Abstract
This paper investigates a series of normative principles that are used to justify different aspects of executive compensation within business firms, as well as the remuneration of lower-ranking employees. We look at how businesses perform pay benchmarking; employees’ engagement, fidelity and loyalty (and their effects on pay practices); and the acceptability of what we call both-ends-dipping, that is, receiving both ex ante and ex post benefits for the same work. We make two observations. First, either different or incoherent principles are used to justify the pay of executives compared to employees, or the same principles are applied differently. Second, these differences or inconsistencies tend to be to the benefit of executives and/or to the detriment of employees. We conclude by asking whether there is any reason for thinking differently about executive pay than we do about employee pay. Our analysis leads us to question the principles justifying current executive compensation and to wonder if these principles are potentially being instrumentalized to serve other ends.
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Notes
See, for instance, Frydman and Jenter (2010), Frydman and Saks (2010), Allaire (2012), St-Onge (2014) and a report in the Harvard Business Review (2014). In recent years, the emphasis has been on incentive compensation rather than cash salary. Damodaran (2015), relying on data from Compustat Execucomp, finds that 70% of the typical CEO compensation package in 2013 is equity-based, with cash compensation (salary and cash bonuses) trailing at less than 25%. See also Anderson and Klinger (2016) on the evolution of inequalities regarding retirement plans of CEOs in comparison with employees. The work of Piketty (2014) on inequality is also relevant in this respect.
Equity-based compensation to non-executive employees is on the way out. In the decade leading up to 2010, the number of US employees with stock options declined by a third, to less than 9%. The decline has been even more dramatic in the innovation/high-tech sector, with the percentages of employees having an equity interest in their employer dropping from around 60% to less than 20% (Blasi 2017; Chasan 2013).
Moriarty (2006) refers to ‘the agreement view,’ but we will use these two views interchangeably for the purposes of this paper. A view based on the value of an agreement largely overlaps with a view based on the value of freedom. More generally, notions such as freedom, agreement, consent, coercion, voluntariness, independence, being informed about one’s choices, autonomy, etc. are closely connected with each other. It is often hard to define one of these notions without using the other. For instance, Shaw (2006, 97) uses the notion of an agreement to define the notion of libertarian freedom. This is consistent with the definition we provide above, with free agreement being a condition for just executive pay.
Or consider these other difficult questions that a board may have to answer if it wants to pay an executive according to the efficiency view: Is executive pay efficient as soon as an executive increases value creation for a firm above its cost to that firm? Or must an executive maximize value creation at a given cost? What if a CEO B can create more value than a CEO A, yet has the same cost in terms of their compensation package? Or what if CEO B can create as much value as CEO A, but for a smaller cost? When boards are hiring CEOs, they will consider which candidate is the most likely to create the most value, and this will influence the compensation package that will be offered.
As an example of the force of judgments about deservingness, consider that workers who are less well remunerated often end up under-performing because they feel that they are deprived of what they, too, deserve (Cowherd and Levine 1992). The phenomenon has also been observed among top executives, where high inequalities in levels of compensation may have an impact on performance (Fredrickson et al. 2010).
Consistent with an efficiency view, Boatright (2010, p. 190) claims that executive compensation is justified ‘if it is the result from arm’s-length bargaining,’ with the ultimate aim of this bargaining being ‘maximum wealth creation for shareholders.’ However, his view rests on ‘the justness of a free market capitalist system’ and the ‘relevant ethical principles’ people accept within the system, such as enforcing property rights for freely exchanging goods and services (171 ff.). Boatright even draws a connection between his conception of justice in pay and Nozick’s entitlement theory, thus reinforcing the impression that he considers the preservation of economic freedom as critical. Boatright also claims that there is consensus in the USA on these views, as they are embodied in business laws, market regulations and even general public views. At this point, it becomes unclear whether he endorses the efficiency or the freedom view.
Executive compensation cannot be efficient if firms and executives do not have the necessary freedom to negotiate their employment agreements—if, say, governments imposes labor laws that are too strict or intervene in the labor market in other ways. This is why the market is considered to be preferable to other, more bureaucratic arrangements for organizing economic activities (e.g., Buchanan 1985; Legrand and Bartlett 1993).
For example, advocating less regulation and more economic freedom on executive compensation questions can be viewed as the best way to ensure efficiency in the market. Here, freedom is defended instrumentally, rather than being considered valuable in itself. But it implies that economic freedom may be constrained as soon as it is shown that more freedom will not increase efficiency. Regulations can be imposed on the labor market if, for instance, market failures or distortions need to be corrected. Such interventions may be more difficult to justify under the freedom view.
The compensation literature refers to internal and external equity, with equity appreciation essentially resting on benchmarking considerations.
Albuquerque et al. (2013) provide a different perspective. While they acknowledge that most prior research seems to show that firms are more likely to compare themselves with comparable firms that pay their CEOs better, they question the conclusion that this serves the interest of CEOs and other executives. Instead, their findings suggest that the upward bias in compensation resulting from the peer group selection is more likely to reflect a reward for unobserved CEO talent, rather than self-serving behavior. Referring to Holmstrom and Kaplan (2003) and Bizjak et al. (2008), they conclude that the effect of peer benchmarking on CEO pay is more likely to reflect tighter managerial labor markets than weak governance.
https://blog.mercerpeoplepro.com/salary-compensation-benchmarking-101/. Retrieved November 8, 2017.
http://www.haygroup.com/ca/services/index.aspx?id=6555. Retrieved November 8, 2017.
Scott et al. (2011) also find that employees in large firms are more likely to highlight concerns about the fairness of remuneration than employees of small firms. These findings are somewhat puzzling, as larger firms typically have more formally developed reward programs, policies and structures. One may wonder if the publicly disclosed compensation packages of senior executives at large firms do not contribute to increased concerns about fairness in such firms. In any case, Scott et al. also recommend that large firms pay even more attention to the perceived fairness of their pay practices, which includes a better understanding of the employee perspective in reward program values.
Some firms do refer to internal equity in describing their executive compensation practices (e.g., JPMorgan Chase). However, in contrast to benchmarking, whose mechanics are typically well described with specific objectives or targets, references to internal equity with lower-level employees are typically rather vague.
See Kahn (1990). There are several other definitions of employee engagement being circulated (for instance, by firms such as the Corporate Leadership Council). The above definition only provides a template for analysis.
Firms face a major challenge as the estimated cost arising from poor employee engagement is huge, see Sorenson and Garman (2013).
Macroeconomic data point toward low salary growth in the USA, Canada and the UK despite consistent economic growth, an outcome that is consistent with firms taking measures to lower their labor costs. For example, see The Economist, Why American wage growth is so lousy (April 14, 2015) at https://www.economist.com/blogs/economist-explains/2015/04/economist-explains-12. Retrieved November 8, 2017.
The saga is not over yet. On March 6, 2017, CSX, a large US railway firm, announced that it had appointed Mr. Harrison as its CEO (Atkins 2017).
Overall data from the Conference Board suggest that the average tenure for CEOs of Standard & Poor’s 500 firms has fluctuated at around 9 years since the early 2000 s, with a low of 7.2 years during the financial crisis in 2009 and a high of 11.3 years in 2002. However, these figures are sensitive to extreme cases: For instance, for 2014, the average tenure is 9.9 years for CEOs of Standard & Poor’s 500 firms, but only 9.0 years if we exclude the retirement of two long-serving CEOs (Larry Ellison of Oracle, with 37 years, and Peter Rose of Expeditors International, with 26 years).
Moriarty (2005, p. 258) makes a similar distinction when he writes that what he calls the utility view, as opposed to the desert view, ‘conceives of wages not as rewards for past work, but as incentives for future work.’
One may point out that executives get something like a ‘welcome to the firm’ bonus and something like a ‘see you later’ bonus, but both bonuses are negotiated up front. Therefore, there would be just one ‘dip’ at the beginning, and this practice would be consistent with the efficiency view. This scenario is certainly plausible. Ex ante and ex post benefits may be negotiated up front in some cases. But it must not be forgotten that ex post benefits do not only involve pay severance packages or retirement plans. They also include ad hoc bonuses that are not negotiated up front. Therefore, there are still many scenarios wherein the dipping-from-both-ends phenomenon may occur.
To illustrate further, the magnitude of executive compensation relative to firms’ earnings has increased from around 5% in 1993–1995 to around 10% in 2001–2003 (Bebchuk and Grinstein 2005; Sur et al. 2015, p. 31). From 1978 to 2011, the increase in CEO compensation, which can be put at more than 725% according to some estimates, is substantially greater than stock market and corporate earnings growth (Mishel and Sabadish 2012).
Piketty (2014, p. 331) points out, for instance, that there is no objective basis for high executive compensation, because the job function is unique and not replicable, which makes it ‘something close to a pure ideological construct’ and, therefore, more likely to be influenced by cultural perceptions.
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The authors would like to acknowledge financial support from the Stephen A. Jarislowsky Chair in Corporate Governance, the Institute for the Governance of Private and Public Organizations, and the Mitacs Accelerate program.
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Magnan, M., Martin, D. Executive Compensation and Employee Remuneration: The Flexible Principles of Justice in Pay. J Bus Ethics 160, 89–105 (2019). https://doi.org/10.1007/s10551-018-3786-5
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DOI: https://doi.org/10.1007/s10551-018-3786-5