Theorizing the Pay-Performance Relationship

Abstract

Executive compensation is significant in modern corporate governance. This paper provides an overview of three of the most widely used theoretical frameworks for describing executive compensation, which is the value, agency, and symbolic models. A critical assessment of the three theoretical approaches indicates that their application in explaining executive pay neglects many external factors that should determine compensation. The author concludes that a more comprehensive approach to understanding executive compensation could be founded on socially constructed arrangements in corporate governance in which all the players involved have significant discretion to affect the outcomes of their decisions.

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Introduction

Executive pay is one of the most widely discussed topics in corporate governance, especially during this age of corporate social responsibility. Studies note structuring compensation for the services rendered by Chief Executive Officers (CEOs), is among the most critical functions of modern human resource management since it directly affects corporate strategy, firm performance, and the behavior of employees (Bolton, Mehran & Shapiro, 2015). The determining factors and implications of alternative executive pay programs have been extensively studied. Precisely, different conjectures related to the elements that result in high levels of CEO pay and the resultant organizational performance have received a multidisciplinary focus in research, such as from political science, sociology, psychology, finance, and economics scholars (Bettis, Bizjak, Coles & Kalpathy, 2018).

Presently, studies report that CEOs receive premium pays and that the levels of their compensations are so large that they warrant public and governmental scrutiny. For example, according to Edmans and Gabaix (2016), the executives of the biggest companies in the US received a mean of $15.6 million as compensation for the services that they offered to their firms in 2016, which is close to 271 times higher than the average annual compensation that a typical worker makes. The trend in executive pay is such that CEO compensation is exceedingly high and it continues growing faster than what the rest of the employees receive. According to Carberry and Zajac (2017), the reported statistic indicates that insignificant proportions of organizations’ efforts and profits are being shared with ordinary workers despite their importance to the success of corporate processes. Comparatively, an online article reporting statistics about executive compensation indicates that corporate managers earned only thirty times what their employees made in 1978 (Conyon, 2014). The latter literature indicates that the compensation strategies were scaled with each employee, including CEOs in the organizations because of considerations for ‘internal equity.’ However, external equity became the approach to executive compensation during the 1980s, which suggests that firms began paying their CEOs on a scale with their counterparts in other companies (Bolton et al., 2015). Considering firms are different in their resource capabilities, the pay scale adopted in the 80s soon became problematic.

Studies report that the huge compensation packages that CEOs have received over the past few decades have been bolstered primarily by huge stock grants, options gains, supplemental retirement pay, and long-term incentive pay. For instance, as Carberry and Zajac (2017) report, only thirty-seven percent of CEO compensation in 2013 involved cash while fifty-four percent was in the form of stock and stock options. The same report indicates that a significant proportion of corporations in the US included stock options in their executive compensation packages following the economic crisis of 2008. The reasoning behind this decision was the idea that the low value of stocks during the economic recession meant that giving the CEOs excess equity would probably make the companies richer in the future (Bolton et al., 2015). Consequently, it is notable that these types of compensation plans always connect executive retribution to the financial performance of their companies through the inclusion of criteria that focus on market-based and accounting measures.

Nevertheless, some scholars have consistently doubted the effectiveness of connecting executive retribution exclusively to any financial returns considering that such a practice could result in unintended consequences (Mengistae & Colin Xu, 2014). Other researchers have further explicitly blamed the overwhelming concentration on organizational financial performance for the wave of corporate scandals that have emerged in recent years (Bettis et al., 2018). According to the latter literature, “the foundation of business malfeasance is the continued emphasis that firms have been compelled to give to the maximization of shareholder value in the past few years without considering the potentiality of adverse outcomes of such decisions (Bettis et al., 2018). These concerns have also come in the wake of growing public and governmental interests in the approaches that companies use to compensate their top executives.

In line with the recent concerns, this paper reports the theoretical grounds that found corporate executive compensation strategies. Precisely, the research paper answers the question, “What theoretical models inform the executive compensation strategies by American businesses, and what implications do such theories have on the performance of the firms?” The author finds it necessary to subdivide the paper into two major sections, which are presented as follows:

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  1. Theoretical Foundations—this section reviews the literature on the theories that inform corporate executive retribution. Precisely, it focuses on the three most widely used theories, which are the agency and marginal productivity theories. In answering the research question, the author includes both the primary ideas of the theories and what they mean for corporations.
  2. Critical Analysis—This section includes an in-depth description of the application of the reviewed theories, including the advantages and drawbacks of their usage as well as the issues that remain unsolved.

Reading this paper informs the relationship among the different theories that the literature appraises, noting the shortcomings and advantages.

Theoretical Foundations

While elaborating on the overviews of previous researchers, such as Luo (2015), sixteen individual theories could be used in addressing the issue of executive compensation, and they can broadly be categorized into three. Such a classification, as the latter study indicates, is based on the primary role played by executive pay as perceived by each theory as well as the underlying arguments that legitimize CEO compensation. First, the theories can be grouped into the value model, which addresses the issue of how much the executives should be paid. In legitimizing the practice of paying top managers, the model contests that market forces set the levels to which the professional should be paid. In this sense, according to Shan and Walter (2016), pay is considered the market value of the executive services that CEOs provide to their companies. Second, the agency model perceives executive retribution as a result of agency problems, and its central premise is how to pay business executives. In justifying the pay structures adopted, the theory indicates that market forces and the conceptions of CEO about risk determine the approach to compensating executives. Lastly, the symbolic approach perceives compensation as a reflection of achievements, dignity, status, expectations, and that it plays an extra role in motivating executives (Edmans & Gabaix, 2016). Proponents of this latter theory argue that socially constructed beliefs concerning the implications of serving corporations in executive positions should inform the approach to compensation. Therefore, the model deals with the question of the manner in which socially constructed ideas influence executive compensation. The succeeding paragraphs address each of the three models in detail.

The Value-Based Model

The value-based theory perceives compensation as a reflection of the market value of the services that executives provide to their companies. Notably, the approach applies the laws of demand and supply that are widely described in the economics literature as the determining factors for the levels of executive retribution. The legitimization of executive pay, as Conyon (2014) notes, is grounded firmly in arguments on market mechanisms and forces. Five individual theories constitute the value-based model of executive pay, and they include the superstar model, opportunity cost theory, human capital model, efficiency wage theory, and marginal productivity theory (Shan & Walter, 2016).

In the constructs of the value-based model, marginal productivity is assumedly the most dominant theory explaining the approach to executive pay. According to the theory, the executives’ inputs into the business process are treated in the same way as the rest of the factors of production (Bolton et al., 2015). As the latter study indicates, the value of such input is the same as the equilibrium of demand and supply in the labor market for CEOs. Consequently, the level of executive pay in this approach is the same as the marginal revenue product from the executives. Marginal productivity could therefore be defined as the realized organizational performance minus the perceived performance of the same firm if an alternative executive would have been in charge plus the costs involved in the acquisition of the alternative CEO (Shan & Walter, 2016).

The second theory, the human capital model, an accumulation of skills and knowledge (the central premise of human capital), determines the productivity of executives. In this sense, executives with more skills and knowledge about their roles are presumed to be better-performing compared to those with low capabilities, which explains why one executive would be paid more than the other. Notably, reviewed literature in this paper underscores the significance of the executive labor market on the value of human capital (Conyon, 2014).

The efficiency wage model proposes that executives will always show extra determination in their job if their companies promise them an above-the-market-level wage rate. Since the wage rate will be above the rest of the industry, it is unlikely that executives will leave their corporations or shirk their duties, and as Otten (2017) notes, they are more likely to feel that they valuably contribute to the performance of their companies. The CEOs will consequently have the incentive of working extra hard, which has an extended effect of improving their productivity. While using the constructs of this theory, corporations view executive compensation as resulting from premiums above the industry level in offering incentives plus the value of their CEOs’ marginal revenue productivity.

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The opportunity cost theory holds that the transparency of job positions in the labor market for executives makes it a possibility for corporate managers to switch employers. According to the theory, for a company to hire and retain a CEO, the levels of compensation involved should at least be the same as that which the executive would get if they considered an alternative employer. The fifth theory, the superstar model, deals with the skewness in income distribution. According to Mengistae and Colin Xu (2014), “little talent is never an effective substitute for more talent, and consequently, imperfect substitutions among those who sell talent exist,” (p. 620). The fact that talent is one of the determinants of skill and knowledge endowment as suggested by the human capital theory indicates that skewness will always exist in the way corporations compensate their executives.

The Agency Model

Instead of arguing for how many corporate executives should be paid, the central idea of the agency theory is the approach of paying for their services. The pay levels in this approach are presumably determined by the market value of the services that CEOs provide. Because pay is perceived as a result of agency issues, the question of how managers should be paid is the major problem that these theories seek to solve. Agency issues arise in any circumstance in which one party entrusts the other with the execution of specific responsibility. Two categories of theories can be determined using the agency approach. The first group, which this essay calls group 1, is made of theories that perceive executive compensation as a partial settlement for agency problems through incentive alignment as well as the transference of risks (Mengistae & Colin Xu, 2014). As the latter study suggests, group 2 theories are those, which see compensation as an effect of the discretionary powers of executives as a result of agency problems. The same study suggests that the complete contract and prospect theories make up group 1 models of explaining executive pay while the second group consists of class hegemony and managerial power theories.

Agency problems are adequately described in corporate management literature. For example, Liang, Renneboog, and Sun (2016) sum up three primary assumptions of an agency theory. First, the literature indicates that agents are always risk-averse, second, they conduct themselves under their self-interests and assumptions, and third, the interests of the agents are never in line with those of principals. Two cases can also be determined from the three assumptions. According to the latter study, the first case involves complete information concerning the actions of agents, which implies that no information asymmetries exist between the agents and principals and that the principals are fully aware of the conduct of their agents. Consequently, offering the agents extra incentives would be unnecessary because the principals are completely aware of the manner in which results are attained, which further implies that they will only transfer risks to their agents unnecessarily. The second case concerns limited information on the conduct of the agent, which means that the principals are unaware when their agents deviate from set interests. Agency issues under the second case could arise from moral hazards, including shirking, and adverse selection, such as hubris actions. For instance, agents could be so immersed in the pursuit of their own interests that they forget the agendas of their principals. The principles have two approaches to solving the problems of lack of information, which are to gain more information on the efforts on the conduct of their agents or to offer them incentives in ways that would reconcile involved interests (Bettis et al., 2018). Consequently, through the provision of the incentive, the principals transfer the risk of deviating from the interests of their businesses to the agents. Since the theories assume that agents are risk-averse and are known to maximize their self-interests, they are more likely to adhere to the incentives in ways that would lead them towards furthering the interests of their agents.

The complete contract theory is the first in group 1 since it is the most dominant of all the agency approaches to explaining executive pay. The model suggests that executive pay is used in aligning the interests of business CEOs with those of their shareholders. Since most businesses always desire to explore the interests of their stakeholders, they are often concerned with hiring the right executives who would follow in the footsteps of stakeholder-oriented performance. An incentive for this approach to working, therefore, is considered ideal for businesses (Shan & Walter, 2016). The prospect theory is the second of the group 1 agency approaches. While it is founded on the same idea of agency, it is different from the first theory because it is founded on loss aversion ideas. The theory holds that executives always expect incentives from their employers to reduce the likelihood of incurring losses.

Group 2 theories under the agency approach include managerial power and class hegemony theories. The balance of power between agents and their principals has been argued to affect the outcome of the relationship, which significantly influences the structure and level of executive pay. The managerial power theory does not necessarily perceive executive pay as a tool for alleviating agency issues. Instead, it indicates that because of the agent-principal relationships, executives are always in natural positions to set their pay levels (Ulen & Newman, 2014). Furthermore, because the executives are known to advance their interests, they will always use their power to set high pay packages for themselves.

The Symbolic Model

These theories approach executive pay according to the social constructions, which fit the role, status, and expectations of the society of the firm from executives. The theories collectively suggest that CEOs’ pay should be a reflection of their dignity, executive status, and the expectations of firms and that it is a secondary factor that motivates the managers into serving the interests of their organizations. Seven individual theories constitute the symbolic approach to explaining executive compensation, including social comparison theory, social enacted proportionality theory, psychological contract theory, crowding-out theory, stewardship theory, figurehead theory, and tournament theory.

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As the name suggests, tournament theory approaches pay as a prize that players win in a contest. In this case, first prize in any tournament corresponds to the highest pay to the CEOs for occupying the highest ranks in their organizations. In this case, it is perceived that setting high prizes provides an incentive for managers to climb the ladder of corporate management, which increases their productivity while lowering that of their subordinates (Abudy, Amiram, Rozenbaum & Shust, 2017). On the other hand, the figurehead theory holds that behavior is presumed to be a reflection of the intention and a variety of interests and goals that co-exist within a firm. Challenges that arise from effective coordination of the goals and objectives cause players in the corporate landscape to engage in bargaining and compromising with units that have the greatest power. Consequently, those who influence the major decisions are accorded higher rewards, and some authors, such as Ulen and Newman (2014), term the situation as organizational politics.

As opposed to the rest of the theories, which argue for the powerful positions of executives, the stewardship model looks at the compensation of managers and their employers from the perspective of the CEOs working to meet the interests of their organizations. Notably, the central premise of the model is the idea that companies will most likely pay executives who seek to further the interests of their organizations at the expense of those who deviate from such arrangements (Liang et al., 2016). Based on the idea that a thin line separates intrinsic and extrinsic motivation, the crowding-out theory suggests that extending very high compensations to executives could derail them from perusing organizational interests, which implies the need to balance the pay rates for the CEOs with the factors that could influence the pursuance of corporate interests. The implicit contract theory suggests that employers are always aware of the reciprocity implications of the contracts that they enter with their managers. Consequently, the rates and structure of payment are determined informally and they are mostly founded on the implications of the quality of relationships between businesses and employees.

The sixth situational model, the socially enacted proportionality theory, suggests that executive pay is a result of the existence of different positions, each with an accorded different rank within the organization. As one would always expect, people holding high-ranking positions should always earn the highest. Because of the implications of hierarchy on the pay structure, most companies are roughly pyramidal in their organizational structures—only a few people earn premium pays (Abudy et al., 2017). While the social comparison theory is also rooted in comparative statistics that suggest the pay rates and structures for corporations, the comparison happens at the top management levels or between executives at the same rank, but from other organizations (Simon, 2016). The implications of competition of human resources, therefore, will always mean that companies pay their managers at rates that match their social status, which is spelled by the business landscape (both internally and externally).

Critical Analysis of the Theories

Much as the reviewed theories and their assumptions are fundamentally variant their implications to practice (in setting the pay rates and structures for top executives) could be more informed when they are applied all at once. However, a question arises concerning the levels to which corporations understand the assumptions of each of the models and the assurance that the adopted theories could provide the best approach to understand executive pay. When applied individually, each of the models presents challenges and advantages, which could affect the efficacy of their chosen strategies.

The principle roles played by economic reasoning, market, and pricing mechanisms are implicated in the agency and value-based models of executive pay. The two models suggest that market forces could significantly influence executive pay structures. When observing arguments, which follow the market structure approach, market imperfections should also be considered, which is among the challenges that the two models face (Meyer & Rowan, 2017). While the value-based model helps in building the comprehension of the manner in which economic theories may aid in explaining among executives and between the top corporate figures and the rest of the employees, it is flawed without specific considerations for market inefficiencies. Furthermore, it should be noted that while the agency approach points at the need to consider market forces in structuring executive pay, it underscores the value of internal managerial decisions. The problem, however, lies in the realization that markets can never be strong enough to influence effective decision-making, such as the one involving executive pay. For instance, the market will rarely tell about the hiring and other human resource practices of businesses, which means that the data gathered from studying the labor marketplace is mostly incomplete (Luo, 2015).

One notes that the theories reviewed under the agency model suggest that the primary problem is the management of the relationship between shareholders and companies. The models collectively view executive pay as being reliant on the optimal levels of risk and market values. When the economic perspectives are extended to the value model, the agency theories pinpoint the criticality of addressing other factors apart from the markets, which could have significant effects on the levels of risk. Therefore, these theories are advantageous because they caution organizations about market inefficiencies and the need to factor many factors into determining executive compensation.

The theories that constitute the symbolic approach are founded on the idea of compensation as a symbol of normative judgments, dignity, stewardship, status, accomplishment, socially accepted proportionality, mandate, and the balance between extrinsic and intrinsic motivations. The theories depend on structuring pay structures around socially accepted arguments and beliefs the informational values that executive payments carry. While the economic reasoning of the forces within labor markets plays into their reasoning, the theories do not explicitly consider market forces as the most significant factors influencing the setting of executive pay. A problem arises when corporate institutions base their critical decisions on what they perceive as socially acceptable because this approach compromises critical thinking (Meyer & Rowan, 2017; Murphy, 2014). In most cases, high rates of compensation have motivated executives to deviate from corporate objectives and to focus on enriching themselves, especially because the competition to provide premium pay by companies makes management lucrative.

The theories reviewed in this paper may have provided insight into the different factors that influence executive compensation. However, what remains answered by the research conducted is an empirical analysis and presentation of the approaches that each of the theories provides towards dealing with methodological inefficiencies. Where some companies have attempted to factor market and social aspects into their approaches to structuring executive pay, they have significantly been hampered by inaccuracies in data collection and interpretation (Luo, 2015). Consequently, most of the firms only rely on a few internal and external factors in determining the pay structures for their top executives, which is seriously flawed. The theories also fail to provide an approach to dealing with the ever-growing pay rates for managers in specific industries and companies in the US and elsewhere. Judging from the literature appraised in this paper, the models only provide justifications for the growing gap in income disparities; they explain why low-earning employees should never be bothered by those who earn over 221 times above their average annual earnings.

Conclusion

An appraisal has been made of the importance of theories that explain the structure and level of executive compensation. The variations in the models concerning their central premises are the roles that each one of them plays in arguing for executive pay yielded three closely-related classifications, which are the symbolic approach, the agency approach, and the value-based approach. The focuses of the three models are on what executives payout to reflect, how to pay, and how much to pay respectively. An analysis of the theories reveals that while they inform the need to consider multiple factors in determining executive pay rates and structures, none of them acknowledges the challenges that could come with the proposed approaches, such as limited understanding of the central premises of the models, inaccuracies, and inadequacies in the information on which the strategies could be formulated, and the lack of assurance that many organizations in the US and the rest of the world use more than one theory in informing their executive compensation rates and structures. Consequently, the focus of this paper may have been on the justifications for executive pay, but it has identified that the assessed theories do not propose any methods of addressing the ever-growing disparities in compensation among executives and between CEOs and the rest of the employees. None of the theories appraise critically the relationship between executive pay and performance primarily because of oversimplification. It is proposed, therefore, theorists develop a more comprehensive method of explaining executive retribution by considering it as a construct of socially constructed arrangements in corporate governance in which all the players involved have a significant influence on the outcomes.

References

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