the behavioral agency theory: a general approach towards a …937086/fulltext01.pdf · 2016. 6....
TRANSCRIPT
Frederic Brault & Arjen Hendrick Sanderman
The behavioral agency theory: a
general approach towards a contingent understanding of the
pay-performance relationship
Business Administration
Master’s Thesis
30 ECTS
Term: Spring 2016
Supervisor: Hans Lindkvist
3
i. Abstract
In this thesis the pay performance relationship is discussed within the field of
executive remuneration. A topic that received a lot of attention during the financial
crisis and times of economic recession. The starting point of this is a broken pay
setting process, where existing neoclassical theory is highly divided in providing
explanations for the pay performance relationship. A rather new theory, called the
behavioral agency theory, provides a new perspective on the pay performance
debate and argues for a rather contingent approach. In this paper the selected
underlying assumptions of the behavioral agency theory were tested within a
European context. The index used to select the companies is the Eurostoxx50 index.
The underlying assumptions are the effects of loss averse behavior by principals,
agent motivation and agent time preferences. Significant results were found in
supporting the loss averse behavior by principals and Agent motivation. The agent
time preferences could not be explained by the selected method.
4
ii. Table of Contents
I. ABSTRACT ........................................................................................................................... 3
II. TABLE OF CONTENTS........................................................................................................... 4
III. WORK DISTRIBUTION BETWEEN GROUP MEMBERS ........................................................... 5
IV. LIST OF ABBREVIATIONS AND IMPORTANT CONCEPTS ....................................................... 6
1. INTRODUCTION .................................................................................................................. 7
1.1 THEORETICAL BACKGROUND .................................................................................................... 7
1.2 AIM OF THE RESEARCH ........................................................................................................... 9
2. THEORETICAL FRAMEWORK ............................................................................................. 10
2.1 THE AGENCY THEORY AS A FOUNDATION FOR ORGANIZATIONAL PERFORMANCE ............................... 10
2.2 TOWARDS A BEHAVIORAL AGENCY THEORY ............................................................................... 12
2.3 PRINCIPAL LOSS AVERSION .................................................................................................... 12
2.4 MOTIVATION ..................................................................................................................... 14
2.5 AGENT TIME-PREFERENCES ................................................................................................... 15
2.6 THE MEASURES OF ORGANIZATIONAL PERFORMANCE.................................................................. 16
2.7 SUMMARY OF THE CHAPTER .................................................................................................. 17
3. METHOD ........................................................................................................................... 19
3.1 UNDERLYING CASE .............................................................................................................. 19
3.2 SAMPLE DESCRIPTION .......................................................................................................... 19
3.3 DATA COLLECTION PROCEDURE ............................................................................................. 21
3.4 RESEARCH DESIGN .............................................................................................................. 21
3.5 METHODOLOGY .................................................................................................................. 22
3.5.1 The construct of the hypotheses ................................................................................ 22
3.5.2 Measures of organizational performance ................................................................. 23
3.5.3 Test of the hypotheses ............................................................................................... 24
4. EMPIRICAL FINDINGS AND RESULTS ................................................................................. 25
5. DISCUSSION AND ANALYSIS .............................................................................................. 30
5.1 THEORETICAL DISCUSSION AND ANALYSIS ................................................................................. 30
5.2 DISCUSSION OF RESEARCH DESIGN .......................................................................................... 33
5.3 MANAGERIAL IMPLICATIONS ................................................................................................. 36
5.4 LIMITATIONS AND FUTURE RESEARCH ...................................................................................... 37
6. CONCLUSION .................................................................................................................... 39
REFERENCE LIST ........................................................................................................................ 40
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iii. Work distribution between group members
Chapter/part of the thesis Author
I. ABSTRACT Arjen Hendrick
II. TABLE OF CONTENTS Arjen Hendrick
III. WORK DISTRIBUTION BETWEEN GROUP MEMBERS Arjen Hendrick
IV. LIST OF ABBREVIATIONS AND IMPORTANT
CONCEPTS Arjen Hendrick
1. INTRODUCTION Arjen Hendrick
1.1 THEORETICAL BACKGROUND Arjen Hendrick
1.2 AIM OF THE RESEARCH Arjen Hendrick
2. THEORETICAL FRAMEWORK Arjen Hendrick
2.1 THE AGENCY THEORY AS A FOUNDATION FOR
ORGANIZATIONAL PERFORMANCE Arjen Hendrick
2.2 TOWARDS A BEHAVIORAL AGENCY THEORY Arjen Hendrick
2.3 PRINCIPAL LOSS AVERSION Arjen Hendrick
2.4 MOTIVATION Arjen Hendrick
2.5 AGENT TIME-PREFERENCES Arjen Hendrick
2.6 THE MEASURES OF ORGANIZATIONAL
PERFORMANCE Arjen Hendrick
2.7 SUMMARY OF THE CHAPTER Arjen Hendrick
3.1 UNDERLYING CASE Arjen Hendrick +
Frederic
3.2 SAMPLE DESCRIPTION Arjen Hendrick +
Frederic
3.3 DATA COLLECTION PROCEDURE Arjen Hendrick +
Frederic
3.4 RESEARCH DESIGN Arjen Hendrick +
Frederic
3.5 METHODOLOGY Arjen Hendrick +
Frederic
4. EMPIRICAL FINDINGS AND RESULTS Arjen Hendrick +
Frederic
5.1 THEORETICAL DISCUSSION AND ANALYSIS Arjen Hendrick
5.2 DISCUSSION OF RESEARCH DESIGN Arjen Hendrick +
Frederic
5.3 MANAGERIAL IMPLICATIONS Arjen Hendrick
5.4 LIMITATIONS AND FUTURE RESEARCH Arjen Hendrick +
Frederic
6. CONCLUSION Arjen Hendrick
DATA COLLECTION REMUNERATION Frederic
DATA COLLECTION ORGANIZATIONAL
PERFORMANCE Arjen Hendrick
6
iv. List of abbreviations and important concepts
Abbreviations
CEO : Chief Executive Officer
ES50 : Eurostoxx 50
ES600: Eurostoxx 600
EU: European Union
ROA : Return on Assets
U.K.: United Kingdom
U.S. : United States
Important concepts
Agency theory a theory that applies for publically owned companies
where the owner(s) and the executives are not the same
person. The agency theories argues for interest alignment
to solve this moral hazard problem. (Ross 1973)
Behavioral agency theory a variant of the agency theory that acknowledges the
foundation of the agency theory but argues for
behavioral underlying assumptions (Pepper & Gore
2015)
Managerial power theory a theory that argues that more power of the CEO leads to
a higher remuneration and a weaker pay performance
relationship (Tosi et al. 2000)
Pay performance relationship the relationship between the salary of the CEO (in this
study) and the performance of an organization/firm
Remuneration the synonym of salary or wages
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1. Introduction
1.1 Theoretical background
Remuneration and how to establish it has been studied for many years. Interest in the topic
grew in and after the year of the financial crisis in 2008 when bonuses reached a new all-
time high in the years before. Jensen et al. (2004) found that the average executive
compensation increased from $85.000 dollars in 1970 to $14 million in 2000 before
declining to 9.4 million in 2002. After 2002 it started growing again until the
aforementioned financial crisis in 2008. The crisis made topics as fairness and risk more
important and questions whether the pay performance relationship is still intact. Until today
there are two theories that are laying the foundation of the remuneration literature in
providing a general explanation for executive remuneration. The first significant theory
looks upon executive remuneration as a performance contract between the owner
(principal) and the executive (agent) called the Agency theory (Ross 1973). The Second
theory finds its nature in aspects executive behavior and argues that the power of the
manager determines its total remuneration (Bebchuk & Fried 2004). The more power the
manager has over the pay setting process, the higher his own remuneration will be. This
theory is called the managerial power theory. To develop an understanding of the ongoing
remuneration debate an overview of both theories
Within economics and finance, the main theory is still a neoclassical theory that is often
used in market based explanations (van Essen et al. 2015). This theory outlines that the
height and evolvement of bonuses can be explained along organizational performance,
serving as a performance contract (Ross 1973). From an agency perspective, the
remuneration should serve to motivate the board of directors and therefore align the interest
of the company owners with its directors. This theory finds its origin in a study conducted
by Berle and Means (1932). They recognized that the separation between directors and
owners caused certain problems that needed to be solved. One of the problems that they
addressed is the moral hazard problem. Since the agent does not use his own money but the
money of the principal, he will spend it differently as if it was his own. The agent is more
interested in maximizing his own wealth and therefore a conflict arises with the principal.
A principal must therefore implement systems that encourage the executives to act in his
interest. According to the agency theory, the principal (shareholder) may establish a
remuneration agreement using observable performance measures, prompting the agent (the
executives) to act in the interests of the principal (Davis et al. 1997).
8
Scholars in favor of the managerial power theory often refer to a well-known meta-analysis
in executive compensation conducted by Tosi et al. (2000). They combined the results and
analyzed 42 studies within United States (U.S.) companies. The results showed that the
variance of executive remuneration can be mostly determined by company size (40%)
rather than organizational performance (<5%). This study highlighted the complexities
within the pay-performance debate. Therefore it is often used to strengthen the managerial
power theory (Bebchuk and Fried 2004). Another influential meta-analysis compared chief
executive officer (CEO) total compensation versus performance pay-sensitivity and
conclude that the managerial power theory indicates that it is suitable for predicting
compensation variables as total cash payments and total remuneration but weaker results
for the pay-performance relationship. An interesting findings concerning this pay-
performance relationship is that when the manager is ought to have more influence on the
pay performance process there is a stronger pay performance relationship measured. Also
board independence and institutional ownership positively moderate the pay-performance
relationship (van Essen et al. 2015).
An often overlooked point is the correlation between organizational size and executive
remuneration. Which implies rather a strong relationship between organizational size over
the concept of managerial power. Therefore, regardless of the interesting conceptualization
towards the direction of the managerial power theory both studies, and accordingly most
studies, show the most significant findings in relation to company size and company
performance. The concern of Gregory-Smith (2012) that the pay setting process is broken,
because of their foundation based on orthodox economic theories, seems right. These basic
orthodox or neoclassical theories provide inconsistent proof and fail in providing a one-
size fits all solutions. However, by discarding the agency theory prematurely they might
miss out on the opportunity of understanding the incentive alignment construct (Nyberg et
al. 2010). Their arguments for weak findings were the inconsistent measures (Nyberg et al.
2010).
Based on our findings in the literature it can be said that prior research is highly divided
when it comes to executive remuneration and the adoption of these two theories. The
agency theory seems to justify high remuneration because of a performance contract, where
the managerial power theory argues for a dysfunctional system where executives reward
themselves more than is necessary. However, consistent proof of both theories is still
lacking. Instead of providing more mixed results in both constructs this thesis aims for
9
explaining the pay performance relationship by applying a contingent framework. This
contingent framework uses the principles of the agency theory and build further on
behavioral factors often used by managerial power theorists. This framework is called the
behavioral agency theory (Pepper & Gore 2015). In the literature review behavioral factors
are used to test a modified agency theory. These propositions form the foundation for this
study and will be tested among the top European companies listed in the Eurostoxx50
(ES50) index.
1.2 Aim of the research
Building further on the problematization of the current research within studies about the
pay performance relationship. The conclusion is drawn that based on neoclassical theory
consistent results lack in supporting a clear answer to prove a pay performance relationship.
In the theoretical framework an alternative approach is developed. Three important
variables that differ from the neo-classical agency theory were formed based upon the
behavioral agency theory. This theory uses behavioral economics as a foundation to explain
variations within the pay performance relationship. This theory is mainly derived from a
paper about this subject written by pepper and Gore (2015). In their paper an inductive
approach is used to explain this construct. In order to create a general understanding of the
theory this paper uses a deductive approach to explain behavioral agency tendencies within
the pay performance relationship. The aim of this paper is to theorize, explain and support
the underlying assumptions of the behavioral agency theory and therewith explain
contingent behavior within the pay performance relationship.
Thereby a sample consisting of companies within Europe with the largest market
capitalization is used. Most studies within the executive remuneration area and about the
pay performance relationship are performed with U.S. data. Besides that it is not the main
aim to perform a country/continent comparison, the use of a European sample might
already lead to interesting findings within the pay performance debate.
In the next chapter the theoretical framework of this thesis will be formed, starting with the
agency theory and its principles. Consecutively the behavioral agency theory is explained
and the focus fundamentals of this thesis are elaborated on.
10
2. Theoretical framework
The theoretical framework forms the foundation of this study and argues from a theoretical
perspective for the hypotheses of this study. As elaborated on in the introduction,
neoclassical theories do not provide a consistent answer in explaining variations in
executive remuneration. The introduction ended with the behavioral agency theory as it is
constructed by Pepper and Gore (2015). This theory provides a new dimension of how
executive remuneration should be looked upon and challenges the underlying assumptions
of the agency theory. Figure 1 is a reflection of the theoretical framework. The numbers
refer to the chapters the particular theory is discussed in. The first chapter starts by
explaining the agency theory. After laying out the principles of the agency theory a
connection to the behavioral agency theory is made. Consecutively, the specific
components of the behavioral agency theory are reflected upon. These are behavior,
motivation and agent time preferences. The theoretical explanation of organizational
performance factors follows. The chapter ends with a summary of the hypotheses derived
from the theoretical framework.
Fig 1: The conceptual model of the theoretical framework.
2.1 The agency theory as a foundation for organizational
performance
As mentioned in the introduction of this paper, the agency theory is often used in the studies
of executive remuneration. One of the first papers that addressed the agency theory and
gave a solution to aligning the interests of shareholders and executives was written by Berle
and Means (1936). The basic notion was that the change of the relation between ownership
and leading the company leads to a situation with principle (the owner) and an agent (the
executives). In executive remuneration literature the agency theory is frequently used
11
because of the fact that from an agency point of view, the executive compensation can be
seen as a contract between the agent and the principal (shareholder). This is done in order
to align the interest of the shareholder (principal) with the interest of the executive director
(agent) and can be seen as a justification for the remuneration paid to the executive director
(Westphal & Zajac 1998). The salary of the director can be separated in three different
types of costs according to the agency theory. These three types are monitoring
expenditures by the principals, the bonding expenditures by the agent and the residual
losses. The monitoring expenditures as cost related to the monitoring process of the agent
by setting out performance indicators as guidance. In addition some costs may occur for
resources at the expense of the principal that let the agent act in a favorable way from a
shareholder point of view. Because the agent cannot make the right decision in all
situations, the residual costs are the costs as a consequence of those “poor” decisions
(Jensen & Meckling, 1976). The agency theory is founded on the presumptions that the
agent normally would act in his own interests rather than in favor of the shareholder
because he is rent seeking for his own purposes. The agent can be financially stimulated
and is contingent on effort. Furthermore he makes rational decisions, is risk averse and
preferences time according to the exponential discount function (Jensen 1998).
In the remuneration debate the agency theory has shown mixed results in proving strong
evidence for this theory. Sub categories of the agency theory and executive remuneration
studies are the pay performance relationship and agent and shareholder wealth alignment.
In the early nineteen nighties an important shareholder wealth alignment study investigated
the relationship between share price and CEO pay and found no supporting results (Jensen
and Murphey 1990). This in contradiction with a later study that tested shareholder and
CEO interest alignment (Nyberg et al. 2010). Possible reasons besides the different
approaches could be for example that between the times of both studies there were changes
in the structure of the remuneration packages. In the years after the publication of Jensen
and Murphy (1990) long term performance packages became popular which clearly
improved the relationship between shareholder and CEO wealth alignment.
The first significant meta-analysis found stronger results between company size and only
a weak relationship with company performance (Tosi et al. 2000). Based on these findings
one of the first studies considering this topic of managerial power theory was performed
by Bebchuk and Fried (2002). The shift towards a managerial power theory did neither
show consistent results. An extensive study performed from 1936 to 2005 proved that
neither the agency theory nor the managerial power theory is a fully consistent theory
12
(Frydman & Jenter 2010). Twelve years later a new and bigger meta-analysis was
performed. In this analysis company performance had a more significant value, but
company size remained to be the biggest influencing factor (van Essen et al. 2012). As for
example Gregory-Smith (2012) argued for a broken pay setting process.
Seen as the opposite of the Agency theory is the Stewardship theory. Doucouliagos (1994)
proposed another approach of human behavior, building on the work in the fields of
psychology and sociology. In fact, selfishness is not sole motivation of human action.
Nevertheless, there is not necessarily a divergence of interests between principal and agent
(Donaldson and Davis, 1991). These assumptions about human motivation, prompted the
authors to suggest assumptions of the stewardship theory and consider the agency principal
of motivation differently (Donaldson, 1990). The stewardship theory assumes that
executives are intrinsically motivated and can considered as being "stewards" of their
company. In the stewardship theory, there is not always a divergence of interests between
executives and shareholders. Leaders are satisfied when they are able to improve the
performance of their organization and to care about their personal interests. In the
stewardship theory, leaders compromise between the interests of their organization and
their personal interests (Wasserman, 2006). This theory contradicts the need of expensive
agency costs and the use of bonuses to resolve the agency problem. Although this theory
does not provide a constructive solution or explanation for the level of remuneration, it
indicates that some of the foundations of the agency theory might be more complicated as
argued for.
2.2 Towards a behavioral agency theory
A different dimension is provided by a rather new theory called the behavioral agency
theory, this theory takes the flaws of the agency theory into account. This theory recognizes
fundamentals of the agency but argues for new approaches based on a different and more
current research perspective. The behavioral agency theory looks for explanations within
the subject of behavioral economics. In this thesis factors of the behavioral agency theory
concerning the subjects of principal risk preference, motivation, agent time-preference,
inequity aversion and goal setting are used to explain the construct.
2.3 Principal loss aversion In agency theory, the agents and principals have a neutral stance on risk preference and act
in a linear way to organizational performance and executive pay. Meaning that their
response will be different in a situation when they are losing capital other than when they
13
are in a situation where they are gaining. This is based upon the notion that executive
remuneration is solely to motivate executives to maximize shareholder value (Jensen &
Murphy 1990). This rather high cost is based upon the information asymmetry between the
principal and the agent and therefore needs to be aligned (Gomez-Mejia 1998). Thus,
executive remuneration could be seen as a second best solution for the principal. The
principal rather has its interest aligned at the lowest costs possible, but needs to pay for
performance alignment (Krause et al. 2014). The task of the principal is not to formulate
the executives’ remuneration plan, but only to approve or disapprove. Furthermore, the
principals need to assess whether the agents earned their remuneration or not (Fama 1980).
From a rational perspective this seems logical. Eisenhard (1989) compares it with the
product/quality paradigm. As a customer you want to pay the lowest price possible for a
certain service and as an investor you want to pay the lowest price possible for the services
of the CEO.
However, a handful of scholars have disproven this fact of rational behavior and
acknowledged the differences between rational behavior and actual behavior (Tversky &
Simonson, 1993; Krause et al. 2014; Pepper & Gore 2015). The behavioral agency theory
suggests an alternative view and argues for different behavior in a losing position. This
argument is formulated based on the prospect theory, which initially stated that a person’s
reference level alters how decisions are made (Pepper & Gore 2015). Later on Kahneman
& Tversky (1991) found that also in a neutral position preferences were based upon this
reference level. This theory provides both a different perspective on risk preferences among
shareholders and also argues for limited rationality. Another important finding, based on
the prospect theory is the fact that people are afraid of losses and are therefore more likely
to take risks in a loss situation rather than take risks to gain (Tversky & Kaneman 1981).
Compared to the agency theory Pepper and Gore (2015) argue for a contextual approach
where the perceived loss position leads to risk enhancing decisions. An experimental study
performed by Krause et al. (2014) argues for loss-averse behavior by principals and relates
the case to shareholder voting on executive pay as displayed in figure 1.
14
Fig 2: Agency costs and shareholder decision frames based on (Krause et al. 2014)
The participants of their experiment acted in a negative different way when they were
losing capital. Besides this loss averse behavior another point they found was that principals
do favor strong performance but not necessarily prefer low CEO rewards. This dimension
provides a different view of how to look upon the principal’s decision making when it
comes to remuneration. Based on this prospect theory we argue for a weaker pay
performance relationship in shareholder loss situations. This is based upon the fact that
shareholders are more likely to vote against new remuneration packages, despite of an
increased pay performance relationship.
2.4 Motivation
In the agency theory the general notion is that the agent is solely motivated to gain
personally and can be financially stimulated in order to align interests. Even though this
seems logical from a rational perspective, behavioral economic theory argues for a more
complex understanding of human behavior. This theory acknowledges the fact that the
purpose of incentives is to motivate the agent as for example argued for by Jensen and
Murphy (1990), but rather focuses on the extend the agent can be, and is, motivated because
of these measures. Concerning the topic of agent-motivation there is not only financial
stimulation that affects behavior. One of the early studies regarding this topic found that
there is a distinction between intrinsic and extrinsic motivation (Deci & Ryan 1985).
Intrinsic motivation is defined as the motivation coming from other factors than a financial
reward, looked upon as the agent performing a task for his or her own satisfaction. Extrinsic
motivation is caused solely because of instrumental value. By relating the topic to the pay
performance relationship it could be argued for that the relationship could be weaker
because the motivation of the CEO is not solely extrinsically. Deci and Ryan (1985) argue
that after a certain point monetary compensation can reduce the intrinsic motivation, and
that therefore too much financial stimulation works counterproductive. Later studies
criticized design of the incentive system is poorly executed and argued for a “crowding
Neutral position
Gain position
Loss position
Neutral position High
CEO
rewards
Low
CEO
rewards
Strong organizational
performance
Poor organizational
performance
15
out” effect within executive remuneration that influences the relationship between intrinsic
and extrinsic motivation (Frey & Jegen 2001; Sliwka 2007). Despite of their criticism, the
scholars recognized the problem of applying measures to develop a general econometrical
theory (Frey & Jegen 2001). As a general understanding was tried to be found, answers in
specific parts of were analyzed. Concerning the measure of stock based compensation it is
found that it sometimes can cause unfavorable decision making (Devers et al. 2008). This
finding is a good example that contingent situations are likely to apply. An interesting
distinction is made between motivation and interest alignment by Pepper & Gore (2015).
They argue for emphasizing the interest alignment over motivating the agent. In their
proposition they define the intrinsic and extrinsic motivation as measurable factors based
on contingent factors related to agent’s situation. However, from an investor or outsider’s
perspective where information asymmetry exists (Berle and Means 1936), it is not possible
to collect this data and therefore create a general theory upon. In order to generalize this
statement Murdock (2002) argued that the intrinsic motivation should be seen rather as an
addition other than a moderation.
2.5 Agent time-preferences
In the Agency theory the time-preference of the agent is looked upon as in many financial
models, which is done by discounting the value of money exponentially. This is based upon
the assumption that instant reward is the most preferred option, the further away the reward
the less preferred by the agent. This preference is equally distributed over time (Ross 1973).
The behavioral agency theory looks upon it from a behavioral economic perspective and
rather argues for a hyperbolic discount function. The biggest difference is the time
perception. In the behavioral agency theory the time preference is distributed
hyperbolically instead of equally. This means that rewards in the nearby future more rapidly
lose their value to the agent compared to the agency theory. One of the first studies that
introduced hyperbolic time discounting is Ainslie (1991), in an experimental study. Graves
and Ringuest (2012) argue for a general acceptance of this theory within behavioral
economics. Based on this theory the agent is more likely to make decisions that maximize
short term gains and avoid long term plans as in the agency theory. Concerning the topic
of remuneration it is more likely for the agent to aim for either the short term fixed
remuneration or short term bonuses. It can be argued for that long term stock option plans
are therefore less valuable for the agent or become more relevant in times of granting.
Although both theories discount the value of money over time, from an agency perspective
long term share- and option plans are one of the most measurable forms of interest
alignment. Nyberg et al. (2010) found a more significant relationship between CEO return
16
and interest alignment than previously argued for. From a behavioral economic perspective
the relevancy seems lower. Another notion to take into account is that there are other factors
than organizational performance influencing the share price and therefore affecting long
term option- or share plans. According to Richard et al. (2009) stock market performance
is not solely influenced by organizational performance but is also affected by the volatility
of markets, the economy and psychological factors. Hamann et al. (2013) argue that
environmental instability should be avoided in non-longitudinal studies measuring
organizational performance. By both taking into account the behavioral economical
reasoning and organizational stability measures the years of high stock market volatility
are expected to be weaker.
2.6 The measures of organizational performance
In the literature there seems to be no consensus on valid measures that explain
organizational performance. In a construct validity Hamann et al. (2013) investigated based
on a factor analysis which indicators should be used in explaining organizational
performance and how these can be classified. Based on previous research four different
models were created and tested. In the study of Hamann et al. (2013), three limitations of
previously conducted research is pointed out. The first point focuses on the number of
different dimensions of organizational performance. In early studies the discussion whether
to use three or four different dimensions seemed already an argument (Fryxell & Barton
1990; Venkatraman & Ramanujam 1987). It is argued for that the fewer indicators to
explain a construct make it harder to justify a valid explanation (Hamann et al. 2013).
Second, the argument is the choice of the number of indicators used to measure
organizational performance. The reasoning behind the choice of organizational
performance measures refers often to the use in previous papers, as for example Murphey
et al. (1996). Some of those measures are clearly not related to organizational performance,
as for example size and static balance sheet measures. Studies with significant impact of
scholars in favor of the managerial power theory also used various indicators of
organizational performance. The meta-analysis performed by van Essen et al. (2015) used
any indicator of financial performance which is either a market based- or an accounting
performance measure. Also the often referred to study of Tosi et al (2000) looks at
organizational performance in a wide range and does not specifically uses one construct to
define it. Although the sample size of those studies is significant, the different measures
could give inconsistent results.
17
Third and last, cash flow measures are almost always overlooked when it comes to
organizational performance. This extra dimension is important since it limits the view on
organizational performance and the effects of it. The dimension of accounting measures is
in most studies looked upon as one. After taking into account these limitations a factor
analysis is performed to construct an optimal model that reflects organizational
performance (Hamann et al. 2013). As a result a four dimensional model of performance
measures is recommended. This model separates accounting measures into profitability
measures and liquidity measures and consists of organizational growth and stock market
performance. In contrast to the aforementioned profitability and liquidity measures, the
stock market performance focuses on future instead of the past. By applying these
performance measures a clear reflection of organizational performance is created and
should reflect the construct of organizational performance at best (Hamann et al. 2013).
2.7 Summary of the chapter
This chapter starts with a theoretical discussion of the agency theory and its principles and
builder further on the principles of the behavioral agency theory. The three hypotheses
constructed from the theoretical framework are based upon principal risk aversion, agent
motivation and agent time preference.
Within the agency theory the agent and the principal are able to make rational decisions in
every situation regardless of situational factors, the behavioral agency theory distinguishes
different behavior in loss, neutral and gaining situations. The strongest effects were found
in situations of loss situations. This study connects the effect of principals in loss situations,
also called loss aversion, with the topic of executive remuneration. Based on this behavior
the following hypothesis is constructed:
Hypothesis 1: In years of shareholder losses the link between shareholder remuneration and
organizational performance is expected to be weaker in the year after the shareholders loss.
Within the topic of agent motivation the agency theory argues for solely extrinsic
motivation based on monetary reward. The underlying assumption is that the agent is solely
interested in maximizing his or her own personal gains. The behavioral agency theory
argues that this is an oversimplified approach and separates intrinsic from extrinsic
motivation. Based on this theory the pay performance relationship might not be solely
affected by a financial incentive and therefore the effects of higher flexible stimulation
18
might not be correlated with a stronger pay performance relationship. Acknowledging the
two types of motivation the following hypothesis is formulated:
Hypothesis 2: A higher percentage of flexible remuneration creates a disproportionate
relationship between the intrinsic and extrinsic motivation of the agent. This leads towards
lower organizational performance.
Concerning the agent’s time preferences in both agency and behavioral agency theory the
value of money is discounted in the future. However, the way time is discounted differs.
Time is discounted exponentially within the agency theory and is done hyperbolically
within the behavioral agency theory. The biggest difference can be explained by evaluating
this theory in short term gains. The hyperbolic discount function makes the short term
incentives even more preferable compared to exponential function. Within the topic of
executive remuneration long term incentives are therefore less preferred by agents and the
effect of them is less than argued for. In this study long term incentives are related to stock
market incentives. Combined with the fact that stock market incentives are not only
influenced by organizational performance we argue for a strong effect towards short term
reward when stock market volatility is high.
Hypothesis 3: In years of high stock market volatility the pay performance relationship is
weaker.
19
3. Method
Chapter two ended with the formulation of the hypotheses, this chapter builds further on
how these hypotheses will be tested.
3.1 Underlying Case
The research focuses on CEO remuneration of top European companies and the correlation
between organizational performance. As mentioned on in the research aim, this paper uses
the behavioral agency theory to analyze contingencies that should explain the pay
performance relationship. An alternative sample is chosen by selecting companies in
Europe over the United States. Many important studies concerning this topic are focused
on either the United States or Great Britain. This study does not attempt to find different
results or aims to find abnormalities because of this sample. The ES50 index is used to
select the companies listed in the sample. This index contains the 50 largest companies
within the Eurozone. This index provides relevant companies from all over Europe to serve
as a good reflection of large companies in Europe within all industries. Those 50 companies
are based in twelve European countries: Austria, Belgium, Finland, France, Germany,
Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain.
3.2 Sample Description
The ES50 contains 50 companies, this is the index where the selected companies are
selected from. Among those 50 companies, at the end of March 2016, 19 of them are French
(which represent 37% of the values), 14 are German (32%), 6 are Spanish (10%), 5 are
Italian (7%), 4 are Dutch (8%), 2 are Belgium (4%), and 1 is Finnish (2%).
Figure 3: Country reflection of the ES50 index
These companies are divided over 10 different sectors, Banks (14%), Industrial Goods &
Services (11%), Chemicals (9%), Insurance (8%), Personal & Household Goods (7%),
Health Care (7%), Technology (7%), Oil & Gas (7%), Telecommunication (6%), and Food
20
& Beverage (6%). The sample includes 35 of the 50 values from the ES50. Subtracted are
companies from the financial service sector within this paper.
Because of new regulations within the financial service sector banks and insurance
companies are excluded. The European Union presented their amendment on the Basel 3
banking regulations affecting the banking and insurance sector (EU 2013). The European
Union explains these reasons on the basis of three lessons that can be learned from the
financial crisis. First of all the cooperation of monetary and fiscal and supervisory institutes
around the globe should improve. Second of all there is a difference in the ability of
companies to deal with shocks in the markets. This is mainly due to quality and the level
of capital and its availability, liquidity management and the effectiveness of internal
corporate governance. Third, by regulating banks across the borders a wider range of
instruments could have been applied. The bail-out option was merely seen as the only
option. When this was regulated across borders a wider set of measurements could be
applied (EU 2013).
Regarding the remuneration and bonus payments in the financial sector these regulations
put a cap on the bonus payments. The initial cap is a 1:1 ratio bonus salary payment versus
fixed salary; this can be extended to a 2:1 ratio in certain conditions. When the shareholders
vote in favor of this bonus payment extension the 2:1 ratio can be implemented. Six
comments were made by Murphy (2013) as a response to the change in legislation of the
European Union. The first one says that the fixed salaries increase and harms the
adaptability of banks to market cycles. This will make the banks in the end more vulnerable.
Second, it does not lower the risk taking. Third, the cap on the bonuses will decrease the
motivation to create value for the bank. Fourth, talent will flee outside of Europe. This will
leave the European banking sector with less talented people. Fifth, the competitiveness of
European banks compared to the outside world will decrease drastically. Sixth and final,
the new measure does nothing with existing bonus contracts, therefore a one size fits all
solution is not feasible for this problem. The decision concerning the exclusion of the
financial service sector the first and third reason of Murphy (2013) mainly caused this
decision.
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3.3 Data Collection Procedure
The first step in the data collection procedure is collecting the organizational performance
and executive remuneration data. The data concerning organizational performance was
extracted from a database. Karlstad University has a subscription on a database named
Amadeus from Bureau van Dijk. Amadeus contains comprehensive information of around
21 million companies across Europe. This database was used to extract the data of the
independent variables for each performance measure. All of the variables of the four
dimensional model were extracted from the database. Unfortunately not all data was
available for every company in our sample. In two categories there was a significant
amount of data lacking. This data was concerning the performance measures net sales and
dividends paid. Additional data was gathered from a database called Statista, another online
database where Karlstad University has a subscription on. For the data concerning the
dividend per share the website Morningstar was used.
The data concerning CEO remuneration was not available in the databases and needed
therefore to be collected with an alternative approach. This was done by extracting the data
from the annual reports of the selected companies. First, the dependent variables listing
information about CEO remuneration were divided into three different types of
remuneration, separated in fixed salary, short term and long term remuneration. The reason
to separate the salary components in just three categories and not in for example six
categories as listed by Mallin (2013) are the differences in reporting formats by the
companies in the ES50.
3.4 Research Design
The research conducted is a deductive analysis that is quantitatively performed. Mallin
(2011) describes a deductive approach as a study that derives hypothesis from a theoretical
construct consisting of previous research in the particular area. Consecutively, empirical
data is tested to prove these hypotheses. Hypotheses 1, 2 and 3 were tested using a bivariate
correlation analysis. The Relationships between scores (hypotheses 1, 2 and 3) were
analyzed using the Pearson correlation model. The Pearson product-moment correlation
coefficient, P, is a value between +1 and −1 inclusive, where 1 is total positive correlation,
0 is no correlation, and −1 is total negative correlation. When correlations are found and
have a 0,05 or 0,01 significance level it is recognized as a relationship, this does not imply
causation (Bryman & Bell 2013)
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3.5 Methodology
Within the methodology the systematical analysis of the research is presented (Bryman &
Bell 2011). First the construct of the hypotheses are explained, followed by the measures
of organizational performance. The chapter ends with the tests of the hypotheses.
3.5.1 The construct of the hypotheses
Based on the research design the hypotheses are tested as elaborated on below.
Hypothesis 1: In years of shareholder losses the link between shareholder remuneration and
organizational performance is expected to be weaker in the year after the shareholders loss.
Shareholder losses years = Losses
Shareholder Gains years = Gains
Organizational Performance = Perf
Absolute Value = AbsV
If AbsV[P(Losses,Perf)] < AbsV[P(Gains,Perf)] so H1 is true, the
relationship is lower.
Hypothesis 2: A higher percentage of flexible remuneration creates a disproportionate
relationship between the intrinsic and extrinsic motivation of the agent. This leads towards
lower organizational performance.
Remuneration of Short term bonuses = Rshortterm
Total remuneration = Rtotal
Organizational Performance = Perf
Absolute Value = AbsV
If AbsV[P(Rshortterm,Perf)] > AbsV[P(Rtotal,Perf)] so H2 is true, the
relationship is stronger.
Hypothesis 3: In years of high stock market volatility the pay performance relationship is
weaker.
Remuneration of long term stock option = Rlongterm
Total remuneration = Rtotal
Organizational Performance = Perf
Absolute Value = AbsV
If AbsV[P(Rlongterm,Perf)] > AbsV[P(Rtotal,Perf)] so H3 is true, the
relationship is stronger.
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3.5.2 Measures of organizational performance
Profitability measures indicate how well a firm is performing in terms of its ability to
generate profit. Hamann et al. (2013) found that the most significant values, that also take
company size into account, are return per employee, return on sales and return on assets.
The return per employee looks at a company’s return in relation to the number of
employees. In the database Amadeus the total number of employees and the revenues
represented as net profit before taxes. This is calculated in the following way:
Return per employee: Net profit before taxes / Total number of employees
The return on sales is a ratio widely used to evaluate a company's operational efficiency.
Return on sale: Net profit before taxes / Sales
The return on assets (ROA) is an indicator of how profitable a company is relative to its
total assets. ROA gives an idea as to how efficient management is at using its assets to
generate earnings.
Return on assets: Net profit before taxes / total assets
Liquidity measures indicate the ability to pay operating expenses and other short-term, or
current, liabilities. The liquidity ratios are a result of dividing cash and other liquid assets
by the short term borrowings and current liabilities. They show the number of times the
short term debt obligations are covered by the cash and liquid assets. The three measures
used to measure the liquidity of our sample are Cash flow per employee, Cash flow on sales
and cash flow return on assets. Cash flow per employee is a ratio which represent the
amount of cash from operations per employee, measured as followed:
Cash flow per employee: Cash flow / total employees
Cash flow return on sales compares a company's operating cash flow to its net sales, which
gives investors an idea of the company's ability to turn sales into cash. It is calculated as
the cash flow on net sales.
Cash flow on sales: Cash flow / total sales
Cash flow return on assets measures how efficiently a business uses its assets to create a
return or income. It is calculated as cash flow from operations on total assets. The higher
the ratio, the more efficient the business is.
Cash flow return on assets: Cash flow / total assets
Growth measures indicate expansion and measure the growth of certain parameters
compared to previous year(s). The employment growth also called the job growth figure is
expressed as the gross number of jobs created in the company compared to the last year.
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Employment growth: Employment year-Employment year/Employments year *100
The sales growth is the amount by which the average sales volume of a company's products
or services has grown compared to the last year.
Sales Growth: Sales year - sales year/sales year *100
The Asset Growth Rate of a company compares the total assets held at the end of the year
compared to its Total Assets from the previous year.
Asset growth: Assets year- Assets year/ Assets year *100
Stock Market Performance measures the performance of a company and represents the
measures closest to the interest of the investors. In contrast to the aforementioned
profitability, liquidity and growth measures, the stock market performance focuses on
future instead of the past. The measure representing stock market performance is the total
shareholders return. This is measured as the change of stock price of a year compared to its
previous year including the dividends received.
Shareholder return: Stock value end of current year- Stock value end of previous year +
dividend current year
3.5.3 Test of the hypotheses
The first hypothesis focuses upon the years of shareholder losses the link between
shareholder remuneration and organizational performance is expected to be weaker the year
after the shareholder experienced the losses. After the data collection process two samples
were created. One sample containing the pay/performance data from the years after a
shareholder loss and the other one containing all the data within the sample. A bivariate
correlation analysis was performed in SPSS to test those results.
With the second hypothesis an analysis of the relationship between fixed and flexible
remuneration and the effects on organizational performance is made. First of all the
distinction between fixed and flexible was calculated in the dataset stored in Excel. After
the creation of this variable a bivariate correlation analysis was performed in Excel.
The third and last hypothesis focuses on stock market volatility. To calculate the stock
market volatility the daily market data was extracted from Yahoo finance. The stock market
volatility was calculated using the following formula:
The standard deviation refers to the annual standard deviation of the daily close values of
the ES50 index. T is the factor time and relates in this case to the annual trading days, which
are 252 days a year.
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4. Empirical findings and results
In order to create a better understanding of key variables used in the hypotheses and
improve the readability, the descriptive statistics are briefly explained. As pointed out by
Podsakoff and Dalton (1987), researchers do not frequently post stability measures of their
results. By doing so it also allows the reader to create his or her own critical reflection.
Three important variables are briefly highlighted before the presentation of the results.
These variables are: total salary, flexible remuneration and the fixed flexible. The range of
the total salary varies from 1.027.355 to 16.163.400. This range gives an indication of the
wide variety of the CEO remuneration within the ES50. However most of the results are
concentrated around the mean of 5.191.203. With a standard deviation of 2.890.044 the
data overall sample seems to be in balance, with a couple outliers. By taking a further look
at the flexible part of the remuneration also a rather outstretched sample can be recognized
with a minimum of 284.026 and a maximum of 13.863.400. The flexible part of the
remuneration seems to be centered on 58 to 78 percent of the total remuneration. The results
per hypothesis are listed below. All of the results that are shown are listed and calculated
in Euro (€).
Hypothesis 1
In years of shareholder losses the link between shareholder remuneration and
organizational performance is expected to be weaker the year after.
The data of the first hypothesis was examined in two different ways. First the data was
separated in Shareholder gain- and shareholder loss positions referring to figure 1 in the
literature review. The first analysis focused on the differences between shareholder
remuneration and organizational performance during the years of shareholders losses and
during the years of shareholders gains. In figure 2the results of the SPSS bivariate
correlation analysis is shown.
26
Figure 4: Correlation between organizational performance factors and two indicators of the
remuneration (variation of the salary compare to previous year and the total salary) separately
during the years of shareholders losses and years of shareholders gains between 2010 and 2013.
As can be seen in figure 2 the overall results show no promising new insights nor a
structural pattern. There is neither correlation during the years of shareholders losses nor
during years of shareholders gains. However, there is one significant relationship that can
be found. The relationship between return per employee and the total salary during the
years of shareholders losses was found to be a significant negative relationship (-0,407).
This correlation is significant at the 0.05 level (2-tailed). This result suggests that for a
weaker return per employee, the total salary of the CEO is higher.
The second comparison analyses the correlation between shareholder remuneration and
organizational performance during the years of shareholders losses and to our complete
sample. In figure 3 the results of the SPSS bivariate correlation analysis is shown.
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Figure 5: Correlation between organizational performance factors and two indicators of the
remuneration (variation of the salary compare to previous year and the total salary) separately
during the years of shareholders losses and to our entire sample between 2010 and 2013.
The data concerning shareholder losses is identical to the data used in the first comparison.
And so the relationship between return per employee and the total salary during the years
of shareholders losses was found to be a significant negative relationship (-0,407).
Concerning the second part of the figure the Sig. 2‐tailed level indicates four times .000
which shows that there is significance between the total salary of the CEO and
organizational performance factors. In details, there is significance between the total salary
of the CEO and return on sales and the relationship is a positive 40,8%, which means that
as one variable goes up or down so will the other one. There is also significance between
the total salary of the CEO and return on assets and the relationship is a positive 40,9%.
Then we found the significance between the total salary of the CEO and the cash flow
return on assets and the relationship is a positive 36,1%. Finally, there is significance
between the total salary of the CEO and shareholder return and the relationship is a positive
36,7%.
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Hypothesis 2
A higher percentage of flexible remuneration creates a disproportionate relationship
between the intrinsic and extrinsic motivation of the agent. This leads towards lower
organizational performance.
Figure 6: Correlation between organizational performance factors and the part of flexible
remuneration.
As can be seen in figure 4 the overall results there is not a pattern recognizable pattern
within higher flexible remuneration and the linkage between organizational performance.
However, there is one significant relationship that can be found. The relationship between
return on sales and the flexible/fixed salary ratio was found to be a significant relationship
(0,238). This correlation is significant at the 0.05 level (2-tailed). This result shows that
here is a relation between flexible part of the CEO remuneration and the return on sales.
Hypothesis 3
In years of high stock market volatility the pay performance relationship is weaker.
The annual volatility as shown in figure 5 displays rather small differences between the
annual volatility between the years 2012, 2013 and 2014. According to these volatility
numbers it is expected to find the lowest correlation in 2012 and the highest correlation in
the year 2013
Year Volatility
2012 10,75
2013 8,12
2014 9,02
Figure 7: Annual volatility.
The variables related to the CEO remuneration can be divided into an interval value
reflected by the total salary, and a ratio reflected by the change of total salary.
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Change of total salary
In 2012, the relationship between the change of salary compared to previous year and return
on assets was found to be a significant relationship (0,343). Another significant relationship
between an organizational performance factor and total salary change is the factor of cash
flow return on assets (0.391). Both correlations are significant at the 0.05 level (2-
tailed). In 2013, the relationship between the changes of total salary compared to previous
years significantly negative relations were found with all of the organizational growth
factors. Employment growth was found to be a significantly negative relationship (-0,431),
also sales growth was found to be a significantly negative relationship (-0,513) and the
same finally for assets growth (-0,513). All those correlations are significant at the 0.01
level (2-tailed). In 2014 shareholder return was found to be a significant relationship
(0,349), which means that if the salary increases compared to the previous year the
shareholder return also increases. This correlation is significant at the 0.05 level (2-tailed).
Also, the relationship between the fixed on flexible ratio and return on sales was found to
be a significant relationship (0,355).
Total salary
Comparing the organizational performance indicators with the static salary gives us an
entire different perspective than relating organizational performance to salary change. In
2012 significant relations between total salary and the organizational performance factors
were found for return on sales (0,464), return on assets (0,411), employment growth
(0.417), Sales growth (0.381), asset growth (0.390) and shareholder return (0.505). In 2013
no significant relationships were found related to organizational performance. In 2014
significant relations between total salary and the organizational performance factors were
found for return on Sales: (0,498), return on assets: (0,594), cashflow return on assets:
(0.571), asset growth: (0.381) and shareholder return: (0.367)
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5. Discussion and analysis
5.1 Theoretical discussion and analysis
In the theoretical discussion the results are analyzed and brought into relation with the
theory of the theoretical framework. The hypotheses are discussed upon in ascending order.
Hypothesis 1
The first hypothesis tests whether in years of shareholder losses the link between
shareholder remuneration and organizational performance is weaker in the year after a
shareholder loss. The organizational performance was tested with two salary variables,
salary growth and total salary. The measure that is more supportive in explaining this
hypothesis is the total salary. The results that were found by comparing the years of
shareholder losses with salary growth were significantly weaker than the years of
shareholder losses. The results indicate that there might be a causation between loss averse
behavior and the decision making by investors that influences the pay performance
relationship. This insinuates that the preferences of the principal, as argued for in the
agency theory as being neutral, might not be so neutral after all (Krause et al. 2014). In the
behavioral agency theory constructed by Pepper & Gore (2015) the loss averse behavior of
the principals is argued for. However, in their propositions a rather inductive approach is
drawn in contrast to the statistical analysis where a rather general approach is applied.
Therefore it is difficult to draw a hard conclusion from these results. The findings of Krause
et al. (2014), based on an experiment are supportive for this theory. By taking into account
personal behavioral factors and analyze it from a general perspective, a significant
relationship is found. However, something that should be acknowledged is that the moment
of obtaining the shares is not taken into account in this thesis. Regardless of the positive
outcome of the first hypothesis, stronger results might be found when moment of obtaining
a stock is calculated in. On the other hand, results are usually annually reported on and for
example institutional investors might rather be reviewed upon their quarterly/annual results
rather than their moment of entry. The results of this analysis should be seen as preliminary
findings directed towards loss averse behavior. Additional research is needed to confirm
this over time.
Hypothesis 2
The second hypothesis tests if a higher percentage of flexible remuneration creates a
disproportionate relationship between the intrinsic and extrinsic motivation of the agent
31
which leads towards a weaker pay performance relationship. As can be extracted from the
results, there is only one significantly positive relationship that rather seems incidental than
explaining the construct. The overall results of the second hypothesis show no clear results
that support that a higher flexible remuneration has a stronger relationship with
organizational performance. This is an indication that more flexible remuneration does not
necessarily accelerates organizational performance. By testing this hypothesis a general
approach to the topic is examined. This means that purely intrinsic and extrinsic motivation
cannot solely looked upon as the explanation. A possible further direction, which is argued
by Pepper & Gore (2015), suggests a personal approach where the intrinsic and extrinsic
motivation should be evaluated on pay effort curves from individuals. However, this would
lead away from a general theory and deductive approaches would be more difficult in
explaining certain behavior. Although, when the variance of the reference levels of the
motivation of executives would are established boundaries can be created to measure upon.
Besides giving an indication about motivation and interest alignment, the results of this
hypothesis also support the claims made by Frey and Jegen (2001) and Sliwka (2007) for
a possible broken pay setting process. Therefore we argue that specific linkages should be
sought in specific parts of the executive remuneration, as for example the long term/short
term relationship or cash versus stocks. Because of the general approach this study is
limited in seeking the explanation by just comparing the fixed flexible relationship. By
expanding the understanding of the impact of motivation of organizational performance,
the relevancy of the question about the relationship between internal and external
motivation and how this can be explained within the remuneration construct is simple. If
the agency construct can be explained by behavioral factors an optimal salary range can be
created where executive remuneration can be tested upon. A possible other explanation
could be that non-organizational performance factors determining executive. This could be
another interesting view upon executive remuneration. Since non-financial performance
measures became more interesting after the publication of the balanced scorecard by
Kaplan and Norton (1995).
Hypothesis 3
The third hypothesis tests if in the years of high stock market volatility, the pay
performance relationship is weaker. After calculating an annual volatility measure for the
years 2012, 2013 and 2014, a comparative analysis was made between these years. In the
year of 2013, when stock market volatility was at the lowest point, the weakest pay
performance relationship was found. This result contradicts the initial assumption and
32
therewith our hypothesis. From a behavioral economic perspective, the assumption was
made that in years of high stock market volatility the focus of the CEO would even have a
stronger hyperbolic effect on time preference and therefore weaken the pay performance
relationship, according to the effect found by Ainslie (1991). Hamann et al. (2013) argued
for avoiding years of high stock market volatility because it would influence the pay
performance relationship. In the years that are analyzed, relatively small differences among
the volatility are recognized, which could be a reason for the contradicting results. In the
years 2012 and 2014 the pay performance relationship is found stronger than the original
sample, which clearly indicates that the results of 2013 influence the sample. However, the
reason of this influence cannot be explained by stock market volatility. Despite of the
results from Hamann et al. (2013), who were not coming from only one particular industry,
a possible explanation of a stronger pay performance relationship may differ within certain
industries. As for example the financial services sector, which is excluded from the sample
used in this study, who is also result wise more related to stock market performance. In this
test the effect of stock market performance was not isolated and for example solely tested
in relations to (long term) stock option and share plans. Therefore, other factors might play
an important role in explaining these variations. This does however encourage to zoom in
to the year 2013 to find a better understanding of these results and develop a better
understanding of these movements.
The topic of executive remuneration and the pay performance relationship has been a
widely discussed subject. As one of the first studies of connecting the behavioral agency
theory in explaining the pay performance relationship this study contributed to the
executive remuneration construct. By implementing behavioral theory in order to explain
the pay performance relationship this study provided a new foundation for scholars to build
further on. Rather than altering existing theory a new foundations for theorizing about
executive remuneration is provided. This study suggest that motivation and loss aversion
play a role in explaining the pay performance relationship. The evidence regarding the
effects of stock market volatility does not to hold in our findings. The findings provide an
explanation for the inconsistent results in previous research, reflected upon in the large
meta studies (Tosi et al. 2000; van Essen et al. 2015). An implication that should be
considered by reading this study is the sample that is coming from a different geographical
location. Hence, the comparability might be affected as elaborated on the previous chapter.
Therefore future studies need to place this theory in a different context to test if a general
understanding can be created.
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5.2 Discussion of research design
In this paragraph a reflection on the research design is made based on the two main quality
indicators of quantitative research, reliability and validity.
Reliability
In order to get reliable results a study needs to be able to be repeated by others. These others
should find similar results and come to similar conclusions. To test if this meets those
requirements two reliability measures are used. The first measure is stability and the second
measure is internal reliability (Bryman & Bell 2011). The data collected in this study can
be separated into two major streams. The first part is manually collected and is extracted
from annual reports and the second part is collected via a query from a database called
Amadeus. Even though the data coming from annual reports has a high stability over time,
the manual data collection process is prone to errors. The possible errors within this process
could be due to misinterpretation, the inability to find the data or registration errors.
Misinterpretation or the inability to find the data can be caused by the different reporting
formats used by the companies that were analyzed. These errors are tried to be minimized
over by cross checking the results. The data from the database Amadeus could change over
time, or could hold incorrect information. In their brochure a reference is made to 35 experts
and local information providers to guarantee quality and completeness (Bureau van Dijk
2016). Besides that, the time of retrieving the information from the information from the
database is also listed. If necessary comparisons can be made over time, or the logged data
can be retrieved. Another event, with a small risk, that could influence the results is when
false company data is discovered by auditors or journalists. An example of this are
company scandals being unraveled. However, the chances of being so are minimal. The
stability of the measures have not been tested by a test-retest method or other statistical
stability measures.
Validity
Bryman and Bell (2011) refer to validity as being the most important criterion of research.
In the validity evaluation there is reviewed upon if the measures that try to explain a certain
construct really measures that construct. Bryman and Bell (2011) distinguish four different
measures of validity: internal-, external-, measurement- and ecological validity. In this
paragraph the study is reviewed upon these four measures of validity.
Internal validity is concerned with the causality question, in this chapter it is reasoned for
why a certain relation implies causality. Therefore, it should answer the question whether
34
the independent variable really is the only variable that is influencing the dependent
variables. In other words, if factor A is influenced by factor B, is factor B really the (only)
factor that influences factor A (Bryman & Bell 2011)
In the first hypothesis it was found that the years of shareholder losses with salary growth
were significantly weaker than the years of shareholder losses. As argued upon in the
theoretical discussion and analysis, similar results were found by comparing this to
shareholder gains. This indicates that there is rather another discrepancy in our sample
rather than a fully supported hypothesis. Therefore it can be argued for that a purely
causational relationship is non-existent and further research is required.
The second hypothesis did not show a strong relationship between a higher percentage of
flexible remuneration and organizational performance nor did it show a negatively
significant relationship. This lies within our expectations but does not rule out other factors
influencing these results. The short and long term bonuses were not separated in
determining the flexible remuneration, because of the different reporting formats used by
companies. More extensive future research should develop a deeper understanding of how
the different parts of executive remuneration work on this concept.
The third hypothesis tests if in the years of high stock market volatility the pay performance
relationship is weaker. As elaborated on in the theoretical discussion and analysis there was
no relationship found by testing this hypothesis. Often statisticians argue for causality
rather by the relationships they found than by explaining the drivers behind relationship
(Brymann & Bell 2011). In the case of a non-existent relationship there is argued for other
factors influencing the results rather the factors in our initial design.
External validity
The external validity describes if the results can be generalized and do not only apply for
the field and topic the study was performed in, but also apply to a broader context (Bryman
& Bell 2011). The results of this study can partly be generalized, but do hold some points
that should be taken into account. As a reflection of Europe the index with the 50 largest
companies was chosen. This index does not reflect the average company in Europe does
come closest to the market capitalization of the companies used in US and UK based
studies. However, the findings of study cannot be taken as general findings within all
publically owned companies within Europe for example. Therefore a sample including for
example the Eurostoxx 600 (ES600) would be a better reflection. Another important fact
35
to take into account is that the companies within the financial service sector are excluded.
In many studies the financial sector has been targeted because of their high remuneration
standards, which makes this study more difficult to compare in a context. The years a study
is performed in are in contexts of executive remuneration extremely important. Corporate
governance codes and legislation can change rapidly which changes the context the results
should be viewed upon. The years 2012, 2013 and 2014 are the three latest years that could
be reviewed upon with reliable and consistent company information. Assessing similar
within a time range of post financial crisis studies (>2010) should be able to be generalized
based on the years that were selected in this study.
Measurement validity
In the measurement validity chapter a reflection is made of the measures used and their
relation to the construct (Bryman & Bell 2011). In other words, do the measurements of
organizational performance really measure an organization’s performance? The
measurements used in this study are based on a study published in a renowned journal. In
this article different models were tested and to find the measures that reflect the best
construct validity or also called measurement validity that reflects organizational
performance (Hamann et al. 2013). Therefore the assumption is made that the right
measures were used to reflect organizational performance. It could be argued for that the
remuneration data could be more specified, but as argued for before in this chapter this was
made impossible because of different reporting standards.
Ecological validity
Ecological validity allows to generalize or not from observed behavior in the laboratory to
natural behavior in the world (Schmuckler, 2001). Related to the critique of e.g. Blumer
(1956) statistical analysis is often criticized for its lack of taking the social factors behind
the numbers into account. Therefore it is argued that the statistical numbers would insinuate
that the world can be seen as if being static. This does not reflect real life relationships.
Even though it seems that this will be a never ending discussion among researchers it
should be part of the explanation and decision and performing a certain study. Concerning
the topic of executive remuneration, it can be argued for that the amounts of money does
not come close to salaries they will ever get paid. However, the data used in this study is
based on real time company and remuneration information and should therefore reflect a
real world reflection of the EU’s largest companies.
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5.3 Managerial implications
In this paragraph the managerial implications that impacts or influences real life situations
are discussed. Based on the results and previous research within this thesis, valuable points
can be extracted that can change behavior in the pay-setting process.
From a managerial point of view the subject and results of this study are especially
interesting for shareholders and the remuneration committee. The results that were found
contribute and should be taken into account when analyzing and estimating executive
remuneration. There are two findings in this study that can be recognized as being
interesting to take into account within the pay setting process.
First, when not necessarily more flexible remuneration leads to a stronger a pay
performance relationship it seems important for the remuneration committee to put extra
emphasis on the design of the remuneration package. It would be short sighted to think that
the pay performance relationship is the only point of interest of the remuneration
committee. In this topic there is already a contradiction noticeable. For example as earlier
elaborated on the fact that interest alignment and the pay performance relationship are not
necessarily measuring the same factors. Besides that the CEO is not the only person that
the remuneration committee is concerned with. However, by focusing on the remuneration
relationship it can be stated that there is not a simple solution to maximize the pay
performance relationship based on our findings. By simply increasing or uncapping the
bonuses it is not necessarily a guaranteed solution for maximized motivation. The results
of this paper can be used as an indication that this relationship is more complex.
The second point of managerial implications is about the difference in the years after the
year of shareholder losses and the pay performance relationship. It is found that this has a
significant weaker relationship. This indicates that either the new remuneration packages
proposed to the shareholders are disapproved or already adapted in a way that is less
sensitive for organizational performance. A remuneration committee should take this
relationship into account when constructing the remuneration package. In years of
shareholder losses the committee should develop a package that is adapted to the expected
behavior. Important is to relate this also to the first implication. Meaning that the committee
should focus on the specific components to cut on, rather than removing the variable pay.
A stronger pay performance relation with an overall lower remuneration should be
favorable by shareholders over a higher fixed salary and lower flexible rewards. This so
37
that in prosperous the years they both profit, but on a downtrend the agency costs are
minimized.
5.4 Limitations and future research
In this paragraph the limitations that impacted or influenced the interpretations and findings
of our research are discussed. While reading the results of this study the limitations have to
be taken into account to create the right understanding. These limitations are discussed
upon in the following order: sample, data collection method, the complexity of data, and
our analysis.
The discussion start with limitations that are concerned with the sample. Based on this
sample there a two limitations noticeable. First the limitation within the selected index and
second the limitation of the index compared to the market. The data selection within the
index is limited because of the exclusion of companies within the financial service sector.
Even though the reason of exclusion is clear, because of the influence of regulations
influencing the pay performance relationship, the sample does not comprise all of the ES50
companies. Therefore it could be argued for that this study is therefore limited in explaining
certain pay performance tendencies in the ES50. Second, as defined in the research aim,
the sample consists of European companies. The selected sample reflects only the 35 largest
companies within Europe. The focus on the largest companies within Europe is because of
comparability reasons with U.S. studies. Nevertheless, in order to create a complete
understanding of for example all publically listed companies within Europe different
indexes can be used to explain the construct. An example could be the ES600, including
600 of Europe’s largest companies. Future studies could compare the U.S. and Europe with
the ES50 and ES600 index in order to rule out between these continents and extend
elaborate the understanding of the pay performance construct.
The limitations concerning the data collection method can be argued upon by the sources
used. To examine organizational performance data the database Amadeus was used as
described in the third chapter. Karlstad University owns a subscription to this database and
therefore the access was free of charge. There are also other databases providing similar
information as for example Hoovers, LexisNexis, Bloomberg, Worldscope, Datastream and
Macrobond. Even though Amadeus fulfilled the needs for this research almost entirely, not
all requested data was available. Being reliable on one database can therefore be seen as a
limitation. Additional access can serve as a quality of the data provided with for e.g. other
38
databases is missing. Taking into account the limited budget available for performing this
study, a best possible setup is created.
Concerning the complexity of data this study is limited in ruling out other influencing
factors. Since the inconsistent results in previous studies an all including approach is often
used. This study focuses on the agency theory and uses measures of organizational
performance modified by organizational size. The size of firms as proven in the two meta-
analysis studies is often an explanation for high salary. As elaborated on in the introduction,
organizational size and the managerial power theory are often intertwined. As specific
corporate governance items hold together with organizational size. Regardless of this fact
the factors of managerial power nor specific corporate government characteristics are
included in this study. Future research could benefit of isolating more factors than just
organizational size as was done in this study.
39
6. Conclusion
In this thesis we discussed the pay performance relationship within the field of executive
remuneration. A topic that received a lot of attention during the financial crisis and times
of economic recession. Instead of following the trend and elaborate on topics such as
fairness or greed, a rather new theory was chosen to create an understanding of the driving
factors behind it. The starting point of this paper is the argument for a broken pay setting
process where existing neoclassical theory is highly divided in providing explanations for
the pay performance relationship. These neoclassical theories are known as the agency
theory and the managerial power theory. The behavioral agency theory provides a new
perspective on the pay performance debate and argues for a rather contingent approach.
One of the contingent factors a significant relationship was found between organizational
performance and loss averse behavior of a principal. This is in line with the expectations
and provides a foundation for further theorizing. The second hypothesis that was tested
concerned the agent’s motivation and was tested by comparing fixed with flexible
remuneration. Higher flexible remuneration does not necessarily mean stronger overall
performance of the company. This could partly be explained by the agent’s motivation. An
interesting thought brought forward in the thesis is how non-organizational performance
measures might also affect flexible remuneration and cause noise within the pay
performance debate. The third hypothesis measured if stock market volatility influenced
the pay performance relationship, no strong results were found in favor of this hypothesis.
Overall, this paper found mixed results in providing a general understanding of the pay
performance relationship by testing the foundations of the behavioral agency theory. One
of the main articles that formed the foundation of this argued for an inductive approach
(Pepper & Gore 2015). Future studies within the remuneration topic should provide further
inductive analysis to provide directions for deductive theorizing within the topic. Let the
findings of this study be an encouragement for future researchers to adopt the behavioral
agency theory within the field of executive remuneration.
40
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