Executive Compensation and Financial Performance Research Paper

Introduction

It is generally agreed that executive officers play critical roles in running day-to-day activities of companies and firms in many industries (Ismail, Yabai, and Hahn 14; Aaron, McMillan, and Dunne 48). They are tasked to ensure that proper strategies are implemented; resources are used with highest levels of efficacy; and are involved in critical decision-making processes while acting as links among key stakeholders (Adams 1; Comp and Smith 10; Overton and Stoffer 2).

It is imperative to note that most executives receive exorbitantly higher compensation packages relative to other employees. For instance, the CEOs pay has been on the rise with major companies paying 42 times, 85 times, and 531 times more than average employees in 1980, by 1990, and in 2000 respectively (Ismail, Yabai, and Hahn 14).

The extremely high inequalities in the compensation of executives and other employees have raised concerns among pundits, practitioners, and other stakeholders. While other experts justify the level of executive compensation by citing the key roles executives play in running the companies, others view the compensation as too discriminatory and unjustifiable. (Ferracone 38; Devers, Cannella, and Reilly 1021)

This paper examines the justification of huge executive compensation in relation to other employees. Particularly, the paper seeks to establish whether there is a correlation between high executive compensation and companies’ financial performance and value. Throughout the discussion, executive compensation will entail all the salaries, incentives, and other benefits, as illustrated by Ellig (4).

Are the US Executives Overpaid?

Since the early 1990s, executive compensation has been increasing drastically. Currently, the median pays for CEOs are more than 500 times the median pay of other workers. As such, there are numerous views and opinions concerning whether what executives in the US get is fair and justifiable.

In attempts to address the issue of whether the executives are fairly compensated, Ferracone put forward three thoughts, which could resonate with a majority of scholars and practitioners.

1. Executive compensations are basically too exaggerated.
2. There are executive compensation outliers that draw unwarranted and/or undue attention and generate media frenzy and public outcry
3. There are numerous occurrences where companies pay too much to the executives when the performance is low

However, the author flaws the views and anxieties that are just concerned with executive compensation without paying attention to other pertinent issues. According to Ferracone, “median executive compensation is not really the issue” (p. 8) and, therefore, other factors should be considered in determining whether executives are overpaid and justifying the drastic increase since the 1990s.

For instance, the element of inflation should be factored in when addressing the extreme rise in executive compensation. Moreover, the median firms’ sizes have drastically increased over the last 20 years, and, therefore, there should be corresponding increases in executive payment. However, this could be counter-argued since it does not comprehensively address the huge ratio between executive compensation and median workers’ pay.

Nevertheless, the argument by Ferracone, that the real concern is not the high executive compensation but rather the outliers and performance and pay alignment is popular among some pundits and investors.

Does the High Executive Compensation Result in Good Performance?

Numerous studies have been carried out to investigate the correlation between high executive compensation and firms’ performance. Most of the studies are country-based and, therefore, they focus on the performance of companies under specific economies.

Oyerogba, Riro, and Memba (11) carried out an empirical study on the influence of executive compensation on the performance of firms in Nigeria, a developing country, with data from 2004 to 2013. The study sample included 70 firms picked from approximately 200 listed corporations.

After descriptive and inferential statistics, the authors discovered that there existed a constructively positive relationship between some aspects of executive compensation, including cash incentives and bonuses and the financial performance of median firms. Nevertheless, the positive relationship was not revealed insignificant levels between non-cash incentives and performance.

Ismail, Yabai, and Hahn (14) researched through a study on the relationship between executive compensation and company financial performance using a sample of 100 firms from Malaysia. Data was collected in a span of five years, 2006-2010, and the results revealed that there is a significantly positive relationship between executive payment and companies’ financial performance. As such, correlations and regressions were established to vary from weak positive to strong positive.

Gao and Li (370) used a sample from public companies listed on NYSE, AMEX, or NASDAC and private firms in the US across approximately 50 industries to investigate the comparability of private and public firms in financial performance with increased executive compensation. Data from 1999 to 2011 was used, and the results revealed that CEOs in public companies get 30% more in compensation than executives in similar firms in the private sector. Moreover, it was evident that in median firms, private and public, executive compensations have positive and significant relationships with accounting performance. However, the relationship was relatively weaker in private companies.

In addition, the authors demonstrated that issues such as executive ownership, employee stock ownership, stock liquidity, and discipline from the takeover market contribute highly to the establishing of a pay-performance relationship in the comparison of private firms and public firms.

Tarus, Basweti, and Nyaoga (113) investigated the effect of executive compensation on the financial performance of insurance firms in Kenya, which is a developing country. The authors considered adopting the regression model to establish whether there is a relationship between executive remuneration and financial performance. It was evident that there are insignificant relationships between CEOs pay in the selected sample and financial performance.

Thus, the study revealed a negative correlation and, therefore, capping executive compensation to maximize shareholders returns should be considered. It was also evident that performance ratio had minimal implications on the determination of executive pay (Tarus, Basweti, and Nyaoga 113)

Kutum (272) conducted an inter-industry survey that investigated the relationship between executive compensation and firm sizes and financial performance.

The following table indicates the outcomes and the proof of the proposed hypotheses.

Table 1. Hypotheses on the correlation between executive compensation and firm size/performance. Source: ¹

Hypotheses 1, 2, and 3 were validated with significantly strong positive and, therefore, there is a correlation between executive compensation and firms’ sizes. However, Hypothesis 4, 5, and 6 had no correlation implying that CEOs had an insignificant correlation to banks performance.

From the above cases, it is evident that many empirical studies link high company financial performance to high executive compensation. However, the results of these studies may not portray what actually happens in every firm. As such, there are many cases where high executive compensations do not translate to higher financial performance. The study by Kutum presents interesting facts that pundits and practitioners should consider.

How Executive Compensation in the US Companies Compare with Other Countries

In many countries, boards of management determine the executive compensations (Buigut, Soi, and Koskei 223; Ismail, Yabai, and Hahn 14). Moreover, it is worth noting that the compensation may have slight differences in term of the modes and types of payment, but a common element in among many, if not all, countries is that the executive compensation is drastically increasing (Conyon, Fernandes, and Ferreira 2).

Compared to other countries, the US companies have conventionally been the top paying. Although western countries pay more than other regions, the US companies stand out in making extremely high executive compensation (McDonnell par. 2). In 2012, for instance, more than $15 million was paid to only 100 CEOs in the US with at least 25 of them having projections of $100 million in half a decade earnings.

Though paying slightly less than the US, the UK companies are the highest in the continental Europe while German and France leading in Europe in CEO pay.

Conyon, Fernandes, and Ferreira did a transatlantic analysis on executive compensation among ten European countries and the US. It was evident that comparison of the executive pay between the US and other region has faced the challenges of in accurate reporting and/or lack of disclosure of CEOs pays.

Moreover, it was apparent that the public uproar across the Atlantic region is linked to the latest global financial meltdown. Nevertheless, recent developments have made it easier for scholars and pundits to make effective comparisons since more disclosures on executive compensation are happening in Europe.

The authors used data from Boardex and Execucomp for the European countries and the US respectively. Using roughly 1500 US companies and 900 firms in Europe and with data from a span of six years, Conyon, Fernandes, and Ferreira found that executive compensation in the United States firms are modestly higher than the CEOs pay in European firms. This could be linked to the controlling of firms and ownership evident in Europe. In addition, comprehensive comparison revealed that tighter links between executive compensation and performance are present in the US firms relative to European companies.

Moreover, it was revealed that executives in the US firms controlled relatively more wealth in stock and options than European CEOs. Consequently, the authors made the inference that considerable discrepancies and differences between the US and the European executive compensations could be ascribed to the higher use of stock and options by the US firms CEOs relative to their European counterparts.

Concerning the CEO and other employees’ compensation ratio, the US is extremely higher relative to other countries. Executives’ compensations in the US are 400-500 times more than what majority of other employees get. This is exceptionally on the higher side compared to the 22, 15, and 12 ratios for the UK, France, and Germany respectively.

It is imperative to note that the European Union has made a suggestion to cap the executive compensation with countries such as France narrowing the gap between the CEO pay and other workers’ compensations (McDonnell par. 3).

In Asia, the MENA regions and other emerging economies, the executive compensations are lower than the US (Sun, Zhao, and Yang 775). Nevertheless, they are drastically on the rise surpassing the pay in Europe in 2011 in some Asian countries. It is worth noting that if accurate executive compensation was reported in Asia, especially in china, pundits purport that it would almost 50 times that the reported.

Companies’ Performance versus Executive Compensation

A study done by the Wall Street journal revealed that although considerable numbers of executive compensations are tied to financial performance, high CEOs pays do not always translate to high performances.

Table 2. Executive compensation for top five performing firms in the Wall Street Journal survey. Source: ²

The above table represents some of the best performing companies from various industries as seen in the survey by the wall street journal. It is evident that the expenditure on the executive compensation is justifiable if compared with the shareholder returns. However, it is apparent that the executive compensations in all the listed companies do not digress significantly from the mean executive pay in the sample used.

As such, the positive performance cannot be attributed to executive compensation higher than the mean pay. In fact, some of the CEOs such as Garry C. Kelly of Southwest Airlines received only $5 with a 126% shareholder return.

Table 3. Executive compensation for the bottom five performing firms in the Wall Street Journal survey. Source: ³

The CEOs in table 3 received competitive remuneration during the time under survey. For instance, Filip K. Asherman of Chicago Bridge &Iron and Steven L. Newman of Transocean received $14.3 and $14.2 respectively. Nevertheless, the companies experienced dismal financial performances having extreme negatives in shareholder returns.

From the two categories of firms, it can be concluded that executive compensation can be extremely high and yet a company has a negative financial performance. Moreover, positive company performance may be realized even with the market executive compensations.

Therefore, it could be established that increasing executive compensation does not translate to augmented financial performance (Wang 1). Thus, hiring a highly compensated CEO by poorly performing firm may not change its performance.

Although increasing CEO’s pay could be motivational and increase commitment, other elements that affect the performance of a form should be considered in the endeavors to transform a poorly performing firm into a successful company.

Team Managers’ Salaries and Winning Percentages

Comparable to the compensation for CEOs, the contracts and payment of sports managers/coaches receive considerably intense public scrutiny and interest (Thomas and Horn 189).

It is apparent that team managers receive considerable huge payment. For instance, compensations for head basketball manager at NCAA Division 1 programs are three to four times more relative to what the university presidents earn (Brewer, McEvoy, and Popp 75). Moreover, it is imperative to note that the coaches control considerably huge amounts of revenue.

Although winning percentages (wins and losses) are not the only element used in determining the effectiveness of a team manager, they are vital factors that are used as ultimate evaluating tools for job performance.

Brewer, McEvoy, and Popp (74) investigated some of the factors that influence the determination of coaches’ pays in the NCAA and came up with a model that involved key factors such as lifetime success, experience, and revenues generated by the sport.

From the secondary sources used, the authors suggested that hiring or keeping a highly compensated team coach does not translate to increased winning percentage. It was also apparent that there exist huge discrepancies in guaranteed sports coaching pay per win in a particular NCAA season where some coaches would get $ 1million while others were given $ 50 thousand (Brewer, McEvoy, and Popp 76).

Conclusion

Executive compensation has received considerable scholars’ scrutiny and public uproar for some time in history. The scrutiny and interest on executive compensation have intensified by the recent global financial crisis. Some stakeholders deem it necessary to have reforms and proper regulatory frameworks in executive pay in many countries, especially the US and in Europe.

Apparently, there are three viewpoints that can be adopted in dealing with the controversies regarding the overpaying of the executives in the US. First, it can be argued that the executive compensations are exaggerated. Second, executive outliers draw undue attention. Third, there are instances when pay does not reflect performance. As such, addressing the pay-performance relationships is vital.

Comparing the executive compensation in the US and the rest of the world has revealed that US CEOs get the highest pay. The European executive less compared to their US counterparts and have a lower ratio compared to other workers. It is imperative to note that the European Union proposes for the capping of executive compensation.

Regarding the executive pay in Asia and emerging economies, it is evident that the US median surpasses the average CEO pay in countries such as China. However, it is apparent that the rise in executive pay in Asia is drastic and may exceed the Europe region. Moreover, some pundits believe that the executive compensation in Asia and emerging economies may be underreported making comparison difficult.

This paper has revealed that oftentimes, high executive compensation does not translate to high firm financial performance. Although some empirical studies reveal some correlation between performance and executive compensation, some CEOs get excessively high pay yet they ran the worst performing companies.

Moreover, it is evident that hiring and keeping the highest paid coaches does not always result in increased team winning percentages.

Recommendations

1. It is evident that even well-intended regulations oftentimes have negative/punitive effects and, therefore, they should be cautiously put in place while considering corporate governance as opposed to political interventions
2. Future research on the rise of executive pay should factor in critical issues such as inflation
3. To address the underperforming of a company, stakeholders should consider carrying out comprehensive survey in all pertinent departments to come up with an appropriate solution as opposed to hiring a more highly compensated CEO

Works Cited

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Footnotes

1. Kutum, Imad. “Is there a Relation between CEO Remuneration and Banks‟ Size and Performance?” International Journal of Accounting and Financial Reporting, vol. 5, no. 1, 2015, 281
2. Lublin, Joann S. How Much the Best-Performing and Worst-Performing CEOs Got Paid. 2015. Web.
3. Lublin, Joann S. How Much the Best-Performing and Worst-Performing CEOs Got Paid. 2015. Web.