Executives create the conditions for an environment of innovation. And, according to outcomes from recent research, this is related to executive pay.

In a recent paper (see HERE), M.D. Amore and V. Failla explore the link between executive pay dispersion in US listed companies and corporate innovation between 1992 and 2006.

Pay dispersion is defined as the ratio of compensation between the highest and lowest paid executive disclosed for each company. Innovation is measured using the number of patents granted in a given year. To account for the technological and economic importance of each patent, forward citation counts is used as a proxy and another measure of innovation.

The research found that executive pay dispersion acts as a double-edged sword. On the one hand, the higher the dispersion in variable pay, the higher the innovation. On the other hand, the larger the dispersion in fixed pay, the lower the innovation.

Hence, when boards monitor executive compensation policy, it is important to consider the dispersion and not just the level of compensation.

Hypothesis

The paper posits that pay dispersion within an executive team’s remuneration has opposing effects on innovation:

1 . When pay dispersion is considered legitimate and accepted, there is incentive for executives to engage in co-operation and knowledge sharing;

2 . When pay dispersion is weakly legitimised, it creates obstacles for knowledge sharing and co-operation. This leads to harmful consequences for innovation .

Compared to past research, this paper focuses on separating these effects by considering the dispersion in fixed remuneration and variable remuneration separately.

Analysis

Patent and citation counts were modelled against total remuneration dispersion, fixed remuneration dispersion and variable remuneration dispersion.

Individual company effects and trends in innovation over time were accounted for. Control variables were introduced to limit the differences created by corporate size and structure:

1 . Company revenue

2 . Capital to labour ratio i.e. property, plant and equipment divided by employees

3 . Company age in years

4 . Number of executives disclosed by companies

5 . CEO’s age and tenure

To further the robustness of their conclusion and account for confounding variables, the model was retested with changes made to the data set and model variables. Table 2 shows the potential confounding variables and the robustness tests conducted.

Table 2: Robustness tests to account for other influential factors

Ultimately, the robustness tests support the outcome from the original model. Higher variable pay dispersion leads to higher innovation, while higher fixed pay dispersion leads to lower innovation.

The paper does not consider the interaction of internal and external corporate governance mechanisms in shaping innovative outcomes. The study could be further extended by including remuneration of lower-ranked employees and accounting for institutional factors such as changes in government incentives to influence innovation.

GA Comments

As recognised in the paper, patent and citation counts are a limited measure of innovation. It can be argued that companies will only file patents for innovations useful to their business. However, a higher citation count reflects a usefulness to society and other companies but does not necessarily translate to higher business outcomes to themselves. In terms of executive compensation incentives, influencing executives to improve the number and quality of patents is futile if the company does not benefit themselves.

While executives have control over the company’s strategic goals and direction, implementation still comes down to middle management and lower-level employees. A culture that allows for continuous innovation is unlikely to result solely from executive action, and any causal relationship between executive compensation and innovation may be tenuous.

The sample only considers 1992 to 2006 due to a lack of available data matching disclosed executive compensation and patent information. While this analysis may hold true for that time period, there have been large changes to executive compensation in terms of scheme design and corporate governance as well as overall market changes since 2006.

Another point of note is the sample being only US companies. Pay dispersion might be less significant within other countries and therefore may not be as impactful to the behaviour of executives. The relationship might not hold true in other countries, whose social and corporate culture may be more conducive of pay dispersion without affecting innovation outcomes.

Board action – check list

1 . Monitor innovation- how does the company compare to local and global competitors in filing patents? What have been the trends?

2 . How dispersed is executive fixed pay relative to competitors? Has this an inverse relationship to patents filed? What have been the trends?

3 . How dispersed is executive variable pay relative to competitors? Has this an inverse relationship to patents filed? What have been the trends?

4 . Do employee engagement surveys have items that indicate support for innovation? What have been the trends?

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