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A Review of Some Questions on Executive Pay.

Brian G M Main (University of Edinburgh)

Paper presented at NYU/LSE Corporate Governance Conference – London School of Economics, November 4/5, 2004.

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Executive Summary:

• The paper reviews a fairly standard set of questions that arise when executive pay is discussed. Most of these are dealt with in section 2.

• The paper then focuses, in sections 3 through 5, on three aspects of executive

remuneration that, until recently, have been less thoroughly discussed. These are: the interaction between risk and design of the pay package; the influences of institutional arrangements; and psychological considerations that affect the motivation of the CEO and decision making by the remuneration committee.

• Section 2 concludes that executive pay has gone up over recent years

following a reassessment of what senior executives are worth to companies. Some of this may be an unintended consequence of increased transparency and process. There is evidence to support the view that there is a competitive market for executive talent, but the jobs involved are sufficiently idiosyncratic that arguments regarding rent extraction can also be sustained. There is a limit to the extent to which independent directors can, in any real sense, restrain executive pay. Remuneration consultants are now key players in the process, and their influence may repay study. The spread of stock options and other forms of stock based compensation has offered tools to effect incentive alignment, but these have not always been used or explained effectively. Alternatives to stock based compensation exist and are used (including termination) but, in terms of the intensive margin of pay variability, stock based compensation has many attractions. Executive compensation seems to be effective (in making companies more productive), but there are difficulties in drawing definitive conclusions on this from the evidence available.

• Section 3 points out that one aspect of incentive alignment that has recently

been the subject of increased attention is the extent to which over-invested executives can be persuaded to take sufficiently risky decisions to satisfy investor expectations.

• Section 4 draws attention to the fact that there are strong institutional

influences on companies and on remuneration committees. In an attempt to legitimise their actions, remuneration committees strive to conform with what others are doing, so producing an isomorphism in behaviours and outcomes.

• Section 5 questions the emphasis placed on extrinsic motivation and points to

the evidence regarding the hidden costs of rewards through the loss of intrinsic motivation. There is also a discussion of the ‘extrinsic motivation bias’ and the extent to which this may lead remuneration committees to place excessive emphasis on complex remuneration packages.

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1. Introduction Academic research on the topic of executive remuneration has a long history. Gomez-Mejia and Wiseman (1997, p291) identify its beginnings as dating at least as far back as an empirical study published in the Quarterly Journal of Economics in 1925. Over more recent years, however, there has been an exponential growth of activity in the area, due to it being seen as an effective lens through which to study the inner workings of the firm. Murphy (1999, p2486) shows that between 1970 and 1996 the rate of growth of academic publications in the area outpaced the growth in executive pay itself- whether measured narrowly as base-plus-bonus or more widely to include equity components of pay. This increase in interest among academics owes both to the fact that, unusually, detailed ad hominem pay data is readily available in the public domain. It has also helped that developments in theorizing, particularly in the areas of normative agency models (Jensen and Meckling, 1976) and strategic leadership (Hambrick and Mason, 1984), have encouraged researchers to consider this particular locus of corporate enterprise. The vast majority of research in this area has been conducted in the USA and has been thoroughly surveyed in recent papers (Gomez-Mejia and Wiseman, 1997; Murphy, 1999; Core et al., 2003a). Because of the importance placed by principal-agent theory on the need to align the interests of the CEO with those of the shareholders, and because contracting over pay arrangements appears so obviously to offer just such opportunities, the link between CEO pay and company performance has assumed a totemic quality. But the research results have not been encouraging. In a meta analysis of CEO pay studies, Tosi et al. (2000) report that, while size accounts for 40% pay variance, performance only accounts for 5%. This leads them to conclude that incentive alignment explanations of CEO pay are “weakly supported at best” (Tosi et al., 2000, p329). Indeed, Barkema and Gomez-Mejia (1998, p135) express the opinion that, “..the failure to identify a robust relationship between top management compensation and firm performance has led scholars into a blind alley”. This paper offers a brief and partial review of the progress made, to date, in addressing some of the more obvious questions asked about executive pay. Many of these questions were recently addressed in Abowd and Kaplan (1999). These cover the range: (a) why has executive pay escalated?; (b) is excessive CEO pay a serious social and political issue, or is there an efficient market for executive pay?; (c) how far can independent directors restrain excessive rewards?; (d) has the spread of stock option schemes in the past two decades helped matters?; (e) are there better alternatives to stock option schemes?; and (f) what are the effects of executive compensation? We then focus on three relatively overlooked aspects of executive pay. The first concerns the tension between the propensity or willingness on the part of the overinvested CEO to take risks, and the amount of risk-taking that would be desirable in the eyes of the diversified shareholder. It will be argued that commentators would be well advised to bear in mind the key message from Jensen and Murphy (1990a),

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namely that the really important consideration in CEO remuneration is how you pay rather than simply what you pay. This remains ever true, even if pay arrangements are often a lot more complex than is generally understood (Kole, 1997). The second consideration pertains to the institutional context within which CEO pay decisions are taken. There are two reasons why the institutional context is so often overlooked. First, the particular theoretical lens most often deployed in considering executive remuneration, namely principal-agent theory, is not one that encourages reference to institutional detail. Second, the fact that the preponderance of research taking place in this field is done in the USA and, hence, sharing a more or less common institutional setting, also underplays the importance of such considerations. But certain developments within the UK, such as the self-regulatory movement starting with Cadbury (1992) and moving on through Greenbury (1995), Hampel (1998) and Higgs (2003), plus the activity of organisations such as the Association of British Insurers (1987) all combine to provide an interesting demonstration of the power of institutions to influence events. Although commonly referred to under the common heading of the ‘Anglo-American model’, executive pay awards in the USA and the UK are very different in some fundamentally important ways. This institutional influence does not always lead to intended outcomes, and it is possible to interpret some developments in executive pay as the unanticipated consequences of governance reform and increased transparency. The third, and final, aspect to be considered concerns the psychological underpinnings of human motivation and decision making. In particular, we examine the possibility that the overwhelming importance placed on extrinsic aspects of executive motivation (e.g., through pay design) may, in effect, undermine equally if not more important considerations of intrinsic motivation. This idea, that there are hidden costs to rewards, has long been discussed in the context of the classroom (Kohn, 1993), but it can be argued that it is no less significant in the context of executive pay. Furthermore, in addition to those receiving the pay, it is also useful to consider the manner in which the remuneration committee frames it deliberations regarding the appropriate pay design to award. We shall argue that a common ‘attribution error’ leads people to see others as being much more instrumental or more extrinsically motivated in their behaviour than may, in fact, be fair or accurate. Section 2 of the paper offers a brief overview of the standard questions asked about executive pay. Section 3 addresses the issue of risk and CEO remuneration arrangements, and Section 4 discusses institutional influences. Section 5 rounds out the substantive discussion with a coverage of psychological considerations, and the paper concludes in section 6. 2. Questions commonly asked about executive pay 2a. Why has executive pay escalated? A common reaction when people look at the level of executive pay, or see the rate at which it has escalated over recent years, is to ask, ‘how do they get away with it?’ And a common answer to this question is, ‘because they can’. Variously dressed up as the ‘self-serving management hypothesis’ (Healey, 1985), ‘rent extraction’

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(Bebchuk et al., 2002) or ‘skimming’ (Bertrand and Mullainathan, 2001), this phenomenon is usually ascribed to boards not doing their job (Lipton and Lorsch, 1992). We shall be returning to the effectiveness of independent directors in general and remuneration committees in particular in section 2c below, but will concentrate here on the notion of the market price of the CEO. In theoretical terms, the leverage on company performance that exactly the right person can have as CEO is sufficiently great that a ‘superstar’ effect (Rosen, 1981) can set in, whereby the competition for the very best talent is so fierce that wages are driven up to unusually high levels. Of course, this inelastic supply or ‘thin market’ argument (Himmelberg and Hubbard, 2000) depends both on boards being able to discern who exactly has and does not have these scare abilities, and on the fact that there are no near substitutes, for example, in the lower echelons of the company. What it is more difficult for this superstar argument to effect, however, is an explanation of the dramatic escalation in CEO pay that has taken place in recent years. For such an explanation, one must turn to evidence (Ezzamel and Watson, 1998, 2002) that suggests there is a ratchet effect at work. Those falling below the going rate experience a greater upward adjustment than those lying above it experience a slow down. In this way, recorded pay increases in one year raise the reference level for the ‘going rate’ in the following year. We shall return to such considerations when we discuss the influence of remuneration committees (section 2c) and institutional factors (section 4). But to anticipate this later discussion, it can be argued that one unintended consequences of increased transparency (publishing details of who gets paid what in each top management team) and institutional accountability (the use of remuneration consultants and the need to demonstrate appropriate process through a remuneration committee report) has been to create an upward ratchet in executive pay. In a desire to demonstrate due process and to justify executive pay awards, remuneration committees give scrupulous attention to the level of pay and the composition of pay in peer group companies. In a decision process that is vulnerable to bounded rationality and cognitive (or psychological) biases, pay awards may assume a tendency towards the upper end of any arguable range. When the published details of such awards are used in the next round of executive pay determination, the upward momentum is continued. A key consideration, in both the USA and the UK, is that the setting of executive pay is not an arms-length transaction (Williamson 1985, p313) but conducted within the collegial atmosphere of a unitary board where psychological influences abound (Bebchuk and Fried, 2004). 2b. Is excessive CEO pay a serious social and political issue, or is there an efficient market for executive pay? In both the business press and the popular press, the issue of top executive pay commands a significant amount of attention. The outcry there, reaching a crescendo at times, seems to leave no doubt that this is a serious social issue. Coverage of the topic has been growing over the years. At times, press comment displays a level of envy that is as elevated as the alleged greed that is being discussed. It is worth noting, however, that it is the transparency that characterises reporting of top pay in the

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corporate sector that facilitates this public debate. Other high earners, whether in the professions or in private equity companies, go relatively unnoticed and un-discussed. On the other hand, the government seems to have decided that, on balance, the issue is not a significant political one. In the early days of the DTI Review of Company Law, there was a suggestion that directors’ pay might be subject to legal constraint. But, once the review process bedded down, Stephen Byers, as the Secretary of State concerned, announced1: “It is not for the Government to determine or dictate levels of pay for company directors”. What followed was a DTI (1999) consultative document which led to the passage of the Directors’ Remuneration Report Regulations 2002. These regulations tightened up on disclosure requirements and, most notably, required the Remuneration Report to be subjected to a vote at the AGM. While remaining far short of shareholders actually deciding the pay of directors, the case of Dr Jeane-Pierre Garnier, CEO of GlaxoSmithKline2, provided the first demonstration of the potential for such a vote to lead to substantial revisions in a CEO’s remuneration package. A more recent DTI (2003) consultative document on the topic of so-called ‘rewards-for-failure’, pertaining to payments made to directors (mainly CEOs) who step down before the end of their contracted period of service, has yet to lead to any major legislative changes. The government remains reluctant to intervene in the process, preferring to allow the market to determine executive pay packages and has made it clear that further interventions are unlikely3. This restraint owes to an awareness that intervention would very probably be severely disruptive. This realisation should not, however, be confused with an acceptance that what currently exists is an unfettered market mechanism leading always and everywhere, through arms-length contracting to an appropriate pricing of executives’ services. In the USA, where the regulatory framework has a markedly more statutory basis than in the UK, executive pay has also been free of political intervention. The one exception is a 1993 change in the tax code, implemented during the first Clinton administration, which essentially encourages remuneration payments in excess of $1m to each of the CEO and the other four most highly paid officers to be in the form of incentive pay. Some commentators see the Clinton tax reform as having had the unintended consequence of encouraging the adoption of generous stock based compensation such as executive share options4. Some have argued (Bebchuk et al., 2002) that this increase in use of executive share options and other forms of stock based compensation is an important aspect of the rent extraction process that is claimed to characterise CEO pay. In an attempt to rebut this rent-seeking critique, evidence from the CEO labour market has been produced (Murphy, 2002; Hall and Murphy, 2003) to question such claims of insider power and self dealing. Examining newly appointed CEOs, Murphy (2002) presents results 1 Quote from a speech given by Stephen Byers on 19 July 1999 to a joint ABI and NAPF seminar on Institutional Investors and the Competitiveness of UK Industry. 2 See, for example, Financial Times 21 May 2003, p.21, on differences between the UK and USA brought to light by the Garnier event. 3 On February 25, 2004, Patricia Hewitt, Trade and Industry Secretary announced that there will be no new laws or regulations concerning executive pay. 4 A Conference Board report cited in the Financial Times 24 August 2004, p15, notes that in 1992 options comprised 27% of median CEO remuneration while by 2000 this had risen to 60%.

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suggesting that incumbents appointed as CEO enjoy no advantage over outside appointments, thereby undermining the rent extraction theory, as incumbents would be expected to enjoy a closer (less arms length) relationship with the board. Hall and Murphy (2003) also argue that the tax and accounting treatment of corporate earnings ensures that payments in the form of share options are particularly attractive because, unlike more convention remuneration, there is currently no charge for such payments against company earnings. In addition to what might be regarded as the intensive margin of executive pay, where pay varies with the level of company performance, there is, of course, also an extensive margin, in the form of the under-performing executive having their employment with the company terminated. This aspect offers an alternative perspective on market efficiency. Following from an influential paper by Fama (1980), such an ‘ex-post settling-up’ or ‘career-concerns’ view suggests that under-performing executives will suffer through the loss of their income stream and subsequent difficulty in finding alternative similarly remunerated employment. Evidence in this area seems to confirm that under-performing executives are more likely to lose their jobs (Weisbach, 1988; Cannella et al., 1995; Borokhovich et al., 1996; Cosh and Hughes, 1997; Conyon and Florou, 2002; Farrell and Whidbee ,2003; Fee and Hadlock, 2004), and that those who do5 will generally end up in less-well remunerated employment. In addition, post-retirement employment is ‘better’ for those CEOs whose pre-retirement firm performance is better (Brickley et al., 1999). So, while the debate is sure to continue to rage, there is undoubtedly a body of evidence to suggest that there exists a functioning labour market for executives and this market displays many of the signs one would expect to see in a competitive market. However, the market for bus drivers it is not. 2c. How far can independent directors restrain excessive rewards? Governance reforms over the past two decades have brought the concept of independence of directors under increasing scrutiny. Gone are the old labels of ‘executive’ and ‘non-executive’, as it was realised that such categories did not reveal those directors who had previously held executive roles or currently had commercial relations with the company. Such connections clearly raise questions as to the robustness of the independence of the directors in question. The empirical impact that such grey areas of independence can have on the strength and effectiveness of the governance mechanism in terms of constraining CEO pay has been documented (Core et al., 1999) and it is significant. It has also been shown that the governance reforms of recent years have made the board a more effective monitoring mechanism. This is true for both the effects of the Cadbury report (Dahya et al., 2002) and the Greenbury Report (Conyon et al., 2002). Recently, Higgs (2003) has recently lent further strength to the role of the independent director in the UK. For the USA, Holmstrom and Kaplan (2001) document an increase in the effectiveness of internal corporate governance mechanisms in the 1990s (in comparison with the 1980s). 5 Mikkleson and Partch (1997) provide evidence to suggest that the strength of labour market discipline (probability of exit from the firm) is markedly lower in periods when take-over activity is lower.

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Things may be getting better, but a recent meta study of corporate governance effectiveness (Dalton et al., 1998) fails to find a systematic connection between board composition or governance structure and financial performance. This may serve as a warning that the whole concept of board independence needs to be approached with a considerable degree of scepticism. The unitary board as a social construct is a locus of CEO power and influence, and it may be best to view the boardroom as a highly socialised environment where concepts of power and social influence are potentially very important (Pfeffer, 1972; Zajac and Westphal, 1996; Hermalin and Weisbach, 2003). It follows that the lack of independence of board decisions may owe to the power of the CEO, for example, in the granting or withholding of resources, (Pfeffer, 1992). It can also arise more subtly through social influence (O’Reilly et al., 1988), similarity (Zajac and Westphal, 1995), or plain old ingratiation and persuasion (Westphal, 1998). The effects can be manifested in a range of outcomes, including the awarding of bonuses (Grinstein and Hribar, 2004), permitting abnormal accounting accruals (Klein, 2002), the awarding of golden parachutes (Wade et al., 1990), the design of long term incentive plans (Westphal and Zajac, 1994), the strength of the pay-performance link (Newman and Mozes, 1999; Newman, 2000), or the re-pricing of executive share options (Pollock et al., 2002). One thing, of which these general observations warn, is that unintended consequences can easily develop from even the best intentioned governance reforms (a theme to which we shall return throughout this paper). Consider the board sub-committee known as the remuneration committee. In the UK, this arrangement effectively became a requirement post-Cadbury (1992). Using data for 1990, shortly before this change, Main and Johnson (1993) examine the influence on CEO pay of the presence or absence of a remuneration committee in 220 large UK companies. They find that while some 30% of the sample report utilising a remuneration committee, the presence of such a committee is actually associated with higher CEO pay rather than lower CEO pay. However, Conyon (1997) repeats a similar analysis in a later period and finds that the adoption of a remuneration committee is associated with lower growth in CEO pay between 1988 (when 60% of his sample have such committees) and 1993 (when 96% have them). On the other hand, Conyon and Peck (1998), analysing FTSE-100 companies for the years 1991 (with 78% of their sample having remuneration committees) and 1994 (91% have remuneration committees), reveal that the presence of a remuneration committee is associated with higher CEO pay. Peck and Ruigrok (2002), in a sample of 126 German companies between 1996 and 2000 (over which period remuneration committees in their sample rise from 60% to 71%), also find that remuneration committees are associated with higher CEO pay. There are weaknesses in these studies that cast some doubt regarding the robustness of the results, but they do serve as a warning that one consequence of establishing a transparent pay allocation mechanism such as the remuneration committee is to give legitimacy to the process. And legitimacy may not always lead to lower pay awards, particularly in a social constructed environment such as the boardroom. This notion of legitimacy is further explored below, in section 4, where institutional influences are analysed.

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Furthermore, looking past the existence of remuneration committees and into their composition, a series of studies (O’Reilly et al., 1988; Main et al., 1995; Westphal and Zajac, 1995) demonstrate how the composition of the remuneration committee (for example, the pay of the outside directors in their own companies) and the relationship among the directors (for example, whether the remuneration committee member has been appointed to the board by the CEO whose pay is being decided) all seem to influence the pay determination process in ways that do not flow naturally from an agency-theory perspective of the process. On the other hand, Daily et al. (1998), using a panel of data for 1991-1994, find no association between the nature of remuneration committee membership (whether ‘grey’ directors, or appointed by the incumbent CEO, or being CEOs themselves) and the level or structure of CEO remuneration. It must be concluded, therefore, that research in this area has yet to reach a consensus. There is, of course, and inherent tension in the unitary board that goes beyond social influence. The board not only performs a monitoring role but also represents a major source of advice and counsel to the CEO. Westphal (1999) uses survey data to highlight the importance of the trade-off faced by outside directors between their supervision-and-monitoring role versus their advice-and-counselling role. An excess of social independence can have an impact on the effectiveness of the board, particularly in the area of advice and counselling. It is also clear that, not withstanding the independence issue, boards possessing asymmetric information with respect to their environment generally attempt to make sense of their situation by a combination of symbolism and substance, where the symbolism can include the justification articulated for executive compensation awards (Wade et al., 1997), stock repurchase program aimed to mollify shareholders (Sanders and Carpenter, 2004), and the rationale given for adopting LTIPs (Zajac and Westphal, 1995). Such institutional forces can introduce issues of legitimacy and symbolism into the determination of executive pay, in ways that may run counter to any incentive effects. We return to this theme in section 4. 2d. Has the spread of stock option schemes in the past two decades helped matters? With few exceptions (Lewellen, 1968), most early studies of executive pay focus on the readily available measures of cash pay (essentially, base plus bonus). Developments, discussed below, in the tax treatment of share options and other forms of stock based compensation (SBC) made this an increasingly partial view of the remuneration picture, and most studies (Jensen and Murphy, 1990; Main et al., 1996; Hall and Leibman, 1998) now track the executive’s holding of options to measure the fluctuations in value of this portfolio with the stock market performance of the firm. The extent to which the current valuation of unexercised and possibly non-vested options is factored into the current wealth calculations of the executive is, of course, debatable. Wiseman and Gomez-Mejia (1998) invoke an ‘instant endowment effect’ to motivate such considerations6. It certainly reveals a much stronger pay-performance connection than had previously been realised. 6 See, also, the further discussion in section 3 below of the Behavioural Agency Model (Wiseman and Gomez-Mejia, 1998).

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Coupled with the recognition that, to a large extent, the pay-performance sensitivity of the stock-based component of remuneration could be calculated using the ‘option delta’ measure rather than estimated econometrically (Yermack, 1995), several studies (Hall and Leibman, 1998; Hall and Murphy, 2002) document not only the importance of SBC but also the extent to which it had become an empirically dominant component of executive pay in the USA. This rise in usage can be seen as a manifestation of the cheapness of paying in this way (Hall and Murphy, 2003) which, during this period, enjoyed a favourable accounting and tax treatment leaving the reported earnings stream looking better than it would otherwise have appeared. In fact, the issue of executive stock options not a new phenomenon. In a useful review of the topic, Blasi et al. (2003) trace out some early developments in usage in the USA. The story they tell goes as follows. Options were first introduced as a management incentive in the 1930s, and by 19527 one-third of the companies on the NYSE were using them. After a change in the tax law in 1964, however, executive share options started to fall out of favour and when, in 1976, the tax code was changed to levy personal income tax rates on option gains, all tax incentives to receive pay in this way were thereby removed. In 1981, however, the Reagan administration created incentive or qualified options whose gains would be treated at capital gains rates for tax purposes. In spite of this advantage, qualified options have not been very popular. They carry the condition of a holding period for the underlying stock of at least one year after exercise of the options, and the gain on exercise cannot be deducted as expense by the company. On the other hand, while non-qualified option gains continue to be subject to personal income tax on exercise, these gains are deductible from the company’s point of view (Hall and Murphy 2003, p 8-9). Furthermore, with income tax rates and capital gains tax rates equalised in the first Reagan administration, nonqualified options were acceptable to executives and could be issued to a company’s advantage. And, as already mentioned, in 1993 the USA federal tax code was changed in a way which discouraged non performance-related cash pay to senior executives in amounts exceeding $1million, by making such payments non tax-deductible. This gave a substantial boost to options, whose use had already recovered substantially thanks to the tax changes. Unsurprisingly, the recent spread of executive share options in the UK is also associated with tax considerations. Before 1984, executive share options were not widely deployed in British boardrooms having very little tax advantage8. However, the Finance Act 1984 created substantial tax incentives to use share options as remuneration. This Act allowed executives to hold options with a face value of up to four-times emoluments, and have any consequent gains on exercise taxed at capital gains rates (then 30%) rather than personal income tax rates (then 60%). In 1988, however, the top rate of income tax dropped to 40% and capital gains and income tax rates were harmonised for the individual, thereby substantially reducing the tax incentive9. Finally, in 1995 all remaining tax advantage was essentially abolished as

7 In 1950, Congress legislated to clarify that executive stock option gains be taxed at capital gains rates rather than at (the significantly higher) personal income tax rate. The Internal Revenue Service had obtained a 1945 Supreme Court ruling that they should be taxed as income Blasi et al. (2003, p70). 8 The gains on exercise were taxed as income, but payment of tax due could be spread over 5 years. 9 Some advantage remained in the form of any option-related tax only being payable on the final disposition of the underlying shares and by the possibility of utilising the annual capital gains allowance as a (modest) tax shield.

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far as executives were concerned. But, by this time, the issue of options had become institutionalised (see section 4, below). The option holding restrictions imposed at four times emoluments under the 1984 Finance Act were designed to limit the tax expenditure implications for the treasury. These restrictions cast a long shadow. They were incorporated into the Association of British Insurers (ABI, 1987) guidelines on the recommended use of executive share options. Modified over the years (Main, 2005), these guidelines had a pervasive influence. Their appeal lay in their legitimising effect, to such an extent that the issue of options with a face value equal to four times emoluments came to be standard boardroom practice. Rather than being a ceiling, this rule was applied, almost as an entitlement, to all boardroom directors whether or not a lesser or greater amount might have been appropriate. Only recently (ABI, 1999) have these restrictions been relaxed and companies are now free to tailor grants of options and their associated performance hurdles to their individual needs10. The escalation in the use of option grants in the board room is made all the more puzzling when the gap between their cost to the firm and their value to the executive is considered. It is possible to use a utility-based approach (Lambert et al., 1991; Hall and Murphy, 2002) to show that to the over-invested executive, who has significant human capital specific to the firm and who probably already owns substantial amounts of undiversified firm equity, further share options are valued11 at considerably less than the opportunity cost to the firm in issuing them. Executive valuations of around 50-70% of the cost to the firm of the options are typical12. This gap can be justified by the expected incentive effect that arises through designing remuneration in this way. Thus, while remuneration through option grants may appear an expensive way to pay the executive, from a principal-agent perspective the resultant increase in efficiency brought about by so aligning the incentives of the executive to the interests of the shareholders more than compensates for the difference. Skovoroda et al. (2004) offer some evidence for the UK to suggest that such effects are, indeed, observed. The fact remains, however, that executive share options continue to attract unfavourable comment from observers. Warren Buffet (quoted in Blasi, 2003, p143) describes executive share options as a “royalty on the passage of time”. A better known remark13 of Buffet’s:

“If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”

10 See Choudhary and Orszag (2003) for an analysis of the extent to which UK companies stretch their CEO’s through the design of conditional performance hurdles.. 11 Cai and Vijh (2002) and Ingersoll (2002) offer slight improvements on the Hall and Murphy (2002) approach with valuation models of CEO options that does not constrain CEO to hold other wealth only at the risk free rate. 12 Meulbroek (2001) reaches a similar conclusion by arguing that the expected return on options depends on the firm’s incremental contribution to the volatility of the market portfolio and not the total volatility of the firm, and therefore is too low to compensate the CEO adequately. 13 From Warren Buffet’s letter to Berkshire Hathaway shareholders, March 1, 1993. Quoted in Financial Times 16 July 2002.

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summarises commonly held frustrations regarding the accounting treatment of executive share options. This situation has recently been addressed in IFRS 2 (IASB, 2004), which is due to be implemented for all annual accounting periods beginning in January 2005. It appears, therefore, that executive share options have spread in popularity because there is evidence that they produce desired incentive effects. They have also, until recently, held the attraction of a very favourable accounting treatment under which they had little impact on reported earnings. It is also true, however, that their use may impact on the risk-taking propensity of executives, and this is a topic explored further in section 3, below. 2e. Are there better alternatives to stock option schemes? To answer this question, one needs first to know, better at what? There are many commentators who intensely dislike the asymmetry of the option package pay-out profile. In this, the downside is considerably more modest than the upside. There is even a widely held view that when dealing with options there is no downside at all. But this is to overlook the fact that options are not a gift, but are implicitly bought by the executive out of remuneration. In the absence of the option package, some other element of remuneration would be higher. This view also neglects the point that is emphasised in Hall and Leibman (1998), namely, that a fall in share price can seriously reduce the value of an option package that is in the money. In terms of alternatives, many prefer the simplicity and directness of share ownership. This, as we shall argue below in section 3, fails to fully address the problem of reconciling the desired risk-avoiding proclivities of the executive and the preferred risk-taking investment decisions as viewed by the shareholder. It also represents poor value for money in the sense that the opportunity cost of granting an executive a contingent claim on a single share through issuing restricted stock, say, is granting an executive a contingent claim on approximately three shares through share options. On the upside at least, the reward-performance relationship is much more levered with options. In the UK, the most significant move away from option schemes occurred after the comment in the Greenbury Report (1995, 6.31), “the other forms of incentive scheme which should be weighed against share options typically reward Directors with a predetermined number of shares or cash amounts, rather than options”. So started the move to Long Term Incentive Plans (LTIPs) in the UK. But while these schemes tend to reward in shares at the end of a three-or-more year performance period, with any payout being subject to performance hurdles, they introduce problems of their own. Importantly, their reliance, in most cases, on comparator peer groups of companies introduces many more subjective dimensions. Analysis for the UK (Buck et al., 2003) shows LTIPs to be less effective than option schemes in linking CEO pay and performance. There are also concerns regarding the robustness of such schemes for the USA, especially in terms of the selection the comparator peer groups (Porac et al., 1999).

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There are certainly alternatives to stock options schemes. Whether they are better or not depends largely on their design and implementation. It also depends on what are the objectives of such schemes. As long as the share price objectively and independently reflects the desired performance of the company, then options can be an attractive device. A company with broader objectives or where there is a strong asymmetry of information with the market may wish to consider other or additional measures. Of course, the fact is that, while important and in many cases dominant, options are seldom the only incentive device in an executive’s remuneration package. Options offer of a direct and powerful linkage with share price, but if there are asymmetries of information between the top management team and the rest of the board or outside shareholders then modified versions of executive share options schemes or alternative equity holding schemes may be worth considering. 2f. What are the effects of executive compensation? The recent meta-study of CEO pay studies in the USA by Tosi et al. (2000) was cited above to underscore the generally weak relationship between performance and pay. This weakness in the empirical connection is somewhat disconcerting to agency theorists but, as Garen (1994) and Haubrich (1994) emphasise, it remains possible to reconcile such modestly sized empirical effects with an agency view. Of greater concern is the lack of clear evidence that paying executives in this way actually makes a difference. The causal link between pay and performance is far from clear. Murphy (1999, p2539) summarizes the situation as: “Unfortunately … there is surprisingly little direct evidence that higher pay-performance sensitivities lead to higher stock price performance”. Even in the rare study that effectively tackles this question of causality (Abowd, 1990) an unambiguous answer can prove elusive. Core et al. (2003a) explain that in a world in which all firms successfully optimise their choice of CEO executive pay design, then there will be no observable relationship between design of pay package and subsequent firm performance, because all such effects will have been already factored into the share price (Demsetz and Lehn, 1985). So in a world of efficient capital markets, only if firms are out of equilibrium (albeit temporarily) will there be any chance of identifying such a relationship. Core and Guay (1999) do find that firms award optimal incentive contracts and issue new tranches of options to move toward the optimum contract (when out of equilibrium). As Larcker (2003, p93) points out, the “extreme economic view14”, is that if all companies are optimising their use of stock-based compensation then there will be no relationship between option holdings and performance as it will already be discounted into the market price, frustrating any attempt to measure causality in pay for performance at the CEO level. Most attempts fail to allow for this effect (Hanlon et al., 2003; Larcker, 2003). Core and Larcker (2002), however, succeed in providing a rare empirical demonstration of the causal effect on firm performance of introducing a stock-based compensation scheme. This is done by measuring change in firm performance in a sample of firms adopting ‘target ownership’ plans for executives

14 Also labelled “the extreme optimisation perspective” in Hanlon et al., 2003, p31. Also see Ittner et al. (2003).

14

(and hence imposing a mandatory increase in CEO stock ownership). The power of this study owes to the way in which the impact of an announcement is studied. On the other hand, less supportive evidence on the efficacy of executive pay comes from a test (Core et al., 2003b) of the predictions of agency theory as it applies to the design of executive compensation packages. What is tested is the expectation that relatively less importance should be placed on stock-price based performance measures as opposed to alternative accounting based measures as the overall riskiness of the organisation increases. Principal-agent theory predicts that, in terms of risk sharing, the riskier the enterprise then the more reliance should be placed on accounting as opposed to (noisier) stock market based measures of performance. What is found, however, is that as risk increases there is an increasing reliance on stock-price based influenced remuneration at the expense of accounting measures. In attempting to explain this finding, the authors propose that CEO pay emerges in a ‘second-best’ form (although ‘third-best’ might, possibly, be a more accurate caricature), to the effect that a compromise can be reached regarding the design of the CEO contract and the design of executive contracts at lower levels15 – a compromise that is necessary owing to what Core et al. (2003b, p979) describe as “contracting frictions in real institutional settings”. We shall turn to discuss the influence of the institutional setting in section 4. Causality, therefore, remains a major challenge in this area. The challenge is not only to prove that something (better performance) happens as a result of paying executives in a certain way, but that the impact is empirically significant when compared to other ways of remunerating. 3. Remuneration and risk taking Remuneration risk, as such, is a well recognised aspect of pay design (Wiseman et al., 2000). But, remuneration risk can take two forms: (i) at the extensive margin, which is associated with job termination and has been discussed above under ‘career concerns’, and (ii) at the intensive margin, which is what concerns us here and relates to the period to period fluctuations in remuneration while with the same employer. Needless to say, the tolerance of agents for such fluctuations will depend on many factors, not least their personal taste for uncertainty. Some executives will be more sensitive than others to remuneration risk. As already noted, Haubrich (1994) uses the risk aversion of the CEO to demonstrate that what seems, at first, to be empirically modest estimates of the pay for performance sensitivities among executives in the USA (Jensen and Murphy, 1990) can be quite large enough16 to represent effective incentive alignment.

15 The idea being that, as a demonstration or leadership effect, the CEO has specific aspects included in their compensation contract to solely encourage the others lower down the organisation to accept these same features, rather than to serve any direct performance-inducing effect on the actual CEO. 16 A constant absolute risk aversion model (CARA) is used but he also explores constant relative risk aversion (CRRA) models. The range for the risk aversion coefficient is from 0.125 through 1.125 for CARA. The more common CRRA estimates used in the literature are in the range 2-3 (see Blume and Friend, 1975), but Haubrich’s CARA assumptions can be interpreted in CRRA terms as being in the range 1.1 - 9.9

15

Much of the discussion of risk in the CEO remuneration contract concerns the proportion of variable pay as a fraction of total remuneration (Beatty and Zajac, 1994; Gray and Cannella, 1997; Aggarwal and Samwick, 1999, 2002; Jin, 2002; Miller et al., 2002; Wright et al., 2002). With some exceptions (Core and Guay, 2002), it is generally agreed that the risk in remuneration will decline with increasing risk of the firm. This is because the risk premium demanded by the executive for accepting ever more risky remuneration arrangements makes it increasingly expensive to compensate the risk-averse agent in this way – no matter that it may suit the diversified, risk neutral principals (Prendergast, 2000). As employees can generally be regarded as risk averse and the principals of firms as risk neutral, it is accepted that there is a compromise or second-best aspect in any linkage between CEO pay and the (risky) outcome of firm performance. However, rather than regarding the CEO as a passive agent with a given proclivity for risk, some analysts have focused explicitly on the impact of the risk aspect of the remuneration package on the CEO’s decision making in terms of risk-taking. The logic here being that risk aversion can incline the CEO to actions that might not be in the interest of the principals. The over-invested CEO may well choose actions that do more to stabilise their personal income stream than to maximise shareholder return. Examples of such actions might be excessive merger activity (Amihud and Lev, 1981; May, 1995) or non-optimal financing decisions (Agrawal and Mandelker, 1987). Overloading CEOs with risky remuneration contracts, the argument goes, can be counterproductive. The payment of any type of bonus dependent on performance, obviously introduces uncertainty into remuneration, but it is the now widespread use of company financial assets as means of payment that really brings this issue to the fore. The implications of risk for asset pricing are well understood and available in most modern finance textbooks (Adams et al., 2003, p247). For example, the impact of risk on share prices can be seen in the capital asset pricing model: })({)( fmjfj RRERRE −+= β (1) where, Rj = return on share j Rf = risk-free rate Rm = return on market portfolio βj = σ jm / σ2

m σ jm = covariance of share j return and market return

σ2m = variance of market return

From this perspective, the larger the risk, in terms of future profit stream, the larger the expected return will have to be and, consequently, the lower will be the share price. Note, that here the component of risk that affects the expected rate of return, and hence the market price, is ‘systematic risk’, the part that correlates with market movements. The remainder, ‘specific risk’, is idiosyncratic to the company and can be diversified away by any investor holding the share as part of a portfolio of investments (as opposed to the CEO, who is almost certainly ‘over-invested’ in the company). Thus,

16

σ2

j = β2j σ2

m + σ2j(ej) (2)

For options, the Black-Scholes formula describes the link between call option price and asset volatility. In particular, the sensitivity of option price to volatility, the ‘Vega’, is given as:

��

�

��

�

�

��

�

��

�

�

Τ

Τ++ΦΤ=

∂∂

j

jfX

S

jj

jR

SC j

j

σ

σ

σ

)2

()log(2

(3)

where, Cj = price of call option on share j σj = standard deviation of return on share j, or volatility Sj = price of share j Xj = exercise price of call option on share j Τ = remaining life of option Φ = cumulative normal distribution function It was initially thought that grants of share options would unambiguously make executives more likely to take risky investment and strategic decisions. The logic seems obvious, at first blush. From equation (3), it can be seen that the value of a holding of options increases with the volatility of the underlying asset (other things equal). Therefore, loading CEOs up with options would seem to incline them to take more risky decisions, as they seek to increase their personal wealth. This is a view Ross (2004, p207) labels “the common folklore” and shows to be false. In this he follows Carpenter (2000), who demonstrates theoretically that while, in general, more options can increase the appetite for risk, the effect at the margin of yet more options is to cause executives to aim for a reduction in volatility17. Examining the hedging decision of a sample of firms, Knopf et al. (2002, p802) point to two opposing tensions of stock options for the CEO, namely, sensitivity to stock return volatility and to the level of the stock price, “Options tie a manager’s wealth to the stock price, thereby decreasing a risk-averse manager’s willingness to bear risk”, even though option values, per se, rise with volatility. The CEO’s wealth is sensitive to stock return volatility and stock price. While the volatility effect inclines the CEO to accept more risk, the second effect decreases the CEO’s willingness to bear risk. It is possible to decompose the incentive effect as follows (Guay, 1999, p46):

Certainty equivalent = E(wealth) –risk premium (4)

17 Ju, Leland and Senbert (2002) use a simulations approach concluding that “relative to the optimal risk level for the firm, a call-type contract can induce both over or under investment in risk depending on managerial risk aversion” (pp. 23-24).

Total Risk

Systematic Risk

SpecificRisk

= +

17

Where the certainty equivalent (CE) is the effective or cash-equivalent remuneration enjoyed by the executive (Lambert et al., 1991; Hall and Murphy, 2002). The impact of volatility (σ ) is then, ∂(CE)/∂σ = ∂E(wealth) /∂σ - ∂(risk premium) /∂σ (5) The effectiveness of executive share options in encouraging risk taking by CEOs has been demonstrated for risky exploration investment decisions in the oil and gas industry (Rajgopal and Shevlin, 2002) and in encouraging risk taking in situations where risk-increasing projects are of greater importance (Guay, 1999). These results support the earlier findings of Agrawal and Mandelker (1987) and DeFusco et al. (1990) and more recent findings by Gilley (2004). On the other hand, Knopf et al. (2002) find that firms hedge less when the CEO is more exposed to compensation risk. At all times, however, it is necessary to consider the entire portfolio of stock based compensation and not simply options in isolation (Sanders, 2001; Certo et al., 2003). Using the entire CEO holding of company equity (shares and options), Skovoroda et al. (2003) find that for 126 out of 204 FTSE350 companies studied, the impact of options on CEOs was to make them less likely to take risky investments. Ju et al. (2002) also find that the net effect on risk-taking depends on a combination of personal circumstances. Furthermore, rather than treating the remuneration contract in a one-size-fits-all mode, is possible to allow individual CEO risk preferences to vary and treat managerial incentives as endogenous. Thus, incentives are set in the knowledge of the attractiveness to the CEO of, for example, diversification as a means of reducing specific risk (Aggarwal and Samwick, 2003). The resulting contract (remuneration design) should, therefore, take into account the volatility of firm returns, the CEO’s risk aversion, and other aspects of the CEO’s tastes. In the consequent equilibrium remuneration contract, those managers with greater need for risk reduction are the ones who are given lower incentives. The empirical evidence here (Aggarwal and Samwick, 2003) does not support the idea that CEOs actively diversify to reduce their exposure to risk. So far, the discussion of risk has taken place in an expected utility framework. It can be argued, however, that expected utility may not be the appropriate view. Alternative frameworks exist within which to consider risk (Gomez-Mejia and Wiseman, 1997). For example, Wiseman and Gomez-Mejia (1998) use a combination of behavioural decision theory (prospect theory) and agency theory to derive a behavioural agency model (BAM). The executive’s risk-taking behaviour is explained by adopting a contingency view, whereby the risk preferences of the agent vary by context or frame of the situation (Kahneman and Tversky, 1979). This leads to a model of loss aversion, which can be used to explain the marked preference in executive pay arrangements for creating rewards for success rather than penalties for failure (DeMeza and Webb, 2003). Empirically, this loss aversion perspective has been deployed to study capital expenditures, R&D spend and income risk (standard deviation of stock analysts’ forecasts) with results that suggest that “rather than aligning principal and agent interests, stock options may aggravate agent risk aversion” (Wiseman et al., 2001, p1).

18

It is clear that, in terms of confronting excessive CEO risk aversion, the efficacy of executive share options and other equity related remuneration instruments cannot be taken for granted. The impact will depend on the CEO’s characteristics, stage of career, existing holdings of company equity and so on. A more individualised and personalised approach is necessary. What worked in the past for a given CEO may not work in the future, as these very past actions (option grants, say) may well condition the CEO’s behaviour in the current and subsequent periods. Once again, we are reminded of the Jensen and Murphy (1990a) injunction, namely it’s how you pay rather than simply how much you pay. We next turn to discuss the institutional context within which executive remuneration contracts are designed and monitored. 4. Institutional influences Most economic analysis of executive pay has adopted a principal-agent approach. As was explained in the introduction, this is for good reason. But agency theory has been criticised for an unhelpful “dyadic reductionism” (Aguilera and Jackson, 2003, p449) that results in poor explanatory power by failing to adequately take account of the wider range of social forces at work. The institutional approach avoids this, although it is also not without its shortcomings. Thus, while criticising neoclassical economics as an atomised or under-socialised view of human action, Granovetter (1985) also warns of the dangers inherent in an over-socialised concept of human action, whereby people are seen as being so sensitive to what other people think, that they accept norms and values with an unreflective obedience that is not perceived as an imposition. Before embarking, here, on a brief exposition of a possible institutional approach to explaining executive remuneration, it is useful to pause to stylise these twin dangers in terms of Granovetter’s (1985, p485) quote from Duesenberry on the distinction between economics versus sociology: “economics is all about how people make choices; sociology is all about how they don’t have any choices to make”. The challenge, then, is to ensure that explanations of executive pay are embedded in the broader social relations that give sense to these, as to so many economic actions, but to do so without losing sight of the economic notions of efficiency and choice. It is, indeed, difficult to examine the CEO pay determination process in large companies without being aware of strong institutional forces at work. In the case of the UK, which enjoys what is generally accepted to be a self-regulatory environment, companies follow a near identical process of remitting the pay decision to a remuneration committee comprising independent directors. This committee is free to (and generally does) take independent advice from a remuneration consultant. A remuneration committee report explaining the logic behind the pay awards appears in the company’s annual report to be defended and voted upon at the AGM. All of these things can be seen as outcomes resulting from a series of committee reports on governance and executive pay (Cadbury, 1992; Greenbury, 1995; Hampel, 1998). The pervading ethos is one of ‘comply or explain’, and yet, in the vast majority of cases, companies simply comply. This can be taken as an example of the type of mimetic process that neo-institutionalists (DiMaggio and Powell, 1983; Scott,

19

1995) see as leading to an isomorphism in organizational practice. Faced with the uncertainty of public reaction, and seeking legitimacy (Bender, 2003), companies move to a uniformity of practice. With this strong drive to isomorphism, remuneration committees look at what other CEOs are being paid (O’Reilly et al., 1988), or at behaviour among cohesive groups of peer companies (Porac et al., 1999), or at the more general ‘going rate’ at other companies (Ezzamel and Watson, 1998). These can be described as institutional reactions. To introduce some precision, institutions can be defined as consisting of:

“cognitive, normative, and regulative structures and activities that provide stability and meaning to social behavior. Institutions are transported by various carriers – cultures, structures, and routines – and they operate at multiple levels of jurisdiction.” Scott (1995, p33)

For executive compensation, the regulative pillar supporting institutional behaviour is probably most prominent in the USA where companies must comply with the relevant SEC regulations (Lo, 2003). These are coercive in the sense that they lay down rules and laws that are monitored in a legally sanctioned manner. Legal constraints also operate in this arena in Europe (Ferranini, Moloney and Vespro, 2003). Compliance arises from expediency driven by the instrumental logic of avoiding penalty. For the UK, the relatively modest strictures of company law and the Directors’ Remuneration Report Regulations 2002 probably come closest to this institutional form. In terms of normative institutional influences, the activities of the independent directors operating on remuneration committees seem to capture this aspect best. Directors are driven by certain norms of behaviour in terms of rights, duties and responsibilities. Decisions are made in the light, not of what is in one’s narrow self-interest, but what is expected of someone in that role. There is a social obligation lying behind behaviours (and decisions) that leads actors to be guided by a sense of what is appropriate in the situation (Dahya et al., 2002; Conyon et al., 2002). Legitimacy arises from a moral sense of being accredited to conduct the role (through a series of selection processes that has defined a career). Finally, there is the cognitive pillar, which most clearly sees aspects of the executive pay decision as emerging from a socially constructed reality (Aguilera and Jackson, 2003). Behaviour here is strongly mimetic as a sense of legitimacy arises from doing what others are doing. Orthodoxy is the key here, and there is a strong drift to isomorphism in the organisational field in question (remuneration committees, for example). Compliance with the system is taken for granted and supported by the organisational culture which provides the individual with a framework within which to construct a social reality for themselves18. Evidence reviewed above, regarding influence effects in the board room, points to this aspect of institutional behaviour 18 A useful example of the difference between the normative and cognitive aspects of institutional behaviour is provided by (Scott, 1995, p43) who quotes two actors standing in the wings and watching the arrival of Queen Elizabeth at a performance. One comments: ‘What and entrance’ while the rejoinder of the other reflecting a more cognitive perspective is: ‘What a part’. The second comment clearly attributes more to external definitions and roles and less to social obligation. Alternatively, in terms of soccer, one can contrast the notion of roles arising from the constitution (laws) of the game such as goalkeeper, referee and so on, as opposed to roles such as striker and wing-back that are essentially socially constructed roles.

20

(O’Reilly et al., 1988; Wade et al., 1990; Zajac and Westphal, 1994, 1995, 1996; Westphal, 1998; Pollock et al., 2002). Individual CEO remuneration outcomes do vary, but the explanations of how these pay aggregates are determined follow a close pattern. Uncertainty is dealt with by imitation, and this continues period after period. What carries institutions forward is the combined inertial force of culture, social structures and routines. Cultures sustain rules where these are relevant, and propagate values and expectations, or support categories and organisational roles. Culture here may pertain to an individual board or to unitary board behaviour in general (Mace 1971; Lorsch, 1989). Social structures are most easily seen in governance systems, but also work subtly through authority and socially constructed identities (Pfeffer, 1992). Finally there are the routines so familiar to organisations, whether these take the form of standard procedures, or simply the performance of various assumed duties or adherence to scripts (Main, 1993, 1994). Inertia may play an important part in sustaining institutions, but institutional activities do not exist in a vacuum. Oliver (1992) stresses three sources of pressure for change on institutionalised norms and practices, namely: functional, political, and social. These particular sources of change occur against the background of organizational entropy continuously pressing against the organisational inertia that attempts to hold institutional practices on course. Political pressures are likely to arise in times of decreasing economic performance, especially if executive pay is seen to be rising in the face of faltering company performance. This can manifest as ‘social outrage’ (Bebchuk et al., 2002). Functional pressure arises from changing economic utility, in the form, say, of a re-evaluation of the usefulness of CEO leadership or increasing competitive forces requiring visible and possibly totemic action on CEO pay (perhaps one interpretation of recent events at SmithKlineBeacham). Finally, social pressure for change arises from a breakdown in social structure, such as relationships, or a change in organizational roles and values, possibly following a takeover or disruptive CEO succession. As an example of the importance of institutional forces in determining executive pay, one need look no further than the way that the Guidelines of the Association of British Insurers (ABI) have shaped stock based compensation in the UK. As mentioned earlier, these guidelines (lasting, with modifications, from 1984 through 1999) limited executives to holding share options with an exercise value summing to no more than four times emoluments. Certain variants on this practice were permitted, but the overwhelming thrust of these provisions was to establish four-times-emoluments as the rule. Furthermore, far from being a ceiling, as the ABI may have intended, the mimetic process ensured that this aspect of the guidelines soon came to assume the character of an entitlement in the boardroom. This serves as an example of a normative isomorphism, where notions or rights or privileges are enforced through professional organisations19. It also helps explain the marked difference between the UK and the USA in the area of stock based compensation in general, and the use of executive share options in particular. 19 On the other hand, in a rare departure for the UK, the reporting standards of the Directors’ Remuneration Committee Report Regulations 2002 represent a coercive isomorphism, although one that can be seen to represent a negotiated outcome.

21

Conyon and Murphy (2000) calculate that the total share option gains realised by all CEOs in the 500 largest UK companies amounted to some £78m in 1997. In the same year, Mike Eisner at Disney Corp (an exceptional character, to be sure) realised some £348m of option gains. While this may be an extreme case, it does serve to underscore the influence of institutional factors on the determination of top executive pay. It can be argued that the institutional environment in which decisions regarding executive pay are being taken is every bit as important to understanding outcomes as the notion of mechanism design portrayed by principal-agent theory. But if such macro or sociological considerations are important then, so too, are the individual psychological frames of reference. It is to these psychological influences that we now turn. 5. Psychological 5a. Extrinsic versus intrinsic motivation The institutional material in the previous section has already offered a challenge to the view that executive pay can be seen entirely as a rationally crafted mechanism by which the principal-agent problem is addressed. On a more individual level, there also seems to be reason to question whether those on the receiving end of these much-discussed pay packages really do react in a way that is consistent with a principal-agent story. Beer and Katz (2003) find that executives from a wide cross-section of countries report that, although their firms generally explain incentive programmes as impacting on individual behaviour and productivity, they themselves do not feel that such programmes significantly affect their behaviour. This, of course, seems difficult to believe. It is a strongly held view of many social sciences, including psychology, that behaviour (productivity, in our case) which is seen as leading to a reward (pay) will tend to be repeated. This is variously known as ‘the law of effect’ (Lawler, 1966, p14) or ‘the principle of reinforcement’ (Pfeffer, 1994, p60). Indeed, Lawler (1966, p15) firmly rejects notion that Maslow or any other Human Relations School authority ever said that pay only satisfies lower order needs, and points out that the original Herzberg et al. (1959, p118) study, for example, shows that pay is a successful motivator when it is geared to achievement and seen as a form of recognition. As a recognition of achievement, then, pay can assist the self-actualisation process. But there is a tension here, as the idea of intrinsic motivation derives from the need to be self-determining and competent – in control, as opposed to being externally controlled (Deci and Ryan, 1985). The danger with extrinsic rewards, of course, is that they have the effect of controlling. As such, they can detract from intrinsic motivation. This is the ‘hidden costs of rewards’ argument (Lepper and Greene, 1978; Kohn, 1993). In our context, should executives see their complicated remuneration packages as controlling then their behaviour may well suffer from a reduction in motivation. Frey (1997) examines the economic approach to intrinsic motivation, and notes the difficulty that economists have with the notion. In particular, he takes as an example the discussion of a prominent study by Richard Titmuss (1970) comparing the

22

partially paid system of blood donation in the USA with the unpaid system in the UK. Titmuss surmises that a move to offer payment for blood donations in the UK might actually decrease the supply. In two independent reviews of this work, Arrow (1972) and Solow (1971), highly able economists fail to come to terms with this argument. Their view is essentially that wherever a certain amount of altruism exists, then adding a monetary incentive can only increase the propensity to supply blood donations. The notion that the monetary payment might alter the nature of the exchange or somehow diminish the motivation to give, is not something that sits comfortably with standard economics. Economics tends to focus on extrinsic motivation to the exclusion of intrinsic motivation. In an attempt to incorporate the distinction between extrinsic and intrinsic motivation into economics, Frey (1997) models a specific interaction between the two. In this model, the presence of external interventions, such as incentive payments (the ‘price effect’) can undermine intrinsic motivation in a ‘crowding-out effect’, and so off-set if not completely undermine the intended result. Using Frey’s (1997, p21) notation: Assume: B = benefits to be derived from activity C = cost entailed P = level of performance ∂B/∂P = BP > 0; and BPP < 0 ∂C/∂P = CP > 0; and CPP > 0 If benefits and costs are also influenced by external interventions (E) as follows: B = B(P,E) ; BP > 0; and BPP < 0 (1)

C = C(P,E) ; CP > 0; and CPP > 0 (2)

Agents will move towards a level of performance to maximise net benefits (B-C), choosing P* such that,

BP = CP (3)

But this condition will be affected by the externally imposed E, and from (3):

BPE + BPP ∂P*/∂E = CPE + CPP ∂P*/∂E (4)

The exact impact of external intervention on performance (∂ P*/∂E) is, therefore, uncertain according to whether the relative price effect (CPE ) or the crowding out effect (BPE ) dominates.

0*

>−−

=∂∂

PPPP

PEPE

BCCB

EP

or 0*

<−−

=∂∂

PPPP

PEPE

BCCB

EP

Frey (1997) considers the following three situations:

23

(i) Here, principal-agent theory achieves its focal effect of increasing the cost of shirking or diminishing the marginal cost of performing (CPE << 0) but with little or no impact on intrinsic motivation through crowding out (BPE ≈ 0), then external incentives always raise performance.

(ii) If, however, external intervention undermines intrinsic motivation by crowding it out, (BPE << 0), and the disciplining effect is weak (CPE ≈ 0), then external incentives have the perverse effect of lowering performance. This is something noted by the cognitive psychologists in their laboratory experiments (Lepper and Greene, 1978; Deci and Ryan, 1985).

(iii) In the third case, the outcome is indeterminate, depending on the relative size of the two effects, but as long as BPE < 0 there is some cost to external incentives.

The motive force here is a change in the perceived task environment, which impacts on the actor’s self-perception. The effect may be due to a sense of impaired self-determination owing to a shift in the locus of control caused by a move, say, from a supportive to a controlling environment. In our executive remuneration context, this might be a move to a tightly specified payment-by-results regime. Bénabou and Tirole (2003) attempt to reconcile the paradigm clash between central theme of economics that incentives work (contingent rewards are positive reinforcers) and “dissonance theorists” (Deci, 1975) who see them as negative reinforcers, in that the action of incentives in the work place is dehumanising and alienating. In a model that is more structural than the reduced form approach sketched above from Frey (1997), the agent is described (Bénabou and Tirole, 2003) as using the nature of the incentives provided to make attributions about the principal’s private information regarding the task at hand, or about the prospects of successfully completing the task. It is shown that this indirect influence of the incentive structure operating through the agent’s inferences may weaken the incentive effect of rewards. The extent of the effect depends on the degree of asymmetry of information between the parties. In an executive compensation setting, it may be thought that this asymmetry is unlikely to be substantial and, if anything, be to the benefit of the incumbent CEO. There is also an important issue regarding the size of the extrinsic incentives. It has been confirmed in both laboratory and field experiments (Gneezy and Rustichini, 2000) that small(ish) incentive payments can be counterproductive. This is true for areas such as productivity in IQ tests or success in collecting for charity. But Gneezy (2003) demonstrates that, while decreases in productivity are observed for small rewards, this negative effect does not arise with large rewards. And, of course, with CEO pay we are talking about some very large rewards. It should also be made clear that this area represents a fault line in psychology between behaviourist psychology (BF Skinner) which sees behaviour as a function of past reinforcements and cognitive social psychology (Deci and Ryan, 1985) which sees activity as determined by expectations and attributions and allows a motivation independent of reward. Several recent meta-studies (Wiersma, 1992; Cameron and Pierce, 1994; Deci et al., 1999; Cameron et al., 2001) have served to underline the fact that this remains a contested area, and matters are far from settled. In particular, there is the issue of whether intrinsic motivation and, indeed, performance should be measured in ‘free time’ or in a task-performance situation. This is vitally important

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when attempting to translate the implications of the (mainly laboratory-based) studies to the workplace. The issues raised here concerning the importance of intrinsic motivation and the possibility that overly extrinsic incentive devices (such as executive share options and long term incentive plans) may ‘crowd out’ intrinsic motivation has led Frey and Osterloh (2004) to reverse the prescription of Hall and Leibman (1998). Hall and Leibman suggested that recent developments in executive pay had moved things in the right direction in terms of addressing the lack of pay-performance sensitivity identified by Jensen and Murphy (1990), and suggesting that CEOs could no longer be regarded as being paid like bureaucrats. But Frey and Osterloh (2004) argue that, from a motivational perspective, it would be no bad thing if CEOs were paid like bureaucrats as the current emphasis on extrinsic incentives runs the risk of crowding out intrinsic motivation in CEOs. 5b. The extrinsic motivation bias The cognitive psychology approach also suggests a reassessment of the behaviour of the remuneration committee in designing the remuneration packages of the CEO and other executives. We have already discussed the institutional forces that lead organizations to follow one another in a search for legitimacy, but there is also a more micro phenomenon in what the remuneration committee members see as fitting by way of executive remuneration. In a series of experiments, Heath (1999) demonstrates that individuals exhibit what he labels an ‘extrinsic incentive bias’ in assessing what motivates others. As the name suggests, this bias involves a tendency to think that, compared to oneself, other people are more driven by extrinsic motivation (through monetary reward, say) than by intrinsic motivation (through learning new things, say). In some ways, this result stands in marked contrast to the more widely recognised ‘fundamental attribution error’ (Jones and Nisbett, 1972) whereby, in attempting to explain an actor’s behaviour, the external observer tends to overemphasise the influence of the individual’s personal disposition rather than the situational factors. Interpreted in terms of the remuneration committee, this would lead them to see the CEO’s actions as more driven by dispositional consideration than by any circumstances such as the presence of executive share options. But, Heath’s empirical evidence suggest quite the reverse, namely that a group such as the remuneration committee is likely to over emphasise importance of the extrinsic aspects to the CEO, diminishing the role of intrinsic motivation. In matters concerning agency relationships, Heath (1999) argues that it is the ‘extrinsic incentive bias’ that is observed and not the ‘fundamental attribution error’. Heath (1999) explains the difference as arising from two things. First, there is the nature of the agency relationship itself, wherein principals (members of the remuneration committee) perceive situational factors such as bonus payments as salient, even when they are not to the agents themselves (they having become habituated). And, second, he invokes the informational difference that exists in ongoing agency relationships but is not present in more casual, short-lived encounters. Because of this, agents can be expected to base their behaviour on stable long term

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preferences and are, consequently, less likely to see their own behaviour as being due to circumstances – quite the reverse of what is likely to happen in the staged setting of a laboratory study or other novel situations. It is, therefore, arguable that remuneration committee decisions may be susceptible to extrinsic motivation bias. If the remuneration committee does perceive the focal CEO to be driven more by extrinsic motivation than is indeed the case, then they are more likely to load the remuneration contract with performance related attributes (and to boost its overall level) than if the intrinsic motivation from leading the company were seen to be more important. The problem with such a misperception and reaction is, of course, that in setting in place these extrinsic rewards the executive may be made to feel a loss of control and, indeed, to feel controlled. As such, due to effects discussed in the earlier part of this section, the basic intrinsic motivation will decline and performance may falter in the face of such high-powered incentives. Of course, the net productivity effect may still be positive (because of the size effect alluded to above) but the net result may be disappointing. 6. Conclusion - could executive compensation be improved? For many, the fascination in studying top executive pay is that it provides a rare opportunity to look inside the black box of the firm. For the top management team, details of remuneration arrangements (levels of pay, bonus arrangements, and other incentive devices) are publicly available. In addition, the performance of the top management team is also observable in a reasonably unambiguous manner. None of this is generally true at other levels of the organisation. Reviewing recent work in this area produces some clear impressions. CEO remuneration has undoubtedly excalated over recent years. This may owe, in part, to an increased awreness of the importance of the pay setting process. Partly encouraged by governance reform, companies have taken steps to ensure that there is a transparent and accountable process through which to determine executive remuneration This may possibly have created an upward ratchet in pay, as companies’ remuneration decisions in one period directly impact on the ‘going rate’ that will be used as a basis in defining the worth of a CEO in the next period. Notwithstanding much press comment, politicians have generally avoided direct intervention in the area. While there is some room for scepticism, evidence exists of a functioning labour market for CEOs and other senior executives. It is certainly not possible to sustain a picture of CEO pay as a conspiracy of insiders managing to enrich themselves at the expense of the shareholder. That said, the pay determination process is conducted in a socially constructed situation, and it would be inappropriate to attempt to portray this as a perfectly competitive labour market. Among other things, both the jobs and the employees concerned are too idiosyncratic so sustain such a story. There is also a limit as to what can be expected by way of pay restraint from independent directors operating in the social context of a unitary board. In recent years, executive share options have offered an effective tool by which to craft remuneration packages. They have been given a substantial boost, in part, by tax considerations and, in part, by accounting conventions regarding the reporting of

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earnings. Somewhat perplexingly, they also represent an expensive medium of payment, costing the employer significantly more than they are worth to the employee. But, in their own right, they possess a useful means of effecting an objective and levered linkage between remuneration and company performance, at least as defined by the share price. This incentive effect can explain the continued use of options even though they are valued by the executive at less than their cost. Other stock based tools (such as LTIPs) suffer from their own failings. In terms of causality, whether paying in this way actually leads to better company performance - something that might be regarded as the $64,000 question - much remains to be done and surprisingly little is known. In addition to causality, three areas call out for more attention. First, while much work has been done examining the effectiveness of incentive alignment, in terms of the expected reward delivered to the executive for a given expected return to the company, less in known regarding the riskiness of the investment and strategic decisions that the CEO is prepared to take. It appears that what Ross (2004) refers to as the ‘common folklore’, of options effecting this alignment, can no longer be taken for granted. This is a matter of reconciling not only the focus of the executive’s actions (say, shareholder value or stakeholder welfare), but also the willingness to engage in risky strategies and risky investments. And, here, ‘risky’ involves the degree of risk, not simply the presence or absence of some risk. Second, more attention could beneficially be given to trying to understand the influences of institutional forces on the determination of executive pay. Marked cross-country differences in practice and outcomes can be explained in this way, as is seen in the matter of share option usage in the UK versus the USA. It also seems probable that within-country understanding of executive pay could be improved by incorporating such institutional practices into our explanations. Thus, while the nature of the potential interactions between executives and their environment has been successfully revealed, it is clear that larger institutional forces are at work. A more complete understanding of these would seem to be necessary for successful policy development in terms of executive remuneration. At the moment, there seems to be a less than complete understanding of what the full impact of successive policy initiatives will be (e.g., Cadbury, Greenbury, or Hampel in the UK). It certainly seems possible that a good number of unintended consequences have ensued. Third, although there has been a considerable amount of work done on analysing the actions of boards and remuneration committees as social constructs, there may be some advantage to looking a more carefully at the psychological perceptions shared by such groupings when they deliberate over the appropriate remuneration package for the CEO and other executives. A mismatch in the balance of extrinsic versus intrinsic motivation in job design can have potentially deleterious effects on the productivity of the top management team. Here, the underlying perceptions and motivations of the main actors are of key importance. This is a question of whether the CEO and other top executives are really driven by extrinsic rewards, or whether an over-reliance on such rewards may, in fact, have a counterproductive or at least costly effect by crowding out the intrinsic motivation that is so obviously available in leading an enterprise. If the remuneration committee shares a distorted or biased image of executive motivations this, in itself, may lead to inappropriately designed compensation contracts.

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As a result of a concerted research effort, much more is now known about how executives react to incentives. One sensible policy innovation that follows from this work is the imminent introduction of International Accounting Standards Board regulation “IFRS2”, concerning the recognition and expensing of share based payments20. We also have a far deeper understanding both of the extent to which environmental variables impact on the nature of the executive contracts and of how the executives themselves have an impact on that environment. One fact emerges from perusing the work done on the topic of top executive remuneration. It has allowed a light to shine inside the black box of the firm. And the box appears to be far from empty!

20 IFRS2 will take effect for all annual periods beginning on or after 1 January 2005 and will involve grants of shares and options made after 7 November 2002 which had not yet vested by 1 January 2005. So the first reports reflecting this rule change will appear in early 2006 for the 2005 year. There is a choice in US GAAP reporting standards in this area (between what is known as the APB 25 Accounting for Stock Issued to Employees model, which is based on intrinsic value at grant date, and the SFAS 123 model, which uses a notion of fair value as its measure). The latter probably lies closer to IFRS2 but there is no expensing currently involved in the US GAAP, merely recognition.

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