Managerial compensation

Transcription

1 Bachelor thesis Finance Managerial compensation CEO compensation the optimal balance of fixed and variable compensation rewards Name: R.H.T. Knevels ANR: Supervisor: P. Geiler Coordinator: J. Grazell Date: May 27, 2011 Faculty of Economics and Business Administration 1

2 Table of Contents 1. Introduction Literature review Agency problem: basic assumptions 2.2. Compensation Schemes Components of compensation 2.3 Criticism on managerial compensation Power of shareholders and markets 2.4. Hypotheses development 3. Data and Methodology Data description 3.2. Empirical model Dependant variables Independent variables 3.3. Descriptive statistics 4. Results Regression analyses Conclusion and recommendations References

3 Chapter 1: Introduction Goldman doubled CEO bonus for 2010 this was the headline of an article in The Financial Times on April 2, The article describes the components of which this year s CEO compensation consists. It describes an increase in bonus by Goldman Sachs. Goldman Sachs justified the increase in bonus by comparing their performance to their main competitors and concluding that their performance was strong. The existence of the managerial compensation schemes can be explained by the agency theory. The Agency theory goes back to Berle and Means (1932) and is advanced by Jensen and Meckling (1976). According to the agency theory, shareholder value may be sacrificed by executives who lack the correct incentives, leading to sub-optimal firm performance. To solve this problem, shareholders must align interest or observe and control managers. Thus the agency problem is the problem of designing mechanisms that will induce agents to act in their principals interests. The costs arising from this are the agency costs, Jensen and Meckling (1976) define it as the sum of the following; cost of monitoring, cost of bonding and residual loss. Managerial compensation schemes can mitigate the agency problem by aligning interests between managers and shareholders. Compensation schemes links CEO and shareholders wealth and this creates incentives for managers to increase shareholder value, because these actions will also increase their own wealth. The design of the optimal compensation scheme as a manner to reduce the agency problem is also referred to as the optimal contracting approach (Fama and Jensen, 1983). There has been a lot of research trying to optimize the compensation contract. According to Fama and Jensen (1983) this will reduce the agency problem, because the vision of shareholders and management will be more on the same line. Jensen and Murphy (1990) say that it is not important how much you pay, but how you pay. Their research indicated a positive relation between pay for CEO s and shareholders value. They suggest equity compensation, because managerial compensation is in that case dependent on company results. Therefore, they believe that managers will act significantly more in the interest of the shareholders. Though there is a problem to design an optimal contract; compensation schemes are not sufficiently high powered due to political limitations on executive pay (Jensen and Murphy, 1990). 3

4 However, critics argue that managerial compensation schemes are not completely able to align the interest of agents and principals. It is even said that managerial compensation is also a part of the agency problem itself. This is called the managerial power approach (Bebchuk and Fried, 2004). Managerial compensation is based on market forces and managerial influence. The managerial power approach claims that managers have substantial power to influence the compensation arrangements and that it therefore departs from the optimal contract method. Even in other countries than the U.S. there is evidence of no link between pay and performance exists, for example Duffhues and Kabir cannot find evidence for a payfor-performance relationship (2008). Previous research focused on the question if compensation plans were a solution to the agency problem. Other research results conclude that compensation is (partially) the problem. This Paper is a study of CEO rewards in relation to company performance. The goal of the study is to determine an optimal balance in fixed and variable reward components to reduce agency problem as much as possible in a way that firm value is maximized and performance is optimal. This paper proceeds as follows. In chapter 2, a literature review will be given. After that the agency problem in general will be discussed. Insight will be given on the compensation schemes and the different components of it. Subsequently the criticism on managerial compensation will be presented. In Chapter 3 describes the data and methodology used in the study and descriptive results will be presented. Chapter 4 will provide the empirical results. Ending with chapter 5 were the findings of our research are summoned and conclusions are made. Therefore the problem statement is: What is the optimal balance in fixed and variable CEO compensation that has a positive effect on the performance and market value of the firm? This study finds a negative or absent pay for performance relationship for current CEOs in S&P 500 companies, restricted to the NYSE. This supports managerial power theory, which indicates that powerful managers are able to extract rents. The optimal balance in fixed and variable pay to maximize market value of the firm and firm performance lies between 0% and 30% fixed pay, and % variable pay. 4

5 Chapter 2 Literature review 2.1. Agency problem: basic assumptions The agency problem was first researched by Berle and Means. The agency problem is worked out further by Jensen and Meckling (1976). Jensen and Meckling (1976, p.4) define an agency relationship as: a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalves which involves delegating some decisions making authority to the agent. So there are two participants, the principal and the agent. Were the agent is supposed to act in the best interest of the principal. The agency problem arises in an organization when there is a separation between ownership and control. Principals give agents a contract because they lack knowledge or don t have the time to do the actions. It is also possible that they don t have they incentives to closely monitor the directors because they own a small percentage of shares. According to Shleifer and Vishny (1986) larger shareholders will monitor CEO s more closely, resulting in less slack of CEO s. Shleifer and Vishny state that a low concentration of ownership may lead to free rider problems. Shareholders pay agents and therefore they expect that managers take actions that increase firm value and thus shareholders wealth (Jensen and Murphy, 1990). In a world with perfect information, the agent acts what is in best interest of the firm, because this will maximize the agents wealth. But in practice, a rational agent acts in his best selfinterest. Principals also act in a way that maximizes their own wealth. The interest of both parties can even be conflicting. Without monitoring or other incentives it is unlikely that both incentives are aligned. And therefore that the agent will not undertake the action what is best for the firm. (Jensen & Meckling, 1976). Managers make different decisions because they are more risk-averse than shareholders. Shareholders are more risk-neutral because they can diversify firm-specific risk by holding a diversified portfolio. A possible result of this may be that managers can reject high risk projects with a positive NPV, while shareholders prefer to take those projects because they will increase firm value. Not only self-interest but also the attitude towards risk contributes to the agency problem by creating different incentives (Smith & Stulz, 1985). In organizations there is information asymmetry, in the case of the agency problem this means that the agent has more knowledge than the principle and is thus able to mislead him. Looking at the interest of managers and shareholders of a firm, shareholders want to maximize value. Managers have other interests, namely: increase the on the job consumption and decrease of 5

6 employment risk (Jensen & Meckling, 1976). On the job consumption is described by benefits experienced due to working for a firm other than financial benefits. Managers try to decrease employment risk by making the firm less risky. Shareholders need to do something to align the interest between them and the managers. Principals try to solve this problem because the presence of the problem is not optimal for them. To solve the agency problem, mechanisms are designed that will induce agents to act in shareholder s interest. These mechanisms are costly and these costs are called the agency costs. Jensen and Meckling (1976) recognize three types of agency costs: 1). Monitoring costs 2). Bonding costs 3) Residual loss Monitoring is an action taken by the principal. By doing this the principal can get inside information and will be better able to understand what is going on in the firm. Therefore it reduces the information asymmetry between the agent and the principal (Jensen and Meckling, 1976). Principals can use this information and start taking actions regarding bad management. For example if the shareholder sees that the manager acts in his own selfinterest, he can fire the manager. Because managers know they are being monitored, they will act in the shareholders best interest. Because this will not result in a job loss and therefore it maximizes their self-interest. This monitoring of the agent is an action taken by the principal. However monitoring the agent can be very costly and perfectly monitoring is almost impossible, because the actions of a CEO are not always transparent and perfectly observable. Trying to perfectly observe managers would induce greater cost that it generates revenues and is thus not worth pursuing (Jensen and Meckling, 1976). It is also not possible to design a contract where every possible action the CEO is supposed to take is described, because most decisions that are made were not predicted in front. The offering of the contract is also a form of monitoring because the principal takes the initiative. Designing optimal compensation contracts will be discussed in more detail paragraph 2.2., because this is the main focus of the paper. The agent can also decide to do something to solve the information asymmetry. They can decide to do bonding. Bonding is any type of activities an agent will do to mitigate the agency problem, by guaranteeing he won t take actions that will harm the principal or to be sure the principal will be compensated if such actions take place (Jensen and Meckling, 1976). The reason he will do this is to give a positive signal to outside capital providers and because of 6

7 that get better deals. The managers may also want to provide positive signals to get more job security. A form of bonding is the initiative of managers to build a trustworthy reputation. If managers are able to create a good reputation the will be able to get better contracts and have better future career opportunities (John and Nachman, 1985). The different ways to mitigate the agency problem should be viewed as complementary rather than a single solution to the whole agency problem. To sum up the above part, the agency problem is the conflict arising when the agent is entrusted to maximize the interests of the principals. Agents are given some decision power and they can use this power to pursue their own interest, because the agent has informational advantage over the principal. The costs arising from designing mechanisms that will induce agents to act in principal s interest are called the agency costs Compensation Schemes Shareholders want to attract an executive who is capable of managing the firm, because they don t have the abilities, knowledge and time to make decisions (Jensen and Murphy, 1990). So they design good compensations plans to attract managers who are suitable for the firm. When a CEO is in its position, misalignment of interest arises as a new problem. We also call this the agency problem. One of the ways to solve the agency problem is to align interest of the principal and the agent. Managerial compensation is a way to do this. The idea behind optimal contracting is to find the most efficient compensation packages to: attract, retain and motivate executives (Conyon, 2006). Past research has proven that different components of compensation create the right incentives for managers. Brander and Poitevin stated in 1992 that all agency costs of debts can be entirely eliminated using managerial contracts. Morgan & Poulsen (2001) research results indicate that firms with stock based managerial compensation, performed better on stock-price performance. Jensen and Murphy (1990) argue that equity-based compensation has a stronger influence on firm performance. Thus shareholders need to design compensation schemes that provide the CEO s with the right incentives to maximize firm value. If shareholders have perfect information about the investments opportunities of the firm and the actions of the CEO. They could design a contract which describes every action mangers should take in each possible situation. In practice this is more difficult, because the actions of managers are not transparent and fully 7

8 observable. Therefore shareholders assign a board of directors, who are responsible for monitoring the CEO s and reviewing major decisions. The level and mix of compensation is determined by the compensation committee. The members of the compensation committee are members of the board of directors. They will be determined by the board, and they have to be independent under the rules of the New York Stock Exchange (NYSE) and meet the legal requirements. This is described in the NYSE rule 303A.05. Members of the committee can be removed by a majority vote of the board. There is a chance that CEO s with a good network will get higher compensations compared to other CEO s with the same qualities. However Daily et al (1998) found no evidence that captured directors led to greater levels of CEO compensation. The compensation committee has to determine the level and mix of different compensation components Components of compensation To determine the optimal mix of different compensation components, the different parts of compensation will be described. For this research compensation is divided in two main components, namely; fixed pay (salary) and variable compensation. Variable compensation consists of an annual bonus, stock options, restricted stock grants and long term incentive plans. This is in line with prior research of Bliss and Rosen (2001), who also state that those components of compensation are the most important. According to Murphy (1998), most executive packages also consist of these components; he only adds all other types of compensation. Base salary Base salary is the fixed component of a compensation package. It does not vary with company s performance. Because CEO s are risk-averse, they prefer a dollar increase in base salary to a dollar increase in variable compensation (Murphy, 1998). Base salary is often set by the compensation committee or through an outside consulting firm. The determination of base salary is based on benchmarking with firms who are similar (Murphy, 1998). According to Murphy (1998) several characteristics of companies and executives influence the level of base salary. Firm size and CEO age, CEO tenure and education level of the CEO raises the base salary. For the CEO s base salary is a very important component of compensation. Since base salary is a fixed amount and risk-free. Base salary also influences the variable parts of compensation. The value of option grants is often determined as a multiple of the base salary and bonuses are expressed as a percentage of base 8

9 salary. (Murphy, 1998). Base salary doesn t create many incentives for the CEO because it increases over years rather than performance. Salary is also not adjusted for bad firm performance. Annual Bonus Bonus is a variable part of compensation, it varies with company performance. The bonus amount is paid out in cash. The level of the bonus is based on pre-specified goals that a CEO can achieve. It is usually related to accounting terms, to make company performance measurable. Bonus is also related to some non-financial measures like customer satisfaction and effort (Murphy, 1998). Most of the times accounting measures are used to determine the bonus, this comes with 2 problems. According to Murphy (1998) two problems arise from this; First accounting measures are backward looking and short-run, so managers can get incentives to focus on the short term rather the long term. This can reduce the profitability of a firm on the long run. Second accounting profits can be manipulated in different ways to increase bonuses (Healy, 1985). This is a problem because if a CEO does this, the company performance is not correctly reflected. Bonuses are short term, because the level of the bonus is determined by last year performance. Most common payout-method is a nonlinear schedule: a target bonus is paid after reaching a certain threshold performance and in most cases there is a cap on the amount managers can receive (Murphy, 1998). This way of bonus setting is problematic, for example if a CEO knows he can never meet the 80% standard, he is no longer motivated to put effort in actions to increase the performance of the firm. To determine the target, some companies use last year s performance. According to Murphy (1998) this will lead to the ratchet effect and managers shirking. The ratchet effect is that targets are typically set higher than current year performance. If last year s performance is used to set the new bonus, CEO s are not motivated to do better than the maximum target, because next year s standard will be higher if they exceed the maximum standard and do not receive any additional bonus. So in fact they are penalized in the next period when they perform very well through Restricted Stocks Restricted stocks are an important part of compensation, because CEO s also become a shareholder. Therefore he shares more incentives with shareholders, which motivates the CEO s to increase shareholder value. When a CEO makes wrong decisions he will decrease his own wealth too. The most effective stock reward is the restricted stock, this stock only 9

10 becomes valuable after certain criteria are fulfilled (Murphy, 1998). The firm can set goals or data on when the stock can be sold. Most restricted stock has a vesting period before CEO s can claim them. Firms can also set an accounting number that the CEO has to reach before he can sell the stock. Because the CEO is not able to sell these shares he builds up the amount owned in the firm. A result of that is that the CEO is more tied to the company and his incentives will be higher. Risk-averse CEO s will demand a risk premium for holding stock which decreases the diversification of their portfolio. The difference with options is that stock grants have a value as long as the share price is above zero. Stock options Murphy (1998, p.23) defines stock options as: Stock options are contracts which give the recipient the right to buy a share of stock at a pre-specified "exercise" (or "strike") price for a pre-specified term The options that a CEO receives are non-tradable and he won t get them if he leaves the company before the exercise date (Murphy, 1998). Options are in the money when the stock price exceeds the pre-specified price. The most options received by CEO s are in the money or at the money. This means that the exercise price is equal or bigger to the share price. When a CEO is able to exercise his option he can buy stocks for the pre-specified price and immediately sell the stocks back to the market at the higher market price. So the option has value for the CEO (Stulz, 2010). Options also provide CEO s with incentives to increase the firm value, because they, provide a direct link between managerial rewards and stock price appreciation (Murphy, 1988). The CEO are not allowed to hedge away risk, like short selling shares. If this was allowed, the incentive effects of options would be eliminated. According to Bebchuck and Fried (2004) rewarding CEO s with options out of the money will increase incentives, because only in strong performance they will increase CEO s wealth. Long term incentives plans (LTIP) Long term incentive plans have the goal to improve CEO s long term performance. This is essential for the future of the firm. According to Murphy (1998) the time span of LTIP is usually three to five years. The main goal of these plans is that CEO s don t cut cost based only on short term incentives. For example cutting cost in R&D to raise compensation this year can result in a long term problems. If the conditions for the long term are met, the CEO will get paid in shares. This provides double- incentives, namely; securing behavior in the long term and increase ownership in the firm. However the direct incentive effect is low. The 10

11 structure of a typical LTIP is similar to the structure of annual bonus plans. With regard to thresholds, targets and caps set to determine the height of the LTIP reward (Murphy, 1998). With the information of the main components of managerial compensation the boards of directors have the task to design an effective compensation scheme. They have to bargain at arm s length with the mangers over their compensation (Bebchuk and fried, 2004). Grinstein and Bebchuk define arm s length bargaining as: boards make pay arrangements with executives were the boards are assumed to focus on the interest of the shareholders (2005). In the case of a CEO and his compensation this would indicate that the CEO has no significant influence on the determination of the compensation. In this way an efficient compensation can be made and both managers and shareholders benefit from it. When the boards of directors and the CEO s have bargained under arm s length, the compensation will be enough to accept the position and remain in the position. The compensation scheme will motivate CEO s to maximize shareholder value. CEO s will require premiums when their pay is linked to firm performance, because they are risk-averse and prefer fixed pay. (Smith & Stulz, 1985). In summary, compensation schemes are an important instrument to motivate and discipline managers. Because a well-defined compensation plans aligns the interest of the risk-averse, self-interested manager with the shareholders interest. Therefore the manager, will still be driven to raise his own wealth, but with this compensation contract his interests will be in line with those of the shareholders. 2.3 Criticism on managerial compensation The existence of compensation schemes can be explained by the agency problem. But not all researchers believe that compensation is a solution to the problem. Bebchuck & Fried (2004) state that compensation plans are not able to align the interest of agents and principals. They believe that managerial power prevents shareholders from setting optimal contracts. Bebchuck and Fried argue that managers can affect their own compensation and will try to weaken the link between pay and performance. Consistent with this view is the research of Duffhues and Kabir in 2008, who also believed that there was no pay for performance in the Netherlands. Bertrand and Mullainathan (2001) find that CEO pay is more based on luck in organizations without big external shareholders. By luck is meant external factors outside managers control that influence performance. 11

12 One main criticisms on managerial compensation contracts is that they are not based on arm s length bargaining. The arm s length bargaining approach assumes that directors act in the best interest of the shareholder and that managers don t have any influence over their pay. Bebchuk and Fried (2004), state that directors have certain incentives, which provide managers with substantial power over their own compensation. Firstly directors have economic incentives. Directors want to be re-elected because it gives them a lot of benefits. CEO s have a significant influence over the nomination process. Directors who do not challenge the CEO s compensation will increase their chance of appointment- and reappointment in the board of directors through the influence of the CEO (Bebchuk and Fried, 2002). Therefore directors have an incentive to act in favor of the CEO to increase his chance of remuneration. Social and psychological factors also play a role in favoring executives. For example social connection and collegiality and respect for each other. For directors favoring executives can be costly. Most directors have shares and granting high compensations might reduce firm value. But the amount of shares they hold is rather insignificant. That is why they keep giving executives high compensations. (Bebchuk & Fried, 2004). Most of the time directors also lack time and knowledge that leads to a good evaluation of compensation plans (Bebchuk and Fried, 2002) Power of shareholders and markets Shareholders can effect compensation of executives in three ways: challenge inefficient contracts in court, vote on stock option plans and voting on the advisory results. (Bebchuk and Fried, 2002). Research of Barris (1992) researched the challenge of inefficient contracts and concluded that this is not very effective because the court refused to overturn decision of the board of directors in almost every case. Voting on stock options has also proven to be insignificant, only one percent of the plans were not approved by shareholders (Thomas & Martin, 2000). Voting on advisory results is also a way in which shareholders can influence the compensation agreements. By doing this, compensation gets media and shareholder attention. Because it is only advisory, therefore it is not a very powerful tool. But it can put pressure on the board of directors. (Bebchuk & Fried, 2004). The power of shareholders to influence a compensation agreement is limited; therefore they are not able to guarantee a compensation agreement process at arm s length. 12

13 There are also market forces that can influence compensation plans (Bebchuk and Fried, 2002). The managerial labor market forces provide managers with positive incentives in the form of compensation and negative incentives in the form of the loss of their jobs (Bebchuk and Fried, 2002). This will protect the interest of shareholders. But Murphy concluded that the direct benefits of higher compensation are higher than the resulting loss in personal wealth for managers. (Murphy, 1998). The market for corporate control should provide managers with incentives to make compensation agreements that maximize firm value (Bebchuk and Fried, 2002). Because when this is not optimal the share prices drops. Making the firm a target for takeovers, where board of directors and CEO s are replaced. The CEO s who are currently in charge; do not want the risk of the loss of their jobs resulting from a takeover. Therefore they should want compensation agreements that maximize firm value. However research has indicated that executives with larger compensation agreements are not more like to become a takeover target. (Agrawal & Walking, 1994). Next to that, firms often have anti takeover protections, making it not attractive or easy to take over the firm (Bebchuk and Fried, 2002). Some examples of anti takeover provisions are pyramidal structures, poison pills, preference shares, staggered boards and certificates. For example staggered boards prevent a hostile takeover from gaining control for at least one year (Bebchuk and Fried, 2002). Therefore the market of control is also not very effective in constraining managerial compensation. From the analysis has become clear that directors often do not adopt an arm s length bargaining approach. And shareholders don t have the power to constrain the board in such a way that it would bargain at arm s length. Market forces can impose some constraints but they cannot prevent the compensation contracting to deviate from arm s length. So the pay-setting process is deviates from arm s length bargaining. Therefore managers can influence their compensation. Managers can do it in such a way that they get paid for something that is not the result of their own efforts. 2.4 Hypotheses Development To provide an answer to the problem statement, this research first examines the determinants of compensation for CEO s. The following hypotheses have been designed to see if the results from past research hold ground for recent years. All hypotheses will be based on total CEO compensation. However, both fixed and variable components are taken into account. After the 13

14 determinants of compensation are known, the optimal balance of fixed and variable compensation will be researched. Firm performance is measured by the annual stock returns to fiscal year end of the firm. Annual stock returns are calculated as follows: Next to annual stock returns, return on assets is also used to measure firm performance. Return on assets is calculated by: The positive relationship is in line with the agency theory, who found that compensation can mitigate the agency problem (Jensen and Meckling, 1976). Therefore, hypothesis 1 is: H1: CEO compensation is positively related to firm performance The size of the company is measured by the natural logarithm of market value of equity of the firm. This is calculated as follows: According to Murphy (1998) a positive relationship between company size and firm performance is expected. Therefore, hypothesis 2 is: H2: CEO compensation is positively related to firm size. Leverage is an indicator of a firms risk the higher the leverage ratio the higher the risk for the company to default. It can be seen as a measure of control, this is consistent with the agency theory. The leverage ratio is calculated by: 14

15 A higher leverage ratio indicates an increase in monitoring and therefore to a decrease in debt. Monitoring leads to more transparency which is negatively related to variable rewards. (Duffhues & Kabir, 2008). Thus hypothesis 3 is: H3: CEO compensation is negatively related to firm s leverage. With hypotheses 3 the optimal balance in fixed and variable rewards will be determined with respect to company performance and market value of the firm. This will be tested by analyzing descriptive results on the following variables: market value of equity, annual stock return and return on assets. Fixed pay will be presented as a percentage of total compensation. Hypothesis 4 is as follows: H4: The optimal percentage of fixed rewards relative to total pay lies between 20% and 40% 15

16 Chapter 3 Data and Methodology Data description The data used in this research includes information about different compensation rewards to CEO s, firm performance, firm size, leverage. And control dummies for time and industry. The data is retrieved from WRDS (Wharton Research Data Services). The datasets used are Fundamentals annual available at CRSP/COMPUSTAT Merged and Annual compensation, available at Compustat North America. The parameters related to this research are referring to S&P 500 companies and is restricted to the NYSE (New York Stock Exchange). Only data on current CEOs is observed. The period of the research is from 2000 to 2005 because this is the period before the financial crisis and therefore the difference in compensation and financial performance between different years won t be so big. However it includes the Dot-com bubble, which burst on March 10, This will have effect the data gathered. We also choose the period , because there was also more data on the compensation components during this period, which makes it able to draw more relevant conclusions, because there are more observations Empirical model A simple linear regression analysis will be used to make the relations between different components of pay and firm performance and firm characteristics clear. The regression model of Duffhues and Kabir (2008) is used as a base for the model adopted in this study. The first equitation describes the relation between total CEO compensation and firm performance. 1) TC (FIX) = + 1 Perf + Size + λ + δ + 2) TC (VAR) = + 1 Perf + Size + λ + δ + Total CEO compensation is the dependent variable. However, the fixed and variable compensation components are taken into account. Further descriptive statistics will be used to determine the optimal balance of fixed and variable compensation. The dataset will be subdivided in ranges of 10% each, where fixed compensation is a percentage of the sum of fixed and variable compensation. The different ranges will be compared to market value, stock return and return on assets to determine the optimal mix of fixed and variable rewards. 16

17 3.2.1 Dependent variables The dependent variables are the different components of CEO compensation. TC is the amounts of total yearly payments to the current CEO in a company for period t. TC is directly retrieved from WRDS and is comprised of the following: salary, bonus, other annual, total value of restricted stock granted, total value of stock options granted (using Black-Scholes), long-term incentive payouts and all other total. The dependent variable FIX is the amount of fixed payments to the CEO and is equal to base salary. The dependent variable VAR is the amount of yearly variable payments to the CEO, calculated as the sum of all variable components; annual bonus, restricted stock grants, stock options and long term incentive plans. For variable compensation all other total and other annual are omitted because they are expected to be not significantly big to change the results. Therefore, the sum of fixed and variable compensation will not be equal to total compensation. Total, fixed and variable compensation are all expressed in natural logarithm to adjust for the non-normality of compensation (Duffhues & Kabir, 2008) Independent variables The independent variables in the regression model for this study can be subdivided into three categories, company performance and company characteristics and control dummies. Company performance Firm performance is measured in a number of ways. The first measure is annual stock returns to the fiscal year end. The independent variable ASR is calculated by: The other performance measurement is ROA, calculated by: According to Duffhues and Kabir (2008), ROA and Annual stock returns are used by several prior studies to proxy financial performance. 17

18 Company characteristics Firm size is a control variable. CEO s in big firms are expected to have higher compensation than CEO in smaller firms (Murphy, 1998). This is because they have more resources available to reward CEO s. Next to that CEO s in big firms are expected to have more skills and they will demand higher rewards. The natural logarithm of market value of equity is used as an indicator for Firm size and is calculated by: Another control variable is leverage (LEV), measured by the leverage ratio: A high ratio has two effects; closer monitoring which limits the excessive rewards and higher risk of default so CEO s will demand a higher compensation. (Duffhues and Kabir, 2008) Control dummies Industry (λ) and time (δ) are used as additional control variables (Duffhues and Kabir, 2008). These dummies pick up common market and industry movements, where the company has no influence on. Following Brick et al. (2006), industry dummies are based on one-digit SIC codes. Each year is also a different dummy. 3.3 Descriptive statistics Descriptive statistics of CEO compensation are described in table 3.1. The total sample consisted of 1647 firm year observations of S&P 500 companies restricted to the NYSE. Total compensation is shown next to the fixed and variable payments made to the current CEO s. 18

19 Table 3.1 Descriptive statistics CEO compensation The table shows statistics of CEO compensation for S&P 500 companies, restricted to the NYSE. Panel A shows the total payments to the current CEO. Panel B shows the fixed compensation to the CEO. Panel C shows variable payments consisting of bonus, stock options, restricted stock grants and long term incentive plans. All monetary amounts are expressed in dollars. Total compensation is not equal to the sum of fixed and variable compensation because variable compensation did not include the variables all other and other annual compensation. These variables are omitted because they are expected to not be significantly big to change the results. Panel A: Total CEO Compensation Mean Median Std. Dev N Total Panel B: Fixed Compensation Mean Median Std. Dev N Total Panel C: Variable Compensation Mean Median Std. Dev N Total In 2000 the average total compensation was $ with a median of $ The median is low compared to the mean, therefore we can conclude that a few CEO s get a very high compensation which raises the average amount. CEO compensation increased during the period , however the annual changes are not always positive. From it increased, from it decreased and the last two years it increased greatly. The fluctuations in total compensation can be explained by the change in variable compensation. When the variable components of compensation increase (decrease), the same movements are observed in the amount of total compensation. The average total compensation over all the 19

20 years is $ Fixed compensation increased with 50,4% during the period of The low value of the median for all components of compensation can be explained by few firms that pay relatively high rewards to the CEO. Table 3.2 shows descriptive statistics on company performance, measured by annual stock returns and return on assets. Firm size is indicated by the market value of equity. Firm s leverage is measured by the leverage ratio. All variables described will be used in the regression model. Table 3.2 Descriptive statistics firm performance and characteristics. The table shows statistics company performance and characteristics from S&P 500 companies restricted to the NYSE. Panel A and B show performance statistics. Panel C indicates the size of a firm and panel D shows the leverage ratio. All monetary amounts are calculated in dollars. The data is gathered from WRDS Panel A: Stock Returns Mean Median Std. Dev. N Total Panel B: Return on Assets Mean Median Std. Dev. N Total Panel C: Market Value of Equity Mean Median Std. Dev. N Total Panel D: Leverage Ratio Mean Median Std. Dev. N Total

21 A remarkable result is the highest stock return in 2003, while the total compensation decreases in that same year. After 2003 stock returns kept increasing, this resulted in higher total pay of CEO s. Return on assets decline in 2001 and 2002 and increase from The average ROA is 5,3% over the period. The average market value of equity over the whole sample is $ 20,47 billion. The leverage ratio is rather constant during , and after that it declines to 0,189. When the leverage ratio is bigger compensation in smaller, indicating a negative correlation. The average leverage ratio is 21,3% over the whole sample. The optimal mix of fixed and variable compensation Table 3.3 shows the descriptive results on market value of equity, annual stock returns and return on assets with 10 intervals with a range of 10% each. The intervals present the percentage of fixed compensation to total compensation. The 20-30% interval for example presents that 20-30% of total compensation consist of fixed pay and 70-80% consist of variable pay. The results of panel A indicate that the highest market value is generated by companies with % fixed pay. There were not many observations of the % range and the median is low with respect to the mean. This suggests that few firms with high market value increase the amount of the mean. The second highest value of market value is in the 0-10% range which reaches a level of 29,475 billion. The results show that when fixed payments decrease, market value will increase. There are two exceptions; the 30-40% interval shows a higher market value of equity than the 20-30%. The same holds for the % interval regarding the previous interval. The results for panel B show that the highest annual stock return is generated by companies with 20-30% fixed pay. Companies with % fixed pay have negative stock returns which indicate that companies should not base compensation entirely on fixed payments. Annual stock returns increase in the 0-30% intervals, after that it decreases with the exception of interval 40-50% which increases compared to the 30-40% interval. Panel C shows return on assets, the highest return on assets is generated in the 0-10% interval and remains almost the same in the 10-20% interval. This shows that firms with a relatively low amount of fixed pay generate the highest return on assets. The results of all panels are that fixed compensation relative to total compensation should be in the 0-30% interval, because this maximizes all variables except market value. Market value 21

22 of equity is maximized in the % interval, but because annual stock returns are very negative for the % it is not beneficial to pay this amount of fixed pay. Table 3.3 Descriptive statistics, percentage fixed compensation to total compensation. The range values represent the percentage of the fixed compensation with respect to the total compensation. Three different panels show the market value and performance indicators of the firms. All monetary amounts are expressed in dollars. Panel A: Market Value of equity (in millions) Range Mean Median Std. Dev. N 0% - 10% % - 20% % - 30% % - 40% % - 50% % - 60% % - 70% % - 80% % - 90% % - 100% Panel B: Annual stock return Range Mean Median Std. Dev. N 0% - 10% 0,071 0,060 0, % - 20% 0,104 0,088 0, % - 30% 0,142 0,085 0, % - 40% 0,125 0,069 0, % - 50% 0,136 0,036 0, % - 60% 0,066 0,019 0, % - 70% 0,096-0,055 0, % - 80% - 0,013-0,126 0, % - 90% - 0,372-0,253 0, % - 100% - 0,078 0,000 0, Panel C: Return on assets Range Mean Median Std. Dev. N 0% - 10% 0,057 0,050 0, % - 20% 0,056 0,050 0, % - 30% 0,052 0,047 0, % - 40% 0,049 0,041 0, % - 50% 0,052 0,034 0, % - 60% 0,048 0,047 0, % - 70% 0,050 0,044 0, % - 80% 0,021 0,029 0, % - 90% 0,030 0,010 0, % - 100% 0,047 0,028 0,

23 Chapter 4 Results 4.1 Regression results Table 4.1 represents the linear regression for total compensation, fixed compensation and variable compensation. In column (1) the results are presented for the Return on assets (ROA) performance metric and in column (2) for the annual stock return (ASR). The number observations vary from 1548 for total compensation to 1642 for fixed compensation. The numbers of observations are different, because there was less data available regarding total compensation. Besides performance measures and firm characteristics, additional control variables industry and time dummies are used. The industry is divided into nine different groups based on the first digit of the SIC-code. No distribution graph of the companies in different industries were made, because the first digit SIC-codes separate the industries but not very precise. Therefore the distribution of the different industries would add little value to this study. The different industry groups are not reported in the regression table for the sake of brevity. For panel A, the results show a statistical non-significant negative relationship between compensation and firm performance. The explanatory power (adjusted R²) indicates a low reliability in comparison to the previous study of Duffhues & Kabir (2008), where this research explains 25,2% of the change in total compensation they explain 62% of change in total compensation. This can be explained by the difference between the observed countries, Duffhues & Kabir researched pay for performance in the Netherlands where this study researches pay for performance for companies in the United States of America. The sample of this study contains more observations, compared with the study of Duffhues and Kabir. Thus the data of this research becomes more diversified and therefore it is harder to explain more of the dependent variable. Also the size of the companies differ, S&P 500 companies are bigger and have more capital to invest. Therefore, CEOs with different capacities are needed. The logarithm of market value of equity (firm size) has a statistically significantly positive relationship with total compensation. This is consistent with the research of Duffhues & Kabir (2008) who state that executives of larger firms receive relatively higher compensation. Leverage shows a statistical non-significant negative relationship to total compensation. In panel B the results for fixed compensation are shown. This model shows that fixed compensation is significantly negative related to return on assets. Annual stock returns show a non-significant positive relation to fixed compensation. 23

24 Table 4.1 Regression results The table shows the regression results. The dependent variables are the natural logarithms of total, fixed and variable compensation. Column (1) presents the regression which used ROA as an indicator for firm performance. Column (2) presents annual stock returns respectively. Firm size is indicated by the natural logarithm of the market value of equity. Additional control variables (industry and time dummies) are used, but not reported for the sake of brevity. The absolute t-statistics are reported in parentheses. Significance levels of 1%, 5% and 10% are indicated by ***, **, * respectively. Panel A. Regression results for Total compensation (1) (2) Constant 3,016 *** (10,41) 5,024*** (20,49) ROA - 0,488 (- 1,45) ASR (-1,07) Ln(MVE) 0,381 *** 0,379 *** (18,53) LEV - 0,178 (- 1,07) Adj. R² 0,252 0,252 F-Statistic 33, No. of obs Panel B. Regression results for Fixed compensation (1) (2) (18,46) - 0,149 (-0,91) Constant 4,934 *** (32,39) ROA -0,611 *** (-2,88) ASR 0,032 4,135*** (22,75) (0,98) 0,146 *** (11,51) 0,015 (0,14) Ln(MVE) 0,149 *** (11,74) LEV - 0,024 (- 0,23) Adj. R² 0,154 0,150 F-Statistic 19,67 19,12 No. of obs Panel C. Regression results for Variable compensation (1) (2) Constant 2,866 *** (6,83) ROA -0,789 * (-1,84) ASR -0, *** (7.12) (-0,62) 0,441*** (17,34) -0,087 (-0,41) Ln(MVE) 0,445 *** (17,46) LEV - 0,139 (- 0,66) Adj. R² 0,225 0,224 F-Statistic 30,48 30,21 No. of obs

25 The natural logarithm of market value of equity is for both performance measures a statistically significant positive determinant of fixed compensation. Leverage is again not statistical significant. Panel B shows a lower adjusted R² and F-statistic and therefore has a rather poor explanatory power. This is consistent with the fact that fixed rewards cannot be easily adjusted. Panel C differs from Panel B in explanatory power, the variables in the model explain 22,5% of changes in variable compensation. Another difference is the positive statistical significance level of 10% for return on assets instead of 1%. The natural logarithm of market value of equity shows a statistically positive relationship to variable compensation. Leverage is again not statistically significant. The results from table 3 suggest that fixed compensation and variable compensation are significantly negatively related to firm performance (ROA). There also exist no link between pay and performance with respect to total compensation. This is not in line with the optimal contracting theory, where CEO compensation acts as an incentive to superior firm performance. It is rather consistent with the managerial power theory, which states that managers can influence their own pay and powerful managers will try to extract rents to use for private benefits (Bebchuk and Fried, 2004). This study is consistent with prior research indicating that the pay-performance relationship is weak or absent (Buck et al., 2003; Fernandes, 2008). This research can indicate that the board of directors was not able to design an effective compensation scheme. It can also indicate that higher rewards are not only used to improve firm performance, but many factors influence the compensation. Compensation is also used to attract, retain and bind CEO s to the firm (Duffhues and Kabir, 2008). 25