.

LITERATURE REVIEW

Executive pay has been a much debated issue in practice as in theory and debates still exist on how executive pay levels and structures can be explained and whether executives are "Overpaid". There is hardly any other aspect of business life that attracts the newspaper headlines as much as executive pay. Almost every day, the media displays outrage about the tremendous heights that executive salary, bonuses and other financial gratuities have soared to. Along with all this turmoil, boards of directors still have problems explaining how, how much, and why they pay their executives as they do. Although many different theories can and are used to explain executive pay, the field is still dominated by the perfect contracting approach of the agency theory as introduced by Jensen and Meckling (1976). This "official story" on executive pay (Bebchuk and Fried, 2004) holds that executive pay is an instrument to alleviate agency problems. To provide the separation between firm ownership and firm control harmless, the wide spread story is usually that executive pay is an instrument to align the interests between shareholders and management (Bebchuk and Fried, 2004).

Based on arguments of market forces and behavioural assumptions of actors risk preferences, pay setting is "simply" seen as a matter of optimal pay design (Gomez-Mejia and Wiseman, 1997). Market forces are assumed to lead to optimal pay levels and structures, compensating executives for the risks they are willing to take to manage the corporation in the best interests of its shareholders (Jensen and Meckling, 1976, Jensen and Murphy, 1990b). One of the most researched relationships in the executive pay literature is the relationship between pay and organisation performance (Gomez-Mejia, 1994; Barkema and Gomez-Mejia, 1998).

Besides the dominant perfect contracting approach of agency theory, two other theories have been reviewed and are discussed. The theories are categorized in three types of approaches.

1) The value approach, comprising of theories that focus on the question how much to pay;

2) the agency approach, comprising of theories that focus more on the question how to pay; and 3) the symbolic approach, comprising of theories that focus more on the question what

executives "ought" to be paid.

Despite the many differences between these theories, the current state of the literature has given rise to signs of convergence in theorizing about executive pay. Observing executive pay is more and more considered to be an observation of the fundamental governance processes in an organization (Hambrick and Finkelstein, 1995) thus, the pay setting process and the result of this process in given pay levels and structures are increasingly seen to have implications for being influenced by socially constructed corporate governance arrangements, organizational processes, and to have implications for executive motivation and motivation for lower level employees . [1] It is argued here that further theorizing and any future attempt to explain what is truly going on in the world of executive pay should more be focused on all mechanisms

that actually shape executive pay. To unravel all of the "nuts and bolts" of executive pay, logical more fruitful explanations thus focus much more on the actual decision making process in which pay is set, rather than finding explanations of pay itself (Elster,1989). The literature on executive pay further reveals at least three major implications for our understanding of executive pay and for further theory development. In contrast to the dominant approach it is argued that:

1) executive pay is not merely a "tool" to align interests between shareholders and executives, but is much more an outcome of pay setting practices;

(2 the actors involved in these pay setting practices have considerable discretion not

only to influence their own pay or the pay of others, but also have discretion to

influence the development and workings of the mechanisms of these practices; and

(3 pay setting practices cannot be fully understood without completely understanding

the implications of national corporate governance arrangements.

The further classification of these three approaches is based on the main role that salary plays in a specific theory and on the underlying legitimizing arguments/ mechanisms of pay within a given theory. The three approaches labelled respectively are:

THE VALUE APPROACH

This approach consists of the following five different theories:

1) marginal productivity theory, 2) efficiency wage theory,

3) human capital theory, 4) opportunity cost theory, and

5) superstar theory.

Within this value approach, the marginal productivity theory is apparently the most

fundamental theory. The input from executives, i.e. the services they provide to the

firm, is treated as any other input factor of production (e.g. Roberts, 1956).

The value of this input is equal to the intersection of supply and demand on the labour market for

executives and this equilibrium pay is equal to the executive's marginal revenue product. The human capital theory, argues that an executive's productivity is influenced by his accumulated knowledge and skills, i.e. his human capital. The more knowledge and skills an executive has, the higher his human capital will be. The third theory, efficiency wage theory (Lazear, 1995; Prendergast, 1999), argues that executives will put in extra effort if they are promised an above-market-level wage. Because pay is set at a level above market level, executives are less likely to leave the firm or to shirk their work, and will feel their contributions to the firm are valuable. An opportunity cost approach, argues that the transparency of job-openings on the executive labour market makes it possible for executives to change employers. This perspective argues that in order to hire or retain an executive the level of pay must at least be equal to the amount that would be paid to an executive for his next best alternative (Thomas, 2002; Gomez-Mejia and Wiseman, 1997). The fifth theory is superstar theory (Rosen, 1981). Although Rosen (1981) does not specifically address the implications of this theory in regard to explanations of executive pay, the theory does indeed address the skewness in the distribution of income. According to Rosen, less talent is hardly a good substitute for more talent and thus imperfect substitution among different "sellers" of talent exists.

When combining the joint consumption and the imperfect substitution features, it becomes apparent that talented persons can serve very large markets and subsequently receive large incomes (Rosen, 1981). The skew-ness in the distribution of executive pay could thus further be explained by the disproportionate premiums that firms are willing to pay for executives' talent or

capabilities for which no good substitutes exist.

THE AGENCY APPROACH

Rather than determining how much to pay executives, the central legitimizing issue in

the agency approach is how to pay them ( Barkema, Geroski, and Schwalbach,1997; Jensen and Murphy, 1990a). Pay levels in this approach are mainly assumed to be based upon the market value of executives' services. Pay is seen as a consequence of agency problems and exists in any situation where one party entrusts responsibility of tasks to another party. In the agency approach a distinction can be made between two groups. One group consists of theories that consider executive pay as a (partial) solution to overcome agency problems by incentive alignment and the transference of risks and the other comprises of theories that consider pay as a result of executives' discretionary powers resulting in turn from agency problems. Both groups consider executive pay as a "tool" with which to alleviate agency problems. Executives are willing to take risks under certain circumstances, i.e. to avoid losses or missing goals or targets.

THE SYMBOLIC APPROACH

This approach to legitimizing executive pay comprises of theories that consider pay more as a social constructed symbol fitting the expectation, status, or role that executives play in a society or firm. The legitimizing arguments are based on social economically constructed beliefs about executive roles and how pay ought to reflect this.

The symbolic approach consists of seven (7) theories:

1) tournament theory, 2) figurehead theory,

3) stewardship theory, 4) crowding-out theory,

5) implicit/ psychological contract theory,

6) social enacted proportionality theory, 7) social comparison theory.

Tournament theory (Lazear and Rosen, 1981) treats pay as a prize in a contest.

Setting a high prize provides incentives for the contestants to climb higher on the corporate ladder (Rosen, 1986) and indirectly increases the productivity of competitors at lower levels (Balsam, 2002). Figurehead theory argues that behaviour is assumed to reflect purpose or intention and that a diversity of goals and interests co-exist within firms (Ungson and Steers 1984). Because of the different roles that managers play and represent, the "appropriate role for the manager may be [that of an] evangelist" (Weick, 1979: 42). Executive pay is viewed as part of the status the executive has within and outside the firm and is intended to reinforce this figurehead image (Gomez-Mejia, 1994). Stewardship theory argues a contradicting view on governance (Davis, Schoorman, and Donaldson, 1997; Donaldson and Davis, 1991). Stewardship theory does not provide a-priori clear hypotheses about pay levels or pay structures and could therefore be questioned as a useful theory to legitimize executive pay. Nevertheless, the views are addressed because the theory does attempt to explain that executive pay does not have to be (strongly) related to shareholder wealth or other measures of the firm's financial performance (Davis, Schoorman, Donaldson, 1997). Extending on the balance of intrinsic and extrinsic motivation, crowding-out theory argues that monetary incentives can crowd-out intrinsic motivation and thereby also good intentions (Frey, 1997a; 1997b). Compensation plays a part of executive motivation, but intrinsic motivation to pursue organizational goals is likely more important. There is a delicate balance between intrinsic and extrinsic motivation. Compensation levels that are too high or the provision of too many extrinsic incentives could drive out intrinsic motivation, resulting in lower efforts by the executives. In turn, high pay levels and high incentives could result in behaviour that pursues goals that are not in line with the

best interests of the firm (e.g. corporate fraud) (Frey and Osterlőh, 2005).

Implicit contract or psychological contract theory (, 1985; Kidder and Buchholtz, 2002; Baker, Gibbons, and Murphy, 2002). This theory argues that a contract exists between an individual and another party that is composed of the individual's beliefs about the nature of the

exchange agreement. Based on social exchange theory, relational contract theory tends to rely on principles of generalized reciprocity. In this respect Baker, Gibbons, and Murphy (2002) use the term relational contracts. Baker et al. (2002) argues that a relational contract is composed of informal agreements and unwritten codes of conduct that affect individuals' behaviour. Compensation is seen as a symbol that reflects appreciation, accomplishment, and dignity (Kidder and Buchholtz, 2002). The socially enacted proportionality theory argues that the value of an executive is the result of positions of different ranks within a firm. Furthermore, it is socially accepted that executives and their immediate subordinates have different salaries. This line of arguing can be followed down to the lowest organizational level where employees are

hired outside the firm. Salaries at this level are set by forces of market competition.

The social comparison theory is also based on comparison but comparison is made at the top level of the firm and with executives externally to the organization. It is argued here that executives use their own pay as a reference point when setting the pay of other executives. This theory originates from the argument that people have the drive to evaluate their abilities and

options. People tend to use other people with similar performances and/or ideas to themselves when selecting reference points. In the case of setting executive pay, executives rely on normative judgments of their own pay and experience and on judgments of the experience and pay of other executives (Gomez-Mejia, 1994; O'Reilly et al., 1988).

CRITICAL ASSESSMENT OF LITERATURE REVIEW

As indicated by Gomez-Mejia (1994), many empirical studies test hypotheses derived from a variety of theoretical models. The contradicting results of these studies have implications for more than one theory. The still ongoing debate about a link between pay and performance is a case in point (Rosen, 1990). Where some argue that the link is not strong enough to support incentive (alignment) arguments, others argue that the link at least exists and would show support for these type of theoretical implications (Gomez-Mejia, 1994; Gomez-Mejia and Wiseman, 1997;Jensen and Murphy, 1990b). Overall, empirical studies on the determinants of

executive pay lack theoretical foundations and show a rather weak fit with the data (Hambrick and Finkelstein, 1995; Mueller and Yun, 1997)2. Subsequently, scholars' known biases and ideological orientation often serve as the best predictors of the findings presented (Gomez-Mejia, 1994; Gomez-Mejia and Wiseman, 1997). Although the theoretical assumptions of the theories are at times fundamentally different, the implications of the different theories provide more

insights than each theory would provide on its own. The question that arises is how the different approaches as set out above can be useful to provide more conclusive explanations for executive pay, and by that provide a better understanding of the legitimization of executive pay in theory and in practice?

Central roles for economic reasoning, pricing and market mechanisms are apparent in

the value and agency approaches on executive pay. These theories argue that market

forces could form a solid basis for explaining executive pay. Most of the theories researched has ideally agreed that market value is one of the key determinants on CEO compensation and legitimizes this as justification for their worth. It could be argued however, that the dominant use of the perfect contracting approach of agency theory in the executive pay literature has become "institutionalized" as wide spread use of this theory has evolved as the standard, or "official story" (Bebchuk and Fried, 2004), when attempting to legitimise executive pay.

Legitimizing executive compensation exclusively based on efficient market assumptions are however problematic and as also made clear from the theories in the agency approach, the actual decision making process within the firm is of importance. Markets cannot decide on anything and provide only signals to inform the decision making process as they are simply not strong enough to completely influence efficient decision making on executive pay.

Within these approaches, executives can influence the board of directors and the pay setting process and they are in the position to influence the board of directors when negotiating their own pay. This insight postulates that executives could be seen as a social class, as indicated by the class hegemony theory, emphasizes the notion that the relative balance of power in societies of different classes could influence corporate governance arrangements and their outcomes in, for instance, certain pay levels and structures.

Especially apparent in the dominant perfect contract approach, but also in many other

economic theories on executive pay, individuals are most often reduced to a set of

"ontological actors, frozen in space and time and isolated from social and cultural

context" (Aquilera and Jackson, 2003; 449).

While each approach legitimizes CEO compensation, each approach comes with its' own difficulties and creates some problem in terms of managing equity and other ethical concerns.

CONCLUSION AND RECOMMENDATION:

In concluding my thoughts on this position, I would like to draw comparison to Vikram Pandit.

In 2008, Pandit became the CEO of Citigroup. He had joined the company six months prior as Head of Investment Banking and Alternative Investments after Citigroup purchased the hedge fund he managed, Old Lane Partners, for $800 million. Between the $165.2 million in proceeds Pandit accrued in the sale and the $40 million compensation package he was offered when appointed CEO, the New York Times dubbed him "Citigroup's quarter billion dollar man."Despite these headlines, Pandit never actually received this amount of money. By the time his share of Old Lane Partners was liquidated in May 2008, it was worth only a fraction of the original value, and the nearly $40 million in restricted shares and stock options awarded to him at promotion were worth only $4 million when they vested years later.

As this example suggests, executive compensation figures are not always what they seem. Executive compensation packages contain a diverse mix of cash and non-cash incentives, payable in one or multiple years and subject to accruals, estimates, and restrictions that often render their ultimate value quite different from their expected value.

While I agree with Edwin Locke [2] , that "I would not say executives with high pay are overpaid just because they are paid highly", I also agree that running a company today is 100 times more difficult than it was in 1960. It takes talent and willingness to take risks, to successfully run an organisation in today's economy. I believe they are worth their salaries especially for the risks they endure (24/7/365 - affecting family life, health and personal privacy). In the United States, the United Kingdom and elsewhere, top executives are routinely being criticised for being overpaid. It is being argued that boards do not respond to market forces, but, instead, are dominated by or are over-generous to their Executives.

They are criticised for not tying Executive Compensation to performance and criticisms have been exacerbated by the financial crisis and the desire to find scapegoats.

It is my belief that these critics are wrong and that there are many misperceptions of Executive Compensation. While executive compensation practices are not perfect, they are driven by market forces and performance and contrary to employee and public perception, executive compensation has not gone up in recent years. In fact, the average CEO pay (adjusted for inflation) has dropped since 2000, while the pay of other groups has increased substantially. The following graph shows average and median expected CEO pay for S&P 500 CEOs since 1994 (adjusted for inflation). It shows that median CEO pay has been stable since 2001; it has not increased and average pay has actually declined substantially. In fact, average CEO pay in 2008 is below the average in 1998.

Chart 1

However, as an HR Professional, when your employees begin thinking that the organisation's strategy has been cast to enrich executives at the expense of shareholders and employees, you are thus faced with a serious internal strategic problem.

It is then up to HR Practitioners to return some equity to compensation of upper management and the individual contributors while trust and respect between the both parties (Employer - employee) still can be salvaged.

From all the literature reviewed, the most workable solutions in my view are those mentioned by Rick Newman, 2009. These are as follows:

Link pay to long-term performance.

Some executives earned millions for driving their companies into the ground because their bonuses and other incentives were linked to quarterly or annual results, not to the company's health in three, five, or seven years. This led them to take risks that boosted short-term performance without worrying about long-term consequences, which obviously didn't work out so well (Enron). Compensation committees should be developed to devise specific formulas for measuring long-term performance

Allow claw-backs.

If you buy a computer or refrigerator that doesn't work out the way you expect, odds are you'll be able to get your money back. But CEOs have been able to wreck companies and walk away unscathed, without returning any of their pay. This would give companies the legal right to reclaim CEO pay if unhappy surprises surface after the boss has pocketed bonuses and other compensation. This might dissuade CEOs from inflating revenues or profits to boost short-term results or concealing risks that could become a problem later on.

Shareholders need to be more involved.

One way to empower shareholders is to enact "say on pay" rules that allow them to have at least an advisory vote on executive pay packages.

"Shareholders have a responsibility to avoid a 'check the box' approach to advisory votes on executive compensation and critically examine recommendations of proxy advisory firms," says the Conference Board.

The Lake Wobegone effect needs to be curtailed.

Most big companies hire outside consultants to evaluate what CEOs get paid at other similar firms, a practice that inevitably leads to pay inflation. The consultants typically determine a pay range for "peer group" companies, with a figure that represents median pay. As a result, most CEOs get above-average pay and the peer group median goes up and up, a practice that has boosted CEO pay to about $8.4 million per year, according to Hewitt Associates.

Lavish perks should be reined in. The list of questionable CEO privileges includes huge severance packages that can be multiples of annual pay, unrestricted use of corporate jets, taxes on perks that count as income, lavish "golden coffin" death benefits that accrue to families, and any other payouts not approved by shareholders. One rule of thumb would be to avoid any perk or payment that's generally controversial and, if in doubt, put it to a shareholder vote.

By implementing these recommendations, it is my view that executive compensation would be viewed differently and all individuals (employees, shareholders and stakeholders) would be able to understand that CEOs are indeed worth what they are paid, and will understand how it is done and why.

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