Does executive pay reflect how talented an executive is?
01/12/2010
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One of the issues in executive pay is whether pay reflects merit.  It is acknowledged that the rates of executive pay increase (with the exception of the years of economic slowdown, witnessed in 1992-1994, and in the past two years) exceed that of other workers.  Reasons for this put forward by economists of various persuasions include:

·         Demand for certain skills and experience exceeds supply

·         Rent seeking, whereby an unbalanced distribution of power and information results in a disproportionate distribution of wealth that does not validly reflect the economic value added by capital (shareholders) or labour (executives) respectively

·         Merit, whereby the level of pay varies with the “talent” and economic value added by individuals

There is evidence for the first proposition.  Australia’s largest companies today have an economic value that considerably exceeds what their economic value would have been if they had grown in accord with GDP growth only.  This implies that the demand for experience running larger enterprises has exceeded the local supply.  In addition, the number of smaller listed companies has greatly exceeded natural population growth, fuelled by greater access to superannuation capital, resulting in shortages of management even at the smaller company end.

There is evidence for the second proposition.  This is most evident in the US, which is a global outlier for executive pay.  In the US, under Delaware corporate law, shareholders have effectively no say in who occupies board directorships, the CEO chairs the board, and the board has sole authority over executive pay.  This is in contrast with other regimes, where there are governance checks and balances that result in relatively modest pay levels.

Now we have some evidence for the third proposition.

In a recent paper, “Premium Pay for Executive Talent: An Empirical Analysis”, the extent to which executive talent affects the level of executive remuneration has been researched.  Until this paper, there has not been much direct evidence on the association between the executive-specific characteristic of talent and remuneration contracts.

The research used US data.  It developed three indicators to capture the executive’s talent.  The first indicator captures the “perceived” dimension of talent, based on whether the executive was a CEO at the previous company, tenure in a prior top position, excess pay at the previous company, and the press coverage while at the previous company.  The other two indicators capture measurable outcomes of actions at the prior employer.  One measures talent using accounting and share price performance at the prior company.  The other captures “perceived” talent by relying on reporting quality, namely whether the prior company has restated its earnings.

Using a sample of 1,844 executives who represent 2,021 job switches at 1,700 unique companies between 1992-2007, the results indicate that executives with greater talent receive higher pay at their new employers.  The findings suggest that there is a reward for talent that is incremental to the new position of the executive and incremental to pay based on the economic characteristics of the new employer.  That these executives are paid a premium potentially reflects competition in the labour market for skilled executives.

The study also examines whether paying for talent is associated with superior performance at the hiring company.  It finds mixed results on whether pay premiums for talent translate into greater accounting and share price performance of the new employer.  The talent indicator based on performance at the prior company is positively associated with accounting performance at the new company.  But the “perceived” talent measure is negatively associated with both accounting and share price performance at the new company, suggesting that paying for “perceived” talent may not pay off for the hiring company.

In effect, the study appears to show that good prior performance results in significant pay premiums to executives who switched companies, i.e. payment for talent.  However, this does not always payoff.

 

The paper is available HERE

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