Managerial pay and "rm performance * Danish evidence - CiteSeerX

Scand. J. Mgmt. 16 (2000) 269}286

Managerial pay and "rm performance * Danish evidence夽 Tor Eriksson*, Mette Lausten Department of Economics, The Aarhus School of Business, Fuglesangs Alle& 20, DK-8210 Aarhus V, Denmark Received 1 September 1997; accepted 1 August 1999

Abstract This study examines the determinants of managerial compensation in a sample of Danish "rms, and tests hypotheses derived from agency theory in the seldom studied (European) institutional setting of relationship-oriented governance systems. We "nd pay}performance sensitivity similar to that found in other settings, small di!erences in sensitivity across management levels, and no evidence in support of the career concern hypothesis. 2000 Elsevier Science Ltd. All rights reserved. Keywords: Managerial pay; Firm performance; Agency theory

1. Introduction The design of compensation contracts for managers and executives has become a subject of great interest in several countries. One of the key issues has been whether the high pay of senior managers, and especially the big increases in their pay, can be justi"ed by the economic performance of the "rms headed by these individuals. For two opposite views on this, see Crystal (1992) and Jensen and Murphy (1990b). At the same time there has been a parallel discussion about the need to introduce more incentive-based remuneration systems at lower levels in "rms as well. 夽 Earlier versions of this paper have been presented at workshops in Uppsala, Tilburg and at the EALE Conference in Chaina. Particularly helpful comments by Harry Barkema, Martin Conyon, Sam Gray and Kevin M. Murphy as well as the referees of this journal are gratefully acknowledged. We also thank Dansk Management Forum, which provided the data used in this paper and Anja Baastrup Nielsen for helping us with the construction of parts of the data set used. * Corresponding author: #45-89-48-64-04; fax: #45-86-15-51-75. E-mail addresses: [email protected] (T. Eriksson), [email protected] (M. Lausten).

0956-5221/00/$ - see front matter 2000 Elsevier Science Ltd. All rights reserved. PII: S 0 9 5 6 - 5 2 2 1 ( 9 9 ) 0 0 0 2 6 - 3

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T. Eriksson, M. Lausten / Scand. J. Mgmt. 16 (2000) 269}286

Contingent pay systems based on corporate pro"ts seem more natural in the case of high-level positions in "rms, since managers and top executives have a more direct impact on the pro"ts of companies than their subordinates do. Also, we would expect free-rider problems to be less important in the case of managers. The literature on CEO pay and its determinants is indeed voluminous. However, as pointed out by Milgrom and Roberts (1992) in their much used textbook, there is little systematic information about executives' pay in countries other than the US or about the pay of middle-level executives. The survey in Rosen (1992) also closes with a call for empirical investigation to be extended beyond the USA to other countries. This paper has two principal aims. The "rst is to examine whether the compensation of Danish managers is systematically related to "rm performance and "rm size. This is the "rst study of its kind to be performed on Danish data, and it adds to the very small empirical literature on the relationship between pay and performance outside the US and the UK. In addition to the pay}performance relationship among managers in general, we also investigate whether there are di!erences between position levels within management, and whether managers are rewarded and punished in a symmetrical fashion. This contrasts with most previous studies which have focused exclusively on the pay}performance relationship for CEOs or the highest paid director (as in the UK studies). The second aim of the paper is to test two other hypotheses which have received relatively little attention in the literature. The "rst is the relative performance hypothesis (Gibbons & Murphy, 1990) according to which "rms, in setting up their compensation packages, use information about the "rm's performance relative to that of other "rms in the same industry. The second is the career concern hypothesis (Gibbons & Murphy, 1992), which predicts that pay}performance elasticity increases with the age of the manager. Whereas prior studies have dealt primarily with large US and UK companies, the institutional setting of this paper is a small open economy, Denmark, with a relationship-oriented corporate governance system. To make an adequate test of hypotheses based on agency theory, a wide variety of di!erent institutional settings is required, since the results might otherwise be country- or culture-speci"c. The empirical tests conducted in this paper are thus intended to shed additional light on the generalizability of the agency-theoretical views. This paper is the "rst study to employ Danish data, thus adding to the small literature of determinants of managerial pay in small open economies with, among other things, a di!erent pattern of "rm size. One distinguishing feature of managerial compensation in Danish "rms is that a relatively low proportion of the "rms have bonus and/or commission systems for their managers. Only 20}25% of all managers and a third of the CEOs in our sample are paid bonuses or commissions, and their share of total compensation varies between 10 and 12% during the period under study. Danish pay practices resemble those in many other European countries, but di!er greatly from those in the US and the UK, where salaries as a percentage of total compensation account on average for about 50}60% (see Abowd & Bognanno, 1995; Murphy, 1999). However, formal contracts in which the contingent pay system is explicitly stated are not a necessary prerequisite for performance-related pay. Most


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Fig. 1. The distribution of the growth rates in total compensation and base salaries for the managers in the sample in 1994.

managers are employed by the same "rm for several years and nothing precludes the board from reconsidering their salaries each year for the following year. Thus the owners' satisfaction or dissatisfaction with the performance of the managers may well be re#ected in changes in base salaries. Indeed, as can be seen from Fig. 1, there is considerable variation in the annual change in base salaries in our sample.

2. Theory and earlier empirical research 2.1. Theoretical background The determinants of managerial pay have received much theoretical attention recently. See Gomez-Mejia and Wiseman (1997) and Murphy (1999) for recent surveys and discussions. Most of the theoretical work has been carried out within the framework of agency models. The problem in principal}agent models like Jensen and Meckling (1976) and HolmstroK m (1979) is how to induce managers to act in the principal's best interest, given that the principal observes output but not e!ort levels. One solution is to tie the agent's reward to the variable in which the principal is interested (some measure of the "rm's performance). The optimal compensation contracts in agency models typically predict a positive correlation between managerial pay and a measure of "rm performance (but are typically silent regarding the form of the compensation scheme). This is the correlation on which we try to shed some additional light in the empirical analysis presented in this paper. Of course, other potentially important factors governing managerial pay should also be accounted for. Some of these factors, such as "rm size, the age and tenure of executives and the evaluation of relative performance, will be discussed below.

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2.2. Earlier empirical research The great majority of the studies of the relationship between managerial pay and "rm performance have been carried out in the US and have mainly been concerned with the compensation of CEOs, typically in very large companies. As demonstrated in a recent international comparison by Abowd and Bognanno (1995), however, the compensation of US chief executives is something of an international `outliera. For reasons not well understood, directors of large US companies are substantially better paid than their colleagues in corresponding "rms in other countries. Moreover, as noted above, they are also paid di!erently. As will be discussed below, the governance system in the North American companies studied is very di!erent from that in many countries in continental Europe, including Denmark. Moreover, the "rms that have been studied in most of the earlier literature have been the big US companies. Hence it is not obvious that the results of previous American research can be carried over to European "rms. As regards other countries, there are a number of studies for the UK, summarized in Conyon, Gregg and Machin (1995), showing in particular that the pay}performance relationship became weaker in the early 1999s as compared to the 1980s. There are only a few studies of the level and structure of managerial pay from countries other than the US and UK. Some examples are Meyerson (1994) for Sweden, Kaplan (1994a) for Germany, Kaplan (1994b) for Japan and the US, Barkema and Pennings (1996) for the Netherlands, and Brunello, Graziano and Parigi (1996) for Italy. Of these, only the last two report performance elasticities. Most of the available evidence points to a positive empirical relationship between pay and performance, notable exceptions being studies from the UK in the 1990s. Many of the US studies * for two recent comprehensive reviews, see Rosen (1992) and Gomez-Mejia (1994) * use stock market indicators as measures of "rm performance, and "nd rather low elasticities with respect to shareholder wealth. The same holds for the studies using accounting earnings measures (see e.g. Leonard, 1990; Sloan, 1993). In an oft-cited study, Jensen and Murphy (1990a) considered that the relationship they found was too weak to provide an adequate incentive for managers to act in the shareholders' interests. Many of the other studies have reached the same conclusion. The strength of the link between pay and performance is interesting not only in view of the public debate about managerial remuneration, but also because it can be interpreted as evidence on principal}agent models. Sometimes the identi"cation of rather a weak link between pay and performance is also taken as evidence of the need for reform and the introduction of the links suggested by principal}agent models. This, for example, is the conclusion drawn by Conyon et al. (1995) concerning the UK. The rather weak relationship has led researchers to focus on a broader range of social and political explanations. Examples of this type of research include O'Reilly, Main and Crystal (1988), who use social comparison models; Balkin and Gomez-Mejia (1990), who focus on organisational strategy; and Lambert, Larcker and Weigelt (1993), who consider the role of internal organisational incentives. (See also GomezMejia, Tosi & Hinkin, 1987; Finkelstein & Hambrick, 1988).


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It is important to note that from the perspective of agency theory the focus on the pay}performance relationship is only a partial analysis. In a more general analysis we also have to consider other incentive mechanisms, such as the threat of dismissal or a tournament-structured competition for positions with a reward structure that is "xed in advance. Tournament theory o!ers another important approach, setting out to explain the structure of compensation within "rms, with promotions playing a key role. Eriksson (1999) examines some aspects of tournament models using the same data source as we have used here.

3. Development of hypotheses As already noted, the great majority of studies of the relationship between managerial pay and "rm performance have been based on data concerning big US "rms, typically Fortune's list of the 500 largest industrial companies. There are at least two reasons why there is so little evidence from outside the US. The "rst is simply lack of data on executive compensation, owing to the fact that in most European countries the disclosure regulations have been less strict than in the US. Secondly, as Pennings (1993) suggested, the dearth of European evidence may also re#ect the cultureboundedness of managerial theories, such that agency and expectancy theory which emphasize individualism and achievement values, for instance, are not universal but are expressions of the US culture. It should be noted, however, that di!erences across countries in pay}performance relations may also arise because of di!erences in corporate governance systems or ownership structures. It is also interesting to extend the analysis to include smaller "rms, as "rm size may be important. In a corporate system like the Danish, where the primary source of outside funds for many "rms is the banking system, one might expect weaker managerial incentives since, unlike shareholders, banks are not residual claimants in good times. Another reason is the size of "rms, which are smaller in Denmark. The optimal pay}performance relation is likely to decline with the size of the "rm as the CEO's direct e!ect on the value of the "rm decreases with "rm size, and due to the greater organisational complexity of large "rms the executive's individual output is more di$cult to monitor in such cases. Thus, our "rst hypothesis is as follows: Hypothesis 1: The ewect of xrm performance on managerial pay is weaker in a country like Denmark that (a) has a more relationship-oriented governance structure than the Anglo-Saxon, shareholder-oriented systems, and (b) has a relatively small xrm size. Agency theory (see e.g. HolmstroK m, 1979) * predicts that when employees face common shocks to productivity, there are advantages to be gained from the employees on a basis of their relative performances. This setting * in which agents are rewarded when other agents similar to themselves perform badly, and are punished when similar agents do well * is e$cient, because it serves to "lter out common risk. As a consequence, there is less `noisea in the performance measure. Four studies have analysed whether incentives are based on absolute or relative performance measures.

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Antle and Smith (1986), using data on executives in 39 "rms and Barro and Barro (1990) who examine a sample of 83 banks, both "nd only weak support for the hypothesis, whereas Gibbons and Murphy (1990), using a much larger data set of 1049 "rms, "nd stronger support for it. Supporting evidence was also obtained by Janakiraman, Lambert and Larcker (1992) in a study of 554 "rms over the period 1970-1988. Thus: Hypothesis 2: The performance of managers is evaluated relative to the average performance in the relevan market or industry. Hence, managerial pay is inyuenced by relative performance. Most previous studies have been concerned with the pay of CEOs. This is also re#ected in Murphy's (1999) survey on executive compensation, where the discussion is exclusively about CEO pay. To some extent it is also natural that the main focus is on the CEO, as a "rm's performance is likely to be more closely linked to the CEO's actions than to the actions of vice presidents or other subordinates. This applies particualrly to the Anglo}Saxon corporate governance system, in which the CEO is the key person. And yet Murphy (1985), the only study of which we are aware that examines di!erences in the pay}performance relationship across hierarchical levels, found no di!erences in the compensation and stock market performance relationship between chairmen, CEOs, presidents and vice presidents. As our data cover a larger section of the corporate hierarchy, we expect the strength of the pay}performance relationship to decline as we move down the hierarchy. This leads to Hypothesis 3: The pay-performance relationship weakens, the further we move down in the corporate hierarchy. Another reason why greater pay}performance elasticity is expected at the top of the hierarchies is that career concerns and promotion opportunities provide important motivation at lower levels. As Lazear (1989) pointed out, the top positions are occupied by more aggressive individuals, and to reduce the incentive for them to compete with each other it may be necessary to compensate them on a basis of absolute performance to a greater extent compared with managers at the middle level. Using a standard agency model with asymmetric information on individual ability, Gibbons and Murphy (1992) have shown that individuals will work harder early in their careers in order to signal ability. Managers closer to retirement are thus predicted to be concerned less with career prospects and more with the immediate rewards. Their model thus yields the following testable hypothesis: because of career concerns, older managers who have been longer with the "rms should be o!ered contracts with steeper incentive provisions. Pay}performance elasticity will consequently incresae with the age or tenure of the individuals. Their model thus leads to Hypothesis 4: Because of career concerns, managers are owered contracts with steeper incentive provisions than lower-level employees. Consequently, the pay}performance elasticity will increase in both the age and the length of service of the individuals.


275

Gibbons and Murphy (1992) provide evidence on chief executive compensation consistent with this prediction. Barro and Barro (1990) and Buchholtz, Young and Powell (1998) also "nd a stronger pay}performance link when CEOs are older or longer tenured. To our knowledge, no other evidence has been provided in the literature.

4. Research method 4.1. Data The data used in this paper comes from two separate sources. Its main component is an unbalanced panel containing information about managers in about 315 Danish "rms (per year) during a four-year period (1992}1995). Most of the "rms are mediumsized or large "rms (large in Danish terms) and are thus obviously not representative of all Danish "rms. However, the data set is representative of the medium-sized and large "rms (with respect to their distribution across industries). The data have been obtained from the con"dential "les of a major Danish consulting "rm (Dansk Management Forum (formerly Institut for Personalera dgivning)) and provides fairly detailed information about the managers' individual characteristics, their pay, the "rms in which they are employed and their currently held position. For each individual we have information about age, time in current position, pay (with and without bonus payments), weeks of vacation, company car, board memberships, type of "rm (industry, number of employees, sales, location, type of "rm) and the position currently held (job status, number of subordinates, responsibility level, job function). Stock options, deferred compensation and stock awards are not registered in our data set, but these three forms of compensation are very uncommon among Danish managers (M+ller & Nielsen, 1994). One advantage of our data set is that we are able to `decomposea the compensation variable into salary and bonus components (which is not possible in many of the US studies, or in any of the UK studies). This is potentially important, as the salary component is likely to be more of an insurance component of the pay, while the bonus element is the part which may be related to performance. The information from the consulting "rm has been supplemented with information on the performance of the "rms derived from a handbook of all major Danish "rms called Greens - B~rsens ha ndbog om dansk erhvervsliv, which is published annually by B+rsens Forlag. Information on the individual "rms has been collected from o$cial registers and from the "rms themselves, and is therefore very accurate. The sample used in the analyses below is made up of the "rms for which we have complete records regarding the "rm performance variables used in the study, namely accounting pro"ts and sales for the period 1990-1994. This leaves us with a sample of 1152 managers in 160 "rms. Of these, 120 are CEOs, 302 higher-level managers and the remaining 730 lower-level managers. The de"nition of higher and lower-level mangers is based on a classi"cation of jobs according to responsibility and authority levels, as used by the consulting "rm that has collected the data. Thus, a lower-level

276


manager's job is classi"ed as a tactics-level job, the higher-level manager's job as a strategy-level job, and the CEO's job as a policy-level job. 4.2. Measurement issues CEO compensation. We use change in compensation as the dependent variable in our analysis of the pay}performance relationship. We make use of the fact that we are able to decompose total compensation into a base salary and a bonus component, and to estimate two di!erent versions of the model * one with base salary and another with total compensation as the dependent variable. A comparison between the mean annual wage growth of the managers in our data set with that of other wage-earners during the period 1984}1994, reveals that during the 1980s the managers enjoyed faster rates of pay growth than average wage-earners * a di!erence of 2}3 percentage points per year. The di!erence shrank in the early 1990s. As can be seen from Fig. 1, there is considerable dispersion in the growth rates for managers, something that does not apply to most other wage-earner groups. The importance of performance-related pay * bonuses and commissions * increased in the 1980s and has continued to do so in the 1990s. In our data set we can thus observe that the share of managers receiving bonuses, as well as the share of bonuses in total pay, both increase between 1990 and 1994 for all groups except, curiously enough, the CEOs, for whom both shares fall slightly. The shares of those receiving bonuses are fairly small: in 1994 34 and 20% for CEOs and other (higher and lower-level) managers, respectively. Although total pay is the same as base salary for a considerable proportion of the managers, where this is not the case there are substantial di!erences in the change in base salary and in total compensation. Performance variables. The performance variable has been operationalized in two alternative ways. The "rst is the rate of return on the "rm's own capital. This variable will be entered both in a level and a change form to allow for `memorya in the process, and it may pick up a decaying or increasing impact of a change in performance. The second performance variable is a set of dummy variables constructed in the following way * see Scheme 1. The xrst dummy (D1) is equal to one if accounting pro"ts (after

Scheme 1. Dummies describing the change in post-tax accounting pro"ts, 1992}1993.


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tax) are positive and the "rm's result is improving, and zero otherwise. The second dummy (D2) assumes the value of one if the result is negative but has improved since last year, and zero otherwise. The third dummy (D3) equals unity if the "rm earns negative pro"ts and the result is deteriorating compared to the previous year, and zero otherwise. The omitted reference category (D4) then refers of course to "rms with positive pro"ts but deteriorating results. Initially, sets of dummy variables were included for each of the three periods 1992}1993, 1991}1992 and 1990}1991, but only the "rst of these ever gained any statistical signi"cance. The reason we used dummies rather than ratios is that relative change measures are meaningless here, since whether a small absolute increase in pro"ts translates into a small or a big relative increase depends on the initial level of pro"ts. The dummy variable technique also allows us to account for whether the "rm was, or still is, making a loss. In view of the fact that several Danish "rms are close companies, not listed at the stock exchange, post-tax accounting pro"ts are used as the performance variable. The relatively small number of Danish "rms in the stock market is also re#ected in the data set used. Since listed companies represent only 10% of the "rms in the sample, we cannot use shareholder wealth or earnings per share or any other stock market indicator as a measure of "rm performance. It should be noted, however, that accounting pro"ts are not necessarily a poor measure of "rm performance (see Rosen, 1992, for a discussion) and they have been used in several studies of managerial compensation. The main motivation for dismissing them is that they are not highly correlated with shareholder returns (see Lev, 1989). Murphy (1999), in what to our knowledge is the "rst systematic study of contracts and performance standards, "nds that the single most common form of performancerelated pay is the bonus, and that performance standards, irrespective of the form of performance pay, are predominantly based on budgeted performance and accounting-based performance measures. Thus, although we do recognize that earnings are likely to be a `noisiera performance measure than stock market measures (which we have for a fraction of the sample only), we do not see the use of accounting pro"ts as a performance indicator as any great disadvantage to our analysis. A separate analysis of the (few) listed companies is on our agenda for further study. The variables described above capture only the development of the "rm's pro"ts compared with the previous year; they do not take into account how well the "rm has performed relative to other "rms in the same industry or market. As a test of the relative-performance evaluation hypothesis (see Gibbons & Murphy, 1990), we introduce a dummy variable that is equal to one if the relative change in the "rm's accounting pro"ts is better than that of the industry average (in our data set). Alternatively, we look at the "rm-level rate-of-return variable in relation to the relevant industry-level averages. In constructing the relative performance variables we have used three broad categories * manufacturing, services and trade * as the bases for the relative comparisons. In addition to pro"ts we have used the level of sales, and change in this, as control variables. In the earlier literature sales were interpreted as a measure of "rm size and regarded as an important determinant of managerial pay (see Ciscel & Carrol, 1980

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for a discussion and critical examination of the evidence). More recently, Rosen (1982) has argued that "rm size may be correlated with performance not only because pro"ts and revenues are likely to be highly correlated, but because large "rms are headed by more able managers since more talented people are needed to control greater resources. 4.3. Analysis The basic model to be estimated is a fairly standard "rst-di!erence compensation equation: change in log (pay) " b (change in performance) #c(individual, ,rm GR K HR\K and/or job characteristics) #e , (1) GR GR in which the subindices i, j and t denote individual, "rm and year, respectively, and the dependent variable is the relative change in pay. An advantage of such a speci"cation is that it controls for individual-speci"c heterogeneity. In cases with only one observation (for example, the CEO) per "rm, "rm-speci"c heterogeneity will also be accounted for. Thus, the "rst-di!erence speci"cation may also account for time-invariant di!erences in management culture and corporate governance, for example. Our general speci"cation allows us to test for two extreme versions of the pay}performance relationship, namely, completely persistent e!ects and transitory e!ects, as well as intermediate versions. Thus, the estimation results shown below are the outcome of a from-general-to-speci"c estimation strategy. The model above has also been estimated on two di!erent samples, in each case with the two di!erent dependent variables. The "rst sample consists of all managers in our data set. The second contains only the CEOs. Both samples are restricted to managers who did not change employer or position between 1990 and 1994. That is to say, individuals with too short a period only in the company are excluded. The reason for restricting the sample in this way is that in order to make sense of estimates from models with lagged performance variables, only the managers who were in o$ce during those years should be included in the analysis. The key coe$cients are of course the bs, which capture the pay-for-performance sensitivity. If there is a close alignment of owner and managerial interests, we would expect to "nd the coe$cient for the "rst dummy (D1) to be positive, and the coe$cient for the third dummy (D3) to be negative. However, as Leonard (1990) pointed out, failing "rms making heavy losses may be forced to pay a compensating pay di!erential to attract and keep skilled managers. Hence, one cannot rule out the possibility that the third dummy (D3) may even attach a positive coe$cient. As for the second dummy (D2), there are no obvious priors. If the earnings equation were to be estimated in terms of levels, we would expect individual and "rm characteristics to be of some importance, as the manager's opportunity costs for his current compensation contract are likely


279

to depend on his age, experience, education, ability, performance in earlier jobs, size of "rm and so on. The "rst-di!erence form captures the e!ects of time-invariant individual traits and "rm characteristics, allowing us to focus on the e!ects of changes in the key variables over time, namely accounting pro"ts and sales. Initially, we also included a host of individual and "rm characteristics suggested by human capital theory. Of these only age, tenure in current position and positionlevel dummies (CEO and higher-level manager) survived tests of statistical signi"cance.

5. Results Sample means and standard deviations for some of the key variables are provided in Table 1. It can be seen that the average age is higher and average tenure in current position is longer at higher organizational levels. For the CEOs, bonuses and commissions represent a greater proportion of the average total compensation. The mean change in pay between 1993 and 1994 is largest for CEOs. The estimates from regressions using the rate of return on the "rm's own capital as the performance variable are set out in Table 2a. We present the results from two di!erent speci"cations * with and without sales and change in sales as explanatory variables * estimated on two di!erent samples using two di!erent dependent variables. Corresponding estimates from estimations with dummies for accounting-pro"ts changes and relative rate-of-return changes as explanatory variables are given in Table 2b and 2c, respectively. Table 1 Managers and their pay in 1994, some descriptive statistics Variable

CEOs

Higherlevel managers

Lowerlevel managers

Age (years)

51.38 (5.80) 8.69 (5.78) 1069.04 (368.89) 4.73 (7.57) 185.55 (178.67) 1235.77 (442.56) 5.17 (10.82) 120

50.21 (6.57) 8.40 (5.67) 678.22 (179.58) 3.54 (3.60) 85.86 (69.46) 751.02 (201.77) 4.15 (5.15) 302

46.72 (7.76) 8.12 (5.64) 436.81 (88.10) 2.99 (3.17) 50.02 (43.49) 476.32 (101.96) 3.33 (3.77) 730

Tenure in current position (years) Salary (1000 DKK) Percent change in salary from 1993 Bonus (average of positive bonuses) (1000 DKK) Total compensation (1000 DKK) Percent change in total comp. from 1993 No. of observations Note: Standard deviations in parentheses.

0.07

*

0.64 (0.18) 0.01 (0.10) *

5.74 (0.50) 0.60 (0.18) 0.01 (0.10) 0.31 (0.08) 0.001 (0.001) 0.08

6.03 (0.51)

Deteriorated since preceding year and negative pro"ts (D3)

Improved since preceding year and negative pro"ts (D2)

Performance of xrm: Improved since preceding year and positive pro"ts (D1)

Constant

0.99 (0.27) 0.39 (0.48) 0.17 (0.36)

(0.27) 0.50 (0.48) 0.14 (0.36)

5.72 (0.55)

1.06

5.25 (0.54)

(1.84)

(2.75) 0.35

(1.49) 2.32

2.01

12.09 (8.21)

0.14

*

1.80 (0.88) !0.10 (0.23) *

15.10 (8.00)

16.60 (8.01)

(1.88)

(2.79) 0.10

(1.50) 1.94

1.99

13.02 (8.25)

1.92 (0.88) !0.12 (0.23) 0.65 (0.40) 0.001 (0.003) 0.15

(0.46)

(0.62) !0.60

(0.34) 0.53

0.93

5.63 (0.69)

0.06

*

0.94 (0.22) 0.29 (0.13) *

5.99 (0.64)

(0.46)

(0.62) !0.58

(0.35) 0.54

0.92

5.70 (0.71)

0.93 (0.23) 0.29 (0.13) 0.12 (0.10) 0.001 (0.001) 0.06

6.14 (0.65)

(2.42)

(3.62) !1.31

(1.96) 3.13

2.22

19.53 (10.78)

0.16

*

2.94 (1.14) 0.28 (0.30) *

23.36 (10.38)

Only CEOs

All managers

All managers

Only CEOs

Change in log total compensation

Change in log salary

(b) Estimations with changes in accounting pro"ts as the performance variable

Adj, R

Percentage change in sales, 1992}1993

Sales in 1993

Change in rate of return, 1992}1993

Performance of xrm: Rate of return on the "rm's own capital, 1993

Constant

Variable

Table 2 (a) Estimations with rate of return on the "rm's own capital as the performance variable

(2.45)

(3.69) !1.33

(1.98) 3.55

2.23

19.20 (10.90)

2.98 (1.16) 0.27 (0.30) 0.17 (0.53) !0.001 (0.004) 0.14

23.80 (10.53)

280 T. Eriksson, M. Lausten / Scand. J. Mgmt. 16 (2000) 269}286

(0.10) 0.001 (0.001) !0.44 (0.31) 0.08

0.33

0.33 (1.47) 0.12

*

*

* 5.78 0.06

0.07 (0.03) !0.01 (0.02) *

5.78 (0.51) 0.08 (0.03) !0.01 (0.02) 0.32 (0.08) 0.001 (0.001) 0.08

6.07 (0.51)

* 0.15

0.24 (0.12) !0.02 (0.05) *

14.75 (7.98) 0.26 (0.12) !0.03 (0.05) 0.67 (0.41) 0.002 (0.003) 0.15

16.27 (7.99)

Note: Standard errors in parantheses, N"1152 for all managers and 120 for CEOs only. Indicates statistical signi"cance at the 5% level. Other explanatory variables included in the estimations (but not shown) were: age and age squared, tenure in current position and dummies for CEOs and higher-level managers. Indicates statistical signi"cance at the 10% level.

Adj. R

Percentage change in sales 1992}1993

Sales in 1993

Change in relative rate of return 1992}1993

Performance of xrm: Rate of return relative to industry average, 1993

Constant

0.60 (0.53) 0.002 (0.004) !0.80 (1.83) 0.12

(c) Estimations in which rate of return relative to industry average is the performance variable

Adj. R

0.02 (0.26) 0.07

*

Percentage change in sales 1992}1993

Sales better than industry average in 1993

*

Sales in 1993

* 0.06

0.18 (0.04) !0.04 (0.03) *

6.00 (0.64)

0.02 (0.34) 0.04

*

*

0.18 (0.04) !0.05 (0.03) 0.14 (0.11) 0.001 (0.001) 0.06

6.17 (0.65)

(0.13) 0.001 (0.001) 0.01 (0.40) 0.04

0.03

* 0.17

0.49 (0.15) !0.09 (0.06) *

23.15 (10.27)

0.78 (1.94) 0.11

*

*

0.50 (0.15) !0.09 (0.06) 0.29 (0.53) 0.001 (0.004) 0.16

23.82 (10.41)

(0.70) 0.001 (0.005) 1.80 (2.42) 0.10

!0.47

T. Eriksson, M. Lausten / Scand. J. Mgmt. 16 (2000) 269}286 281

282


Before turning to the performance indicators, we can note brie#y that there is a relatively stable relationship across speci"cations and samples between change in compensation and age, tenure and position level as predicted by conventional human capital models. The motivation for including lagged performance variables is to study the persistence and dynamics of performance e!ects on pay changes. In our initial analyses it turned out that none of the lagged performance dummies (i.e. from the 1991}1992 and 1990}1991 periods) came nowhere close to di!ering signi"cantly from zero. Thus, these estimation results (which are not reported here) indicate that the e!ects of performance on pay (if any) are only of a short-term nature. In other words, a one-time change in performance generates a change in compensation in the current period only. The results regarding the performance variables di!er between the change in salary and the change in total compensation equations for the speci"cations in which with the rate of return on capital is the performance variable, as in Table 2a. The rate of return on the "rm's own capital is signi"cant and has the expected positive sign in all cases. Moreover, we can note that CEO pay, salary as well as total compensation, is clearly more responsive to changes in "rm performance than that of other managerial employees. These results thus lend some support to hypotheses 1 and 3. For the dummy speci"cation in Table 2b the di!erences are much smaller. It can be noted that only a few of the dummies attach signi"cant coe$cients. If we look more closely at the estimation for all managers in the sample, we can see that managers employed in "rms which earned positive pro"ts in 1992 and have done better in 1993, do get a 0.9}1.1% higher increase in their salaries or total compensation (columns 1, 2, 5 and 6 in Table 2b). Although some of the coe$cients have the expected sign, their magnitudes are rather small, especially in view of the fact (as noted above) that we have been unable to detect any really persistent e!ect from changes in "rm performance. The most surprising results were obtained when the model was estimated on the sample consisting of CEOs only. Clearly this is the group of managers for whom we would expect to "nd a stronger link between pay and performance. None of the performance indicator dummies in Table 2b acquired statistically signi"cant coe$cients. The estimated coe$cients were fairly large in magnitude, however. Thus, the results displayed in Table 2b do not support hypothesis 3. As was noted earlier, in assessing the performance of the managers it may be important to account for the level of the "rm's performance relative to other similar "rms. In order to test the relative-performance hypothesis (hypothesis 2), the rates of return on the "rm's capital and changes therein, were scaled by their industry averages. As can be seen from Table 2c, there is some evidence that relative performance does play a role. The magnitude of the e!ect is relatively small, however, and pertains only to the rate of return on the "rm's own capital. The relative-performance speci"cation does not improve the "t of the equations; the increase in their explanatory power is only marginal. Again we can note that CEO pay is more responsive to the performance of the "rm than other managers' pay. The age and tenure coe$cients do not pick up e!ects of a changing relationship between age or tenure and "rm-performance measures as predicted by


283

hypothesis 4 (Gibbons & Murphy, 1992). We have tested more formally for whether the pay}performance elasticity will increase as the CEOs near retirement age and, for a given number of years remaining as CEO, the slope of the contract will increase in tenure in the current position by introducing interaction terms between performance Table 3 Interaction estimates. Change in log total compensation 1993}1994 * the CEOs Variable

Interaction with tenure

Improved since preceding year and positive pro"ts (D1) Improved since preceding year and negative pro"ts (D2) Deteriorated since preceding year and negative pro"ts (D3)

14.17

16.12

(3.18) 8.44

(7.05) 11.60

(6.87) 4.72

(14.75) 7.26

D1 age

(3.93) !1.49 (0.32) !0.65 (0.59) !0.63 (0.40) *

D2 age

*

D3 age

*

D1 tenure D2 tenure D3 tenure

Adj. R

Change in rate of return, 1992 to 1993 tenure

Change in rate of return tenure Rate of return

age

Change in rate of return age

Adj. R

(9.65) * * * !0.66 (0.31) !0.39 (0.68) !0.35 (0.47)

0.21

Rate of return on "rm's own capital, 1993

Rate of return

Interaction with age

5.39 (2.29) 0.94 (2.40) !0.36 (0.30) !0.12 (0.45) * *

0.12

0.09 0.15 (7.22) 4.58 (8.00) * * 0.13 (0.40) !0.24 (0.45) 0.11

Note: Standard errors in parentheses, N"120 CEOs. Other explanatory variables: same as in Table 2a}2c. Indicates statistical signi"cance at the 5% level. Indicates statistical signi"cance at the 10% level.

284


measures and age on the one hand, and tenure in current position, on the other. The estimation results are shown in Table 3. We were unable to "nd any evidence in support of changing pay}performance elasticity. Rather, the estimates suggest that the slope of the contract decreases, i.e. older CEOs and those with longer time in the "rm are rewarded or punished less than their younger colleagues. It should be noted, however, that our compensation measure does not include shareholdings, and if these increase with tenure and/or age, they may serve to increase incentives.

6. Discussion and conclusions In this study we have examined some of the determinants of managerial compensation in a sample of Danish "rms. This is the "rst study of the compensation of Danish executives, and it adds to the limited literature on empirical analyses of agency theory in a non-US/UK institutional setting. First-di!erence estimates, like those presented in the preceding section, naturally exaggerate the transient elements, since about 90% of the variance in managers' salaries or total compensation are not accounted for. Of the variance explained, about half is related to changes in "rm performance. For most managers the pay-forperformance relation is relatively weak: the changes in their pay are not predominantly driven by changes in corporate performance. A result worth noting is the absence of a strong relation between pay and performance in terms of accounting pro"ts for the CEOs in our sample. Further, the relationship such as it is, is stronger for growth in pro"ts than for growth in losses. On the other hand, the pay of the CEO as well as of the other managers is a!ected by the rate of return on the "rm's own capital. It has been suggested (Pennings, 1993) that compensation schemes may be institution- or culture-speci"c. As regards the existence of a pay-for-performance relationship, however, this does not seem to apply. Comparisons of pay}performance sensitivity across countries are very di$cult to make, but there do not appear to be great di!erences between the US literature and the few European studies available: in both cases the relationship is relatively weak. Brunello et al. (1996) and Barkema and Pennings (1996) also isolate a relationship for Italy and the Netherlands, respectively. Thus, Danish "rms do not have a stronger or a weaker pay}performance relationship than "rms in other countries. Our results do not reject the hypothesis that managerial performance is evaluated relative to that of other "rms in the same industry. However, the speci"cation of relative performance does not outperform a speci"cation of absolute performance in the statistical sense (that is, in terms of explanatory power; cf. Table 2a and Table 2c). Thus, as has been found in previous studies made in other institutional settings, relative performance seems to be a comparatively unimportant aspect of executive compensation, empirically speaking. This is an interesting "nding in view of the prominent role of relative-performance evaluation in the theoretical literature. Few earlier studies have considered the possibility that the sensitivity of pay to performance may di!er between managerial groups. Our study takes a step in that


285

direction as our data allow us to compare pay}performance sensitivity between CEOs and other members of top management. Since the CEO in a relationship-oriented governance structure like the Danish is more of a "rst among equals, it might be expected * as hypothesis 3 implies * that the di!erences in pay}performance sensitivity across hierarchical levels would be small. Unlike Murphy (1985), who found no such di!erence, we found a di!erence of this kind, albeit a slight one. Clearly this is an issue on which further study is needed. One implication of agency theory which has been subject to little empirical testing is the career concern hypothesis. In our empirical analysis we "nd no evidence of steeper incentive contracts as CEOs approach retirement or as their years with the "rm increase. The lack of support for this hypothesis suggests that the whole area of working life and career incentives may be under-researched. Further research could focus on other incentives, such as the working life pro"le of base salaries and the threat of dismissal. One of the open questions in the interpretation of our results concerns the extent to which they re#ect the fact that about 80% of the "rms in the sample are not listed. In our further work on this topic we will distinguish between close and listed "rms and make a separate analysis on the smaller sample of "rms whose shares are sold on the stock market. In interpreting our results, it is also important to note that our analysis is a partial one only, as there are also other incentive mechanisms which may be more e!ective in promoting better performance on the part of managers. One concerns the reward structures based on relative performance that have been analysed in tournament models. Another mechanism concerns managerial mobility between "rms and the threat of dismissal. In our future work we intend to examine both these mechanisms.

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