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Executive pay dispersion, corporate governance, and firm performance

Abstract

Much of the research on management compensation focuses on the level and structure of executives’ pay. In this study, we examine a compensation element that has not received so far considerable research attention—the dispersion of compensation across managers—and its impact on firm performance. We examine the implications of two theoretical models dealing with pay dispersion—tournament versus equity fairness. Tournament theory stipulates that a large pay dispersion provides strong incentives to highly qualified managers, leading to higher efforts and improved enterprise performance, while arguments for equity fairness suggest that greater pay dispersion increases envy and dysfunctional behavior among team members, adversely affecting performance. Consistent with tournament theory, we find that firm performance, measured by either Tobin’s Q or stock performance, is positively associated with the dispersion of management compensation. We also document that the positive association between firm performance and pay dispersion is stronger in firms with high agency costs related to managerial discretion. Furthermore, effective corporate governance, especially high board independence, strengthens the positive association between firm performance and pay dispersion. Our findings thus add to the compensation literature a potentially important dimension: managerial pay dispersion.

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Notes

  1. Tournament theory suggests that, in the presence of costly monitoring of an employee effort and output, compensation may differ from employees’ marginal product and yet be economically efficient. Efficiency is secured by the widening of pay dispersion across the corporate hierarchy (especially toward top positions) acting as an incentive to those lower in the hierarchy to accept wages at less than their expected marginal products, in order to enter a self-financing quasi-lottery (rank-order tournament), where the main prize is the top executive job.

  2. The tournament theory predicts that apart from the promotional incentives and pay differentials between jobs, short-term incentives are also necessary to motivate employees to compete for top positions in the corporate hierarchy. The absence of short-term incentives may induce competitors to prematurely exit the tournament.

  3. The notion that a large pay dispersion may have negative impact on employees through feelings of inequity, leading to a weakened loyalty and increased dysfunctional conflict can be traced to Hicks (1963, p. 334), who stated that “the purely economic correspondence between wage paid to a particular worker and his value to the employer is not a sufficient condition for efficiency. It is also necessary that there should not be strong feelings of injustice about the relative treatment of different employees, since these would diminish the efficiency of the team.”

  4. An implication of this proposition is that concern over equity fairness is more important when close collaboration among employees is desirable, as well as when employees are personally more aggressive in self-promotion at the cost of others (Lazear’s “hawks”). Pay equity has less of an impact on economic efficiency when output is more individually based and when employees are personally more restrained (Lazear’s “doves”).

  5. Tournament incentives are useful when it is difficult to evaluate the absolute performance of the employee. For example, divisional managers of a multi-divisional firm operate in different industries, making the comparison of their absolute performance inappropriate. Furthermore, greater pay dispersion increases the returns for higher performance, thus creating a positive pay–performance link and motivating higher future performance.

  6. Lazear and Rosen (1981) argues that when employee productivity is affected by extraneous factors or noise, employees will reduce their efforts, because such efforts are less likely to affect productivity or outcome. A larger pay dispersion will counteract, to some extent, the adverse impact of uncertainty and noise on employee efforts and productivity.

  7. We alternatively measure firm performance by its stock return and report these results in Sect. 4.4.

  8. We obtain qualitatively similar results when the pooled equation (1) is re-estimated using Generalized Method of Moments (Hansen 1982), which produces standard errors that are not affected by serial correlation of successive observations and cross-sectional heteroscedasticity. In addition, sensitivity analysis (see Sect.  5) that attempts to mitigate serial correlation problems by taking the time-series mean for each firm also yield similar results.

  9. Our results should not be interpreted as evidence against the equity-fairness theory. Rather, we interpret our results suggest that the advantages of greater pay dispersion under the tournament theory outweigh the disadvantages of greater pay dispersion under the equity-fairness theory.

  10. Although the signs on the interaction terms DISPAY * INSIDEQ and DISPAY * INSTEQ are consistent with the notion that strong corporate governance reinforces the positive association between firm performance and pay dispersion, the coefficients are not statistically significant.

  11. Current ROA represents past accounting performance and ROA typically lags stock returns in measuring the benefits of current year projects such as current year R&D expenditures. For example, Cui and Mak (2002) find expensing of R&D will reduce current profitability, however, increase the growth of assets. Thus, high R&D intensive firms are likely to have low current ROA and high future ROA if the R&D succeeds. Since current ROA is a lagging indicator of firm performance, we examine the effect of pay dispersion on future ROA.

  12. We obtain qualitatively similar results with a four-factor model, where the fourth factor is the return momentum (see Carhart 1997).

  13. Other studies document a substitution effect among various corporate governance mechanisms. For example, Chen (2002) finds a negative association between incentive compensation and outside director stock ownership. Vafeas and Waegelein (2007) find that CEO long-term pay and insider ownership are inversely related to audit fees level, substituting for external audit effort in motivating management.

  14. Equation 3 also includes the R&D intensity of the firm which is another proxy for future growth.

  15. The 2SLS uses an instrumental-variables approach to estimate the structural parameters in a system of equations. SUR applies the generalized least squares estimations to a set of seemingly unrelated equations that are related through covariances associated with the error terms across different equations. 3SLS involves generalized least-square estimations and achieve an improvement in efficiency over 2SLS by taking into account cross-equation correlation among the error terms (Greene 2000).

  16. In Table 5, the endogenous variables are TOBINQ and DISPAY. The exogenous variables used as instrumental variables in the system of equations are capital expenditure intensity, research and development intensity, return on assets, firm size, number of business segements, managerial equity ownership, institutional equity ownership, proportion of outside directors on the board, CEO-chairman duality, board size, mean age and mean tenure of the top five executives in the management team.

  17. Ramaswamy and Waegelein (2003) find that post-merger performance is positively associated with long-term incentive compensation plans.

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Acknowledgements

We appreciate the helpful comments from C.F. Lee (the editor), Yakov Amihud, John Core, Albert Madansky, Terry Shevlin, an anonymous referee, and seminar participants at the Pacific Basin Finance, Economics and Accounting Conference.

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Correspondence to Gillian Hian Heng Yeo.

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Lee, K.W., Lev, B. & Yeo, G.H.H. Executive pay dispersion, corporate governance, and firm performance. Rev Quant Finan Acc 30, 315–338 (2008). https://doi.org/10.1007/s11156-007-0053-8

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Keywords

  • Compensation
  • Corporate governance
  • Performance
  • Pay dispersion

JEL Classifications

  • G30
  • G34
  • J33
  • L22