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Performance Conditions in Executive Compensation Contracts: Powerful Incentives or Symbolic Decoupling?

Performance Conditions in Executive Compensation Contracts: Powerful Incentives or Symbolic Decoupling?. Steven Young Lancaster University Management School Idlan Zakaria Essex Business School. Research Objective and Motivation.

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Performance Conditions in Executive Compensation Contracts: Powerful Incentives or Symbolic Decoupling?

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  1. Performance Conditions in Executive Compensation Contracts:Powerful Incentives or Symbolic Decoupling? Steven Young Lancaster University Management School Idlan Zakaria Essex Business School

  2. Research Objective and Motivation • Paper aims to examine issues related to target setting at the executive level of companies • Existing work have examined operational aspects • Availability of new data allows this gap to be filled • Study explores whether: • Targets are set at an appropriate level • Managers misuse their position to reward themselves at the expense of shareholders

  3. Literature Review / Theory • 1970’s budgeting literature • Papers by Hofstede (1968), Stedry (1960), Stedry & Kay (1966) etc focused on target acceptance and finding an appropriate level of ‘difficulty’ • Dunbar’s 40% benchmark • Merchant and Manzoni (1989) • Executive compensation literature • Indjejikian and Nanda (2002) • Choudhary and Orszag (2005)

  4. Literature Review / Theory Agency Theory Jensen and Meckling (1976) “targets in performance contracts are predicted to align owners and managers: therefore when the agency gap is greater, targets are more challenging” • Decoupling Theory • Westphal and Zajac (1994, 1998) • “managers satisfy external demands for accountability but avoid additional compensation risk or loss of autonomy by adopting but not implementing provisions that suggest good governance: therefore targets are more likely to be symbolic when there is more demand to demonstrate effective control

  5. Hypotheses • H1a: All else equal, firms are more likely to adopt challenging performance conditions when executives control the board. • H2a: All else equal, firms are more likely to adopt challenging performance conditions when other governance arrangements (e.g., external ownership power) are weak. • H3a: All else equal, firms are more likely to adopt challenging performance conditions when past realised performance has been poor.

  6. Hypotheses • H4a: All else equal, firms are more likely to adopt challenging performance conditions when competitive rivalry is high. • H5: All else equal, agency-based (symbolic decoupling) associations are more likely to characterise early (late) adopters.

  7. Probability of Target Attainment • Measured using probability of target attainment • Model from Choudhary and Orszag (2005) Measuring Target Difficulty where: z = standard normal variable y*= accumulated nominal growth in eps over 3-year period = expected eps growth over 3-year period = standard deviation in expected eps growth Also used the raw target and the presence of an upper bound as proxies for difficulty

  8. Sample and Data • 500 largest UK firms as at 31 January 2003, from which we obtained 1857 plans • Chose plans that used eps as targets, benchmarked against growth in RPI • Often expressed as: EPS growth of RPI + x% • Final sample has 290 firms, 540 plans • Plan traced back to inception date • All variables collected as of inception date • Manual collection of governance data • EPS data obtained from IBES

  9. Model Tgtdiffit= probability of target attainment CEOpowerit = measured using either CEO duality, board members appointed by the CEO, CEO tenure or CEO ownership, Ownershipit =Herfindahl index to measure concentration of ownership pastaccit+n =Return On Assets (ROA), eps growth pastmktit= stock returns (measured over plan performance period) Herfit = Herfindahl index to measure for competitive intensity Instit = early adoption (years) realit+n = actual eps performance for firm i at time t+n, where n is the

  10. Descriptive Evidence • Median lower threshold targets are 16.73% where as median past performance is 23.30%, realised performance is 29.97% and forecasted performance is 27.1% • 55% of targets are set lower than past and realised performance. • Are targets set too easy? Or is there real underlying performance?

  11. Key Results • Targets are less challenging when there is less executive control of the board • When there is better monitoring, targets are set at a less challenging level • H1a and H2: Accepted • No significant relationships observed for H3-5

  12. Other Observations • Firms set upper bounds in plans when CEOs have been in office longer, have poorer past performance and there is more competitive rivalry in the industry • While early adopters set targets to incentivise, there is no evidence that late adopters are merely being symbolic

  13. Implications • Performance targets are set with incentives in mind, but there is some limited evidence of attempts to decouple • Targets are more likely to be achieved when CEOs have had longer tenureships • Given that lower threshold targets are achieved 55% of the time, does this suggests that targets are set at an appropriate level of difficulty?

  14. Conclusions • Known Issues and Limitations • Results are sensitive to how ‘target difficulty’ is measured • Data from plans that were incepted prior to 1995 is limited • Evidence on the underlying motives of target setting at the executive level of the firm • A mix of both incentivisation and decoupling?

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