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Research Proposal on Determinants of CEO Compensation

1. Abstract

The research paper seeks to identify the factors that determine CEO compensation by examining their practices if the firms listed in FTSE 100 index of the UK from the year 2011 to 2013. The agency theory and empirical evidence in the literature review identify the CEO compensation determinants that will be used in the real research as hypotheses. These include the firm size, performance, and CEO seniority. The proposed research will use a sample of FTSE100 UK companies and employ survey based, history-based, and inferential statistics methodologies. A regression analysis will be conducted to show the strength of the relationship between the independent and dependent variables. The t-tests will show the level of significance of the variables.

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2. Introduction

CEO compensation has attracted great attention of the investor groups, management professionals, institutional shareholders, and the public. The discrepancy in compensation between the CEOs and the lowest paid employee is very high. In the UK, the pay gap is up to 120 times higher. In companies such as Walmart, the cumulative annual earnings of an employee are equal to the remuneration of a CEO in one hour (Gabaix et al. 2013). The big companies pay up to $18 million bonuses to their executives. The financial analysts in the UK hypothesize that since the beginning of the 21st Century, the earnings of the CEOs have risen about ten times faster than that of the average employee (Frydman et al. 2011). One of the reasons for the increase of the executive pay is the quest for firms to present the superiority of their CEOs compared to other firms by the higher perquisite.

The executive compensation structure is one of the mechanisms of internal governance that ensures effective management of the institution. The sum total of executive compensation include basic salary, stock awards and options, cash bonuses based on the past achievements, non-equity incentives, such as performance-based long-term cash incentives, appreciation in pension value and other allowances such as personal security, life insurance, and car use (Lipman, & Hall, 2008).

The aim of compensation packages is to facilitate the work of executives for the interest of the organization rather than their own (Forbes-Pitt, 2011). The reason is that the principal (owner of the organization) is different from the agent (CEO). The owners lack the professional knowledge and expertise to run the organization, or they may be numerous. Moreover, they choose to entrust the management of the organization to another person (Chetty et al. 2007). The firms can govern executive compensation in two ways: they can form compensation committees composed of non-executive directors to determine the executive remuneration or hire compensation consultants.

These concerns create the need to study the primary relationship and dynamics between CEO compensation and the firm size, firm performance and CEO seniority in the UK. The study will explore agency theory and previous academic literature while defining the operating environment regarding CEO compensation.

The study will examine a sample size of 100 UK companies called the FTSE 100, which have the highest market capitalization listed in the London Stock Exchange over the years 2011, 2012 and 2013. The research methodologies adopted in the study include inferential statistics, survey, and empirical methods. The research hypothesis will involve determining the relationship between CEO compensation, firm size, firm performance, CEO seniority, and firm age among FTSE 100 companies in the UK.

The findings of this study will identify common features among the sampled companies and make conclusions on the defined research hypotheses in the context of the UK firms. The study's result will be of great significance since they will put the theoretical hypotheses in the literature to scientific research. It will also be resourceful to the remuneration committees since they will implement the findings of this study in decision making concerning executive compensation.

2.1. Research Questions

The proposed research aims at investigating whether CEO compensation is influenced by firm size, firm performance, CEO seniority, and firm age in the UK. The paper will review the use of fixed salary, stock awards, bonuses, restricted stock, and change of the pension value as compensation measurements; total value of assets, number of employees and market capitalization as measurements of the firm size; net income, return on assets and revenues as measurements of firm performance and CEO age to measure seniority. The study seeks to answer the following research questions:

  1. What is the relationship between CEO compensation and firm size in FTSE 100 companies? Is the relationship consistent with the industries?
  2. What is the relationship between CEO compensation and firm performance in the FTSE 100 companies? Is the relationship consistent with the industries?
  3. What is the relationship between CEO compensation and CEO seniority in FTSE 100 companies?

2.2. The Relevance of the Proposed Research to Business Research

The relevance of this research study is to facilitate the understanding of the primary variables that affect CEO compensation such as firm performance, firm size, and the seniority of the CEO within the UK context. Particularly, the proposed research will try to examine the relationships of its sub-variables that contribute to the derivation of the conclusion among the relationships of micro variables. There are corresponding sub-variables for CEO compensation such as fixed salary, stock awards, bonuses, restricted stock, options granted, non-equity compensation plans, planned payouts, non-qualified compensation and change of the pension value. The sub-variables for firm size are the total value of assets, number of employees, and market capitalization. The sub-variables for firm performance are net income, return on assets and revenues. The age of the CEO in a given year will define seniority.

The existing literature on UK CEO compensation is scanty. The greater number of the past studies were conducted in the 1990s. However, several factors have changed since that time, which requires fresh research studies. Research on the components of executive compensation in the stock market index company level has not been conducted in the UK during the past ten years. Most studies used mainly secondary sources. The studies also concentrated on manufacturing and banking firms. The past studies collected data from the third parties such as associations and magazines. The studies found a positive correlation between CEO compensation firm size, firm performance, and CEO seniority, though the studies did not research the degree of correlation. The limited scope and insufficiency of the above past research studies lends credence to undertake more detailed and complete research on UK CEO compensation factors. The proposed research study is broad since it will use data from 100 companies to make comprehensive conclusions.

The study will use FTSE, the largest stock exchange index in the UK, where the companies with the highest market capitalization are listed. This selection is critical because these companies are firmly established and will provide consistent data during the period of study. Additional data on these companies can be obtained from the UK stock exchange.

The proposed research will add to the existing academic literature about CEO compensation. The study will also help the executive compensation industry, the public, and the entire body of the company stakeholders to understand better the factors that affect CEO compensation.

3. Literature Review

The literature review explores the agency theory, and the empirical evidence involved to explain the determinants of executive compensation.

3.1 CEO Compensation and the Agency Theory

The agency theory will form the basis of the literature review of the executive compensation. It explains executive compensation based on the principal-agent relationship. According to the theory, the interests of the owner of the firm (principal) and the manager (agent) are imperfectly aligned, leading to the agency problem (Bowie & Freeman, 1992). The fact that the owner is not the controller may lead to a conflict of interests. The managers may formulate decisions aimed at personal gains such as embezzling, overspending, empire building, and overinvestment. Other agency problems also include information asymmetry. The principal may not effectively observe the actions of the agent. The agent may be aware of some aspects regarding the situation, but oblivious to the principal. The manager may use these circumstances to engage in mergers for self-interests, fraud, and choose easy tasks. The owners design contracts to award management according to their performance, to align the interests of the owners and the CEO.

The study conducted by (Kulkarni, 1988) formulated two views to explain executive compensation. The optimal contracting view explains that the board of directors set the pay arrangements aimed at maximizing shareholder value. They design optimal contract that minimizes agency costs. The second issue is the managerial power view arguing that CEOs can influence the boards to establish high pay levels for them against the interests of the shareholders. The excess pay is economic rent. The boards are too weak and orchestrate a conflict of interests.

A study of (Frie, 2008) argues that in the public companies of the US, the power and influence of the management has a significant influence on the executive pay, which impose costs on the shareholders. (Bowie & Freeman, 1992) argues that competition among firms for highly skilled and experienced CEOs determine executive pay.

Karake-Shalhoub (2002) suggests two ways through which firms can determine executive compensation. The first one is through the compensation committees formed by non-executive directors. Secondly, the firms can hire external compensation consultants to offer expert advice.

Maiguashca and Marchetti (2013) identified four elements of the executive compensation. They include cash bonuses, basic salary, restricted stock, equity compensation, and other benefits. (Sloof & Praag, 2007) defined executive compensation as the sum of annual salary, non-equity compensation, and cash bonuses.

In the US, firms pay CEOs according to the pay for performance approach. This system uses equity compensation as a form of motivating the CEOs. The value of the underlying assets increases the value of the option. Raised value of the stock options and equity compensation improves firm performance. This in turn increases the holdings of the CEO regarding shares and options. This pay scheme improves the shareholders’ value.

3.2. CEO Compensation and Firm Size

This section will explore the link between firm size and CEO compensation. Various scholars believe that CEO compensation may rise due to the size of the firm increases. (Gabaix et al. 2013) explained that the higher compensation with the size of the firm results from the growth of challenges to manage large firms due to the increasing organizational complexity. (Bebchuk et al. 2005) identified that firms that generate higher revenue and own more assets pay their executives higher perquisites. (Nourayi, 2008) also attested to the raised executive pay associated with large firms and supported it by the increased complexity of the organizations requiring highly qualified managers. (Bebchuk et al. 2011) conducted a study where he sampled 50 US banks and assessed the paid perquisites of the executives from 1997 to 2000. The results of the study indicated that the firms that had more assets paid their executives higher salaries and other perks. (Edmans et al. 2007) reached similar results when he conducted a study across 100 UK banks. (Cheng et al. 2010) found that executive compensation is a function of the firm size, as indicated by the total assets. (Stein, 2011) conducted a similar study in 200 German firms and found that the firm size is an important explanatory variable in explaining the changes in remuneration. (Frydman et al. 2011) examined the increase in market capitalization of US large firms concurrently with the changes in the firms’ executive pay during the period from 1995 to 2010. The results of the study indicated a 400% increase in market capitalization, corresponding to a 400% rise of the CEO earnings within the same period. All the studies above indicate that the large firms offer higher compensation to the CEOs.

3.3. CEO Compensation and Form Performance

This topic will examine the influence of the firm performance on the CEO compensation. It is believed that firm performance is the measure of the firm’s earnings before dividing interests and taxes by the total assets (Ha 2000). The scholar found a positive relationship between this measure and executive pay. The organizations offered bonuses, fixed salaries, and options which commensurate with their return on assets. (Mercer 2009) defined firm performance as the level of profitability and defined that the highly profitable firms paid more remuneration to the executives. (Nourayi, 2008) identified that large firms consider profits and revenues as an important factor in executive compensation contracts. (Ha 2000) argued that CEOs have higher stock option gains in firms that exhibit high performance. (Lipman & Hall 2008) argued that CEO pay and firm performance are positively related. (Bamberg et al. 1987) tested the optimal contracting view and found that the boards align the interests of shareholders with those of the CEO by making the CEO compensation contingent to the firm performance.

3.4. CEO Compensation and Seniority

This topic will explore the relationship between the seniority of the CEO and their compensation. It is believed that the firms aim at retaining experienced CEOs by paying them higher perquisites (Kolb, 2006). The older CEOs manage investment expenditures better, especially because they want to increase short-term earnings before they retire. (Foulkes 1991) conducted a study across 20 firms in the US and defined that CEOs who have worked in the firms for more than ten years earn more than the neophytes. The firms are willing to pay higher salaries to CEOs with long-term experience than those with few years of practice. The above studies indicate positive relationship between CEO compensation and seniority.

The academic literature covered above shows that there is a connection between CEO compensation, firm size, agency theory, firm performance, and CEO seniority. Therefore, there is the need to collect primary data and conduct a comprehensive research to reveal the degree of relationship among these variables.

4. Research Methodology

The study will use the survey-based, history-based and inferential statistics methodologies. The importance of history-based research methodology is the need to explore past corporate records in order to identify the relation between executive compensation, firm size, firm performance as well as firm age and seniority.

The study will collect data from annual reports. The survey-based methodology will not ensure the formation and derivation of the research, but will also help to unearth assumptions and closely held beliefs about executive compensation. The study will use qualitative structured questionnaires to collect this data. Methods of inferential statistics will help in the transformation of survey and historical data into statistical results. Since the research is quantitative, the method will help to derive conclusions of the research theory.

The study will use historical data that will be collected from the FTSE 100 companies listed in the London Stock Exchange from the financial years ending 2011, 2012, and 2013. The study will collect published financial records of these companies for the three years. One hundred structured questionnaires will be designed to verify the financial records for the survey.

Inferential statistics methodologies will employ the use of parametric testing such as T-tests, non-parametric testing, namely the spearman correlation coefficient and measures of central tendency, such as the mean, median, and mode.

The qualitative and quantitative data will be processed by the statistical software STATA. The study will conduct a regression analysis to identify the relationship between the independent and dependent variables. It will present tables of linear and bivariate regression as well as t-tests. Bivariate regression will show the strong relationship between the variables. The t-tests will show the level of their significance.

The sample size will be taken from the period between 2011 and 2013, culminating to a sample size of 300 observations (3 years* 100 firms). The sampling population will include the firms listed in FTSE 100 for the three years to ensure that the data is consistent.

The source of primary historical data will be the websites of the individual companies, Execucomp and ORBIS databases which contain compensation data for executives and financial information for the firms. Other sources of data will be sought, such as annual reports, CEO statements, autobiographies of executives, and magazines.

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