Compensation gaps among top executives: the role of the peer groups

1. Compensation gaps among top executives: the role of the peer groups Chi-Hung Chang Min-Teh Yu Jen-Chih Kuo Graduate Institute of Finance National Chiao Tung University

2. Abstract • This paper explores if the peer groups make a difference in the explanation of the compensation gaps between top executives. • We find that the productivity theory is applied to the large firm peer and the high CEO compensation peer. • The tournament effect is applied for the small firm peer and the pay gaps between non-CEO executives.

3. Background • Determinants of CEO compensation • Personal characteristics – age, educational level, tenure, … • Firm characteristics – firm performance • Benchmarking pay level of peer groups (Bizjak et al. (2008, JFE); Faulkender and Yang (2010, JFE)) • The relevance of benchmarking pay • Representing reservation wage (Hokmstrom and Kaplan (2003, JACF)) • Self-serving (Bizjak et al. (2011, JFE); Faulkender and Yang (2010, JFE)) • How are peer groups determined? • Industry and size – Bizjak et al. (2008, JFE) • Actual disclosure – Faulkender and Yang (2010, JFE)

4. Background • Compensation of non-CEO executives • Productivity – Higher level managers are more productive than lower level ones. • Tournament – Compensation difference can motivate executives’ efforts. • Which one dominates? • Tournament incentives (Kale et al. (2009, JF)) • Productivity differential (Masulis and Zhang (2012, working)) • Research question: • Is the peer group responsible for the difference between the tournament and productivity effect?

5. Why is non-CEO executives’ pay relevant? • Team work of the corporation organization • The gaps between CEO and other top executives vary materially across companies (Masulis and Zhang (2012, working)). Why? • Is the CEO really extremely talented? • Does the firm want to stimulate non-CEO executives’ efforts to multiply the benefit of team work? • Contagion effect in CEO compensation across companies (Bereskin and Cicero (2012, JFE)). Non-CEO executives’ pay in other companies would be referred when determining their rewards.

6. Theories of compensation gaps • Productivity theory • Rosen (1981, 1982); Gabaix and Landier (2008) – Multiplicative productivity models • Higher level managers are more productive than lower level ones. • Tournament theory • Lazear and Rosen (1981); Green and Stokey (1983); Rosen (1986) • A mechanism to elicit executives’ efforts

7. Empirical evidence of compensation gaps • Productivity differentials • Finkelstein and Hambrick (1988, SMJ); Gibbs (1995, JAE); Prendergast (1999, JEL); Anabtawi (2005, ELJ); Masulis and Zhang (2012, working) • Tournament effect • Main et al. (1993, JLE); Eriksson (1999, JLE); Bognanno (2001, JLE) • Controversy still remains.

8. Hypotheses • H1: The compensation gap in the larger peer is more likely to reflect productivity differentials. • H2: The compensation gaps in the peer group with higher CEO pay would more likely support the productivity theory. • H3: The compensation gaps between executives below the CEO would more probably reflect the tournament theory.

9. Empirical strategy • Data: Compensation data from Execcucomp over 1993-2005; firm characteristics data from Compustat. • Determining peers based on industry and size (following Bizjak et al., 2008, JFE). • Industry: 2-digit SIC code • Size: median sales • Size peer groups • CEO compensation peers • Executives compensation peers

10. Variables • CEO compensation gap • Total gap = log(total CEO compensation/median total compensation of non-CEO executives) • Short-term and long-term gap are defined similarly. • Non-CEO executives compensation gap • Total gap = log(Highest non-CEO total compensation/lowest non-CEO executives’ total compensation) • Short-term and long-term gap are defined similarly. • Tournament measure: number of non-CEO executives • Productivity measure: executive’s position tenure, the average pay growth over the past three years

11. Variables (Cont.) • Control variables • Incentive variables • CEO pay growth • CEO tenure • CEO alignment • Executives alignment • Firm characteristics variables • Lagged assets • Lagged market-to-book ratio • R&D intensity

12. Descriptive statistics • Executives pay is substantially higher in larger firms.

13. Descriptive statistics (Cont.) • Compensation gaps between CEO and other executives are substantial.

14. Regression results on size peers • Tournament effect is more significant and the magnitude is larger for the small size peer.

15. Regression results on size peers (Cont.) • Productivity effect is significant for the large size peer.

16. Regression results on CEO compensation peers • Tournament proxy is significant for the low CEO pay peer.

17. Regression results on CEO compensation peers (Cont.) • Productivity proxy is significant for the high and low CEO pay peers.

18. Regression results on non-CEO executives compensation peers • Tournament proxy is significant for the high and low non-CEO executives pay peers.

19. Regression results on non-CEO executives compensation peers (Cont.) • Productivity proxy is generally not significant for the high and low non-CEO peers.

20. Conclusions • This paper examines the role of the peer group on the tournament and productivity effect of the compensation gaps. • Major findings • Productivity differentials are observed in the large size peer and high CEO compensation peer. • Tournament effect is observed in the small size peer and the pay gap among non-CEO executives. • Our findings could help reconcile the debate on the tournament and productivity effect of the compensation gaps of top executives.

21. Thank You!