1. An Introduction
3.2. The Conventional Narrative on the Executive Pay Setting Process
3.2.3. Some Reasons why the Current Pay Levels are said to be Efficient
The mainstream view argues basically that current pay levels are mostly the efficient
outcomes of an efficient process23. Under agency theory, compensation packages are
designed to align pay with firm performance with the intent being, to cause managerial
wealth to move simultaneously with shareholder value24. This according to agency
theorists is the solution to the agency problem and the optimal way of reducing transaction costs.
Agency theory is premised on three key factors; a moral hazard problem, managerial
greed and risk aversion25. These could negatively impact managerial output and cause
them to shirk their duties, seek rents, and greatly inhibit their effectiveness. All these problems per agency theory enthusiasts, are best countered by utilising interest aligning incentives26.
3.2.3.1. As a Solution to Agency-Related Problems:
Agency theorists, argue that there would be diverging interests between managers
and investors and this divergence could lead to residual losses27. Manifestations may
include, an excessive appetite for perquisites or unwarranted acquisitions causing the firm to grow larger, but less efficient. These are managerial idiosyncrasies which accordingly could be traced back to an inadequate incentive regime between the firm
23 Conyon (n18) 25. 24 Ibid, 28.
25 Ibid, 29.
26 Michael Jensen and William Meckling ‘Theory of the Firm: Managerial Behaviour, Agency Costs and
Ownership Structure, Journal of Financial Economics, [1976] Vol.3 No.4 305-360.
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and management28. Therefore, the way to effectively stem these losses, would be to
pay executives well enough to eliminate the need for empire building or the thirst for superfluous perks. While ensuring that pay, is effectively and efficiently aligned to a
firm growth index29.
As it goes by paying more and efficiently linking pay to performance, the firm could eliminate the moral hazard problem. That managers, being aware of this link between pay and performance, would be less likely to shirk and more likely to maximise effort. In the same vein, be more willing to take the risks required to grow the firm and maximize potential and profits. It is important to note, that the efficacy of agency theory is premised on managerial self-interest and one to which agency theory has failed to legislate a proper cure. How do you eliminate greed in the manager-owner continuum?
The failure to find an answer to the above question would mark a flaw in the agency/principal, pay for performance argument, and has possibly rendered it not quite as effective as it would have been intended to be. Some authors have recognised that managers being naturally greedy, would seek avenues to extract rents and having the kind of power they wield in the Anglo-American dispersed shareholder model of
governance, makes it even more likely that they would succeed30.
28 Michael Jensen and Kevin Murphy ‘Remuneration: Where we’ve been, how we got to here, what are
the problems, and how to fix them’, Finance Working Paper No. 44/2004, July 2004, 21.
29 Bebchuk and Fried (n5) 19.
30 Lucien Bebchuk and Jesse Fried ‘Pay Without Performance: An Overview of the Issues’ Journal of
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Although the performance related pay theory looks valid in principle, the application rings a different tune entirely. It could be argued, that there exists a linear connection between performance-related pay and the current high executive pay culture. Pay for performance represents a fine concept which sought significance within a flawed system and took on different kind of significance far drawn from what could have been its original intent. The flaws could not be said to be with the concept itself, at least not entirely, rather with the governance structure in place in the system, within which it was meant to operate. This misuse could be owed in no small measure to the status quo of powerful managers and an inadequate or unwilling monitoring apparatus. It must be said that the current profligacy in the design and composition of CEO compensation, could mostly be attributed to a weak or possibly compromised
monitoring framework31. Whether this bears as evidence managerial influence is yet
to be seen, what it does state however, is that the system of compensation both in its structure and output is far from optimal, much unlike the mainstream narrative would like us to believe.
3.2.3.2. Because Managers Deserve High Pay:
High pay is frequently justified as the just deserts for CEOs in relation to their marginal
productivity32. This argument is premised on the fact that larger portions of executive
31 Bebchuk et al critiqued the design of compensation packages stating that the use of ‘at the money’
options aided the growth of managerial compensation levels and further evidenced the influence managerial power had over the pay setting process. See, Bebchuk, Fried and Walker (n2).
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pay are performance-related33. It is believed, that company boards set performance-
related compensation higher than they would have if it were a fixed wage regime, as an additional incentive to naturally risk-averse managers. Bebchuk et al argue, that performance-related compensation is worth less to executives than a fixed salary. Therefore, those who design compensation structure it in such a way, to ensure that the manager’s potential earnings are similar to or higher than the manager’s
reservation value34. As such, the board could tie pay to the attainment of certain
performance metrics i.e. share price increases, return on earnings etc. which would trigger an award of shares and/or an accounting-based cash bonus. Plus, in some instances additional perquisites could be given as part of the system of reward. In the event of an award of company shares, the compensation realised would be determined by the share price at the time of vesting. Therefore, if the firm had experienced major growth spurts over the vesting period, the manager would be well rewarded thus.
These share award programs have become an integral part of the compensation
policies of most publicly traded companies in the U.K and U.S35. The apparent
simplicity of this approach, ensures that it ignores certain important factors which would be looked at in the next section.
33 A survey of firms within the FTSE 350, has shown that salary payments comprise only a fifth of top
manager’s total compensation, with incentive-based compensation making up the rest. See, High Pay Centre Report ‘Executive remuneration in the FTSE 350 – a focus on performance-related pay’ October 2014. http://highpaycentre.org/files/IDS_report_for_HPC_2014_final_211014.pdf. (accessed
16/03/2015).
34 Bebchuk, Fried and Walker (n2) 762.
35 Jensen noted in the early 1990’s, the negligible impact firm performance had on CEO pay and called
for pay to be made more sensitive to company growth, by making CEO’s hold substantial amounts of firm stock. That being said, today it is estimated that over 95 per cent of U.S managers received some form of their compensation in equity.
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Furthermore, proponents of the mainstream view, argue that executive pay is just reward for talent. This is further exacerbated, they argue, by a shrinking pool of global
CEO talent36. Citing the apparent lack of credible and tested managerial talent, which
they believe gives managers leverage in the negotiation process. That the independent board, in a desperate bid to attract and retain the best talent, are forced to negotiate exorbitantly priced pay packets.
This argument, appears to ignore figures which reveal that, more managerial talent is
drawn from within the firm, than those hired from outside37. Although, it is said that
outside managers usually command higher sums in wages, than those hired from within the firm38.
Further on the managerial talent argument, one author has stated that CEO’s are paid better than other employees, due to their uncanny forecasting and risk assessment
abilities and the importance of these skills in the post-crisis economy39. Srivastava,
disregards prior research, which put current pay levels down to managerial rent- seeking behaviours. He argues instead, that because CEOs can forecast share price movements and the firms overall risk exposure, better than the market can in some instances, they are able to command higher wages. Stating that research had shown, that firms recognising the importance of this skill have begun to link certain components of compensation to these forecasting abilities. Which he believes could
36 Bebchuk and Fried (n5) 20. Randall Thomas (n3) 1230.
37 A recent study showed that 80 per cent of companies within the global Fortune 500, recruited CEOs
from within the company and of those with outside recruits, only four of such recruits were hired while holding CEO posts. See, David Bolchover ‘Global CEO Appointments: A Very Domestic Issue’. Available at (http://highpaycentre.org/files/CEO_mobility_final.pdf).
38 Kathryn J. Kennedy “Excessive Executive Compensation: Prior Federal Attempts to Curb Perceived
Abuses” Houston Business and Tax Law Journal, Vol. 10 2010 pp. 198-259 at 207.
39 Anup Srivastava ‘Do CEOs possess any extraordinary ability? Can those abilities justify large CEO
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explain the unparalleled rise in managerial compensation, which is maximized to
encourage the utilisation of this ‘rare’ skill40.