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Henry: Understanding Strategic Management

Chapter 12

Key Work feature: The controversy surrounding executive remuneration

There is much controversy and debate surrounding what is an appropriate level of executive remuneration. The huge sums being reported on both sides of the Atlantic suggest that something may be wrong. The issue is not the huge size of executive remuneration per se, although some would argue that there should be some connection between executive pay and that of the average worker’s pay, but what exactly are these executives being so highly remunerated for. The debate is therefore best placed in the context of what executive management has (or has not) achieved; in short, is there a link between executive pay and organizational performance.

Gadiesh et al., (2003) argue that setting executive pay should reflect sustained and superior performance. They suggest that institutional investors should focus on what executives are paid for rather than how much they are paid but. They argue that organizations which appear to derive real benefit from linking pay and performance do so by applying 4 basic principles. First, such organizations are clear about what drives value in their businesses. Second, they tie compensation to the real value created by management. Third, they recognize that the frontline drives the bottom line. And four, trust is built through compensation systems that are simple to understand and transparent.

Bebchuk and Fried (2004) suggest that one reason for the disaggregating of pay and performance in the United States is because the CEO wields enormous influence over the board of directors who are responsible for determining executive compensation. As a result compensation boards have the interests of the CEO as their primary concern with shareholder interests as secondary. Bebchuk and Fried refer to this as their managerial power thesis. It is because executive compensation is determined by managerial power rather than determined at arm's length by directors acting as agents of the company that we find incentives for directors to implement compensation arrangements which do not appropriately link pay and performance. For Bebchuk and Fried the issue that requires resolution is the way in which corporations hide the fact that executive pay is often disconnected to performance.

Bebchuk and Fried suggest reforms which they believe would make executive pay more transparent and more closely aligned to performance. These include an expectation that boards take into account the rise in an organization’s share price which result from exogenous factors, such as industry trends, when setting executive compensation. Also corporate governance reforms such as making it easier for shareholders to nominate directors to the organization’s board such that their interests remain paramount.

McConvill (2006) goes further and suggests that the pay for performance is a failed methodology. He argues that agency theory and pay for performance derive from what he considers is an incorrect understanding of human motivation and behavior. Given the inherent divergence between the principal and agent it is accepted in agency theory that an efficient compensation contract needs to link pay with performance in order to ensure that executives operate in the interests of shareholders. This reduces agency costs, such as monitoring executives’ behaviour.

McConvill suggests that executives are not principally motivated by money in terms of their relationship with the company, and therefore money is not the best mechanism to appeal to their interests. He seeks to widen the debate from wealth maximization being an end in itself for executives to a position where executives view money as a means to an end, with that end being personal happiness. This personal happiness is derived by executives doing what is best for the organization in which they are employed. This approach suggests a virtuous cycle in which the interests of organizations and their various stakeholders are best served by recognizing and promoting the positive virtues and objectives that executives bring to their role. This is in stark contrast to assuming that executives are guided purely by a myopic self-interest, centered on obtaining the highest possible compensation.