Long Term Incentive Plans, Executive Pay and UK Company ...

Journal of Management Studies 40:7 November 2003 0022-2380

Long Term Incentive Plans, Executive Pay and UK Company Performance*

Trevor Buck, Alistair Bruce, Brian G. M. Main and Henry Udueni De Montfort University Leicester; Nottingham University Business School; University of Edinburgh Management School; Nottingham University Business School  In agency theory, the remuneration packages of executive directors in large companies are seen as an attempt to give them a pattern of rewards that aligns their interests more closely with shareholders as a whole. The sensitivity of total executive rewards to share price performance has become the conventional yardstick for judgements concerning whether reward packages do indeed serve shareholders’ interests or executives themselves. Long-term incentive plans (LTIPs) introduced in the UK from 1995 have imposed new, firm-specific performance conditions on senior managers. While LTIPs are designed to increase performance-pay sensitivity, however, they also give executives new opportunities to manipulate the terms of LTIPs in their own favour, at the expense of shareholders and stakeholders in general. This paper presents the first estimates of UK total executive rewards that include detailed LTIP valuations. It finds that, while increasing average total rewards, the presence of LTIPs is actually associated with reductions in the sensitivity of executives’ total rewards to shareholder return. This raises doubts concerning both the effectiveness of the LTIP instrument and the validity of an agency perspective in this context.

INTRODUCTION Appropriate incentives for senior managers are vital to company performance. UK executive directors’ aggregate reward levels and their relation to company performance have been a consistent target for government regulation, for self-regulation by the capital market and the accountancy profession, for associations of institutional investors issuing pay guidelines, and for media attacks on ‘fat cats’. Despite Address for reprints: Trevor Buck, Graduate School of Business, De Montfort University, Leicester, LE1 9BH, UK ([email protected]). © Blackwell Publishing Ltd 2003. Published by Blackwell Publishing, 9600 Garsington Road, Oxford, OX4 2DQ , UK and 350 Main Street, Malden, MA 02148, USA.

1710

T. Buck et al.

this widespread concern however, existing research, in the USA as well as the UK, has had to confront major obstacles concerning the realistic valuation of all the components of complex remuneration packages. This point is particularly relevant to the UK since 1995, when the Greenbury Committee called for companyspecific performance conditions. Greenbury urged companies to replace executive share options (ESOs) with conditional ESOs and/or long-term incentive plans (LTIPs). The latter typically award free shares to executives, but subject to conditions intended to satisfy Greenbury’s demand for ‘more challenging performance criteria’. LTIPs are, therefore, defined as grants of cash or shares (usually the latter) with performance conditions. They are, effectively, conditional ESOs with zero exercise prices, thus making no demands on executives’ own monies. Agency theory provides the usual lens through which to analyse developments in executive pay such as LTIPs. (For recent examples, see Fenn and Liang, 2001; Hermalin and Wallace, 2001.) From this perspective, shareholder principals control their managerial agents, and this includes the design of their pay packages. Executive rewards linked to a firm’s share price are now seen as a means of more closely aligning the objectives of salaried managers with those of residualclaiming shareholders concerned with firm value. If the inputs and outputs of managers were cheaply observable, a risk-neutral shareholder could fully insure a risk-averse manager by paying a fixed salary: the manager would then supply optimal effort, with shirking eliminated by monitoring (Rosen, 1992, p. 192). A classic agency problem arises, however, where shareholders cannot cheaply monitor important managerial inputs that are essentially entrepreneurial decisions, involving judgements and attitudes to risk that amount to ‘hidden actions’ (Murphy, 1999, p. 26). With hidden actions, managerial rewards could instead be output-contingent, but in practice, output signals, including share price movements, are ‘noisy’, reflecting managers’ efforts as well as many other factors arguably beyond their control. Equally, greater alignment of shareholder/executive interests could of course be achieved by paying executives exclusively with shares, but executives’ risk-aversion makes this proposition unrealistic in most cases. A proportion of total rewards based on share price has the potential to reduce agency problems, but introduces new ones: ‘lucky’ executives (Bertrand and Mullainathan, 2001), may be rewarded when a firm’s share price rises in line with general capital market trends. In addition, risk-averse executives with undiversified portfolios of financial and human capital will resist proposals to link rewards to share price (Hall and Murphy, 2002). If a proportion of rewards based on equity values is imposed on executives, they will now have an incentive to use their influence to obtain ‘softer’ exercise prices and performance conditions based on share price. This has given rise to the ‘self-serving management’ hypothesis (Benston, 1985) and a recognition of the possibility of managerial ‘skimming’ behaviour © Blackwell Publishing Ltd 2003

Long Term Incentive Plans

1711

in the context of the self-design of executive reward packages (Bertrand and Mullainathan, 2001). This paper addresses the possibility of self-serving (or ‘skimming’) behaviour by managers in relation to the design of executive pay packages that include LTIPs. Any such managerial influence weakens the relevance of an agency perspective that views executives’ reward packages as being imposed by shareholders on senior managers to align their interests more closely. Consequently, alternative perspectives on firms have been developed that emphasize the political nature of many corporate strategic decisions (Porac et al., 1999), outcomes that depend on the relative bargaining power of executives (Pettigrew and McNulty, 1995), and the ability of key actors (e.g. executives) to manipulate the way that their actions are perceived by other stakeholders (Gioia and Thomas, 1996). From both the agency and ‘power’ perspectives, LTIPs that replace unconditional ESOs with gifts of shares, subject to bespoke company performance conditions, now have a dual potential. They can provide realistic performance targets and induce increased efforts from executives to raise shareholder value. Alternatively they can provide new opportunities for executives to ‘skim’ by exploiting any additional discretion given to executives in the choice of peer groups, etc, and also the absence of generally accepted norms for company-specific LTIPs. Evidence from the USA suggests that the design of comparator (peer) groups has indeed been used in an ‘executive-friendly’ manner. In the USA, peer groups are generally not used as an ex ante feature of incentive schemes, as in the UK, but are used ex post when boards must make performance comparisons at AGMs to justify executive rewards actually paid. Porac et al. (1999) report that (p. 112), ‘. . . boards selectively define peers in self-protective ways, such that peer definitions are expanded beyond industry boundaries when firms perform poorly, [and] industries perform well . . .’ They also find (p. 137) that a majority of changes in peer groups on balance favoured the inclusion of lower-performing firms. Likewise, the complexity of LTIPs in the UK gives executives additional opportunity to tilt the design of LTIPs in their own favour. To give some idea of the complexity of LTIPs in the UK and the problems that shareholders have in judging the toughness of targets involved, one example is given here. The HSBC banking group has an LTIP that rewards executives if the firm clears a performance hurdle of earnings-per-share (EPS) growth 2 per cent above an average EPS rate, adjusted upwards for inflation in Hong Kong (50 per cent weighting), UK (35 per cent) and the USA (15 per cent). If this hurdle is cleared, the number of shares distributed to executives depended upon total shareholder return (TSR) in a comparator group of companies made up of nine global financial institutions (50 per cent weighting), a ‘top 20’ of banks (25 per cent) and an index of 300 other banks (25 per cent). If HSBC’s TSR performance is above the fiftieth percentile of this composite group, executives receive the award in shares in full, with an additional 20 per cent of the full award if performance is in the © Blackwell Publishing Ltd 2003

1712

T. Buck et al.

top quartile. This implies that there are ‘flat spots’ in HSBC’s LTIP scheme: LTIP rewards are insensitive to TSR performance that is below the 50 per cent mark and above the 25 per cent mark relative to that of a peer group. We return to the presence of such ‘flat spots’ in our discussion section, below. Judgements on the toughness or otherwise of HSBC’s comparator group would, therefore, involve tracking the share prices of 329 companies in order merely to estimate the relative performance of HSBC’s TSR in the past. Such complexity facing shareholders also confronts researchers (and executives themselves) wishing to make interim valuations of LTIP awards before maturity at the end of the plan, and explains why detailed LTIP valuations have not been available until now. HSBC readily provided the authors with full details of its LTIP comparators in its annual report but some UK firms refused to disclose comparator groups to the authors without, or even after, repeated approaches. Even where peer groups are disclosed, their evaluation by outsiders is hampered by the already-noted absence (and impossibility) of market norms (Veliyath, 1999) for such complex, idiosyncratic schemes. Besides comparator groups, LTIPs also introduce other dimensions of complexity, including the choice of performance hurdle, holding periods, etc. Given the new complexity of LTIPs compared with other components of executive rewards, this paper proposes as its central research question: Can comparisons of the sensitivity to share price of total executive rewards, with and without LTIPs, provide evidence on whether LTIPs are shareholder-serving or manager-serving? This paper now proceeds to address this question. In the next section, it reviews concepts and then develops hypotheses from agency theory. These hypotheses are followed by the third section which covers the data and the results of tests based on estimates of the sensitivity of total executive rewards to TSR in the UK for 1997/98. Of course such an econometric approach can give only one perspective on the overall impact of reward packages, and the authors have elsewhere supplemented this approach with surveys of executives in relation to their perception of incentives, and with case-studies. The paper concludes with a discussion of its implications for policy and theory development. CONCEPTS AND HYPOTHESES Most income measurement combines stock and flow elements, and total executive rewards are no exception. In the case of total executive rewards during a period (e.g. one year), flows of salary, bonus, pension contributions, value of perquisites, dividends received and the estimated value of LTIPs and ESOs awarded during the year must be added to the differences between the value of opening and closing stocks of wealth in the form of shares and options accumulated under earlier schemes. Some of this income is realized (e.g. salary) and some unrealized in the short run (e.g. options) but changes in the value of extant share options are every © Blackwell Publishing Ltd 2003


1713

bit as important in terms of tying the executive’s welfare to the performance of the company. We, therefore include them in our measure of total rewards. Special emphasis is placed here on the particular case of share-related rewards. Before 1995, unconditional ESOs, i.e. ESOs without performance hurdles, were common in large UK companies (Conyon and Murphy, 2000). ESOs permitted executives to buy (without performance conditions) company shares in the future at today’s price, giving them every incentive to raise share value. However, where executives reaped large gains simply as a result of subsequent bull markets, this attracted criticism that their gains had not been ‘earned’. Performance conditions followed for ESO schemes and, in particular, LTIPs. LTIPs are quite heterogeneous. The HSBC scheme outlined above is an extreme example in terms of its complexity. A typical LTIP in a large UK company announced in 1995 would involve some general performance hurdle (e.g. RPI + 3%, or more recently, 4%). If this hurdle is cleared, any award generally depends upon the firm’s TSR performance relative to some comparator group. Under pressure from the Association of British Insurers (ABI) guidelines that schemes should offer no rewards for less than median performance, a typical minimum award vests at the fiftieth percentile with a maximum around the seventieth (Monks Partnership, 2001). As with the HSBC example above, this type of structure implies the existence of ‘flat spots’ outside the 50–70 per cent range, e.g. below 40 per cent and above 80 per cent, where the performance-pay sensitivity is negligible. The valuation of returns from an LTIP scheme is essential in the estimation of performance-pay sensitivities. Even without LTIPs, ESOs in the USA contributed 31 per cent of performance-pay sensitivity (and executives’ share ownership accumulated from past reward packages, 64 per cent) (see Murphy, 1999, p. 34). Of course, gains from ESOs and shares are not always realized within any one year period. With multi-period LTIPs (usually three-year schemes), however, the interim valuation of unrealized gains for an eligible executive for a particular year depends on the not unreasonable assumption that the executive will perceive current year performance to be a best indicator of end-of-plan performance. (Indeed, most companies make this assumption when reporting to executives and shareholders at each year-end.) For any particular year, the valuation, adjusted for various forms of re-capitalization, is then calculated as follows. (1) The performance of the company at the end of the year is measured, using the performance criteria specified in the plan. (2) This measure is compared with the performance of companies in the comparator group as defined by the plan. (In the case of HSBC this means tracking 329 companies and a number of retail price indices.) (3) This comparison generates a provisional level and value of award (based on year-end share price). This is then adjusted according to which year within © Blackwell Publishing Ltd 2003

1714

T. Buck et al. the plan is under scrutiny. Thus, based on the standard three-year plan duration: (3a) For a year coinciding with year one of a plan, the value of the expected final value of the LTIP to the executive is calculated on the assumption that the year’s performance is maintained, and the executive is credited with one third of this calculated provisional final value of award. (3b) For a year coinciding with year two of the plan, the value is given by two thirds of the provisional value of award (calculated as above but for year one and year two outcomes) minus one third of the provisional final value of award as originally calculated in year one. (3c) For the final year of a plan, the value is given by the full value of the actual award at the end of year three minus two thirds of the provisional final value of award as originally calculated in year two.

Having generated LTIP valuations in this way, for schemes announced within the year of study and also for earlier awards, ESO valuations were obtained using the conventional Black–Scholes (B-S) formula. Criticisms of this formula exist (McKnight and Tomkins, 1999), largely on account of the fact that ESOs are not immediately tradable by executives, unlike options in the wider market sense. However, the only alternative to B-S involves the assumption of a utility function for executives in relation to their assumed relative tastes for risk and return (Hall and Murphy, 2002). In addition to these calculations, the estimation of total executive rewards involves the more straightforward aggregation of flow variables such as salary, bonus, perquisites, pension contributions and dividends received on shares accumulated from earlier incentive schemes. Besides valuing new issues of ESOs and LTIPs during the year, the estimation of total rewards also involved the calculation of changes in the value of the stock options and shares held at the beginning of the year and at year-end. Focusing on LTIPs and ESOs, it is clear that in isolation they must have a mechanical relation to performance conditions and a company’s share price. For example, an LTIP offers a minimum yield of zero, a defined maximum positive value as stipulated in the LTIP contract, and a graduated positive contribution for intermediate levels of performance. It is only mildly interesting, therefore, to analyse the sensitivity of the association between a company’s executive rewards through an LTIP alone and the firm’s TSR, as this is defined by the scheme. It is interesting, however, that these long term incentives are likely to be complements or substitutes for other elements of rewards and governance (Holderness et al., 1999, p. 437) and their overall value must lie in their negative or positive contribution to the sensitivity of the executive’s total rewards to share performance. It is the overall sensitivity of the reward package that must influence executives’ actions and which is the focus of this study, and in particular the relative sensitivity of packages with and without the innovation of an LTIP. © Blackwell Publishing Ltd 2003


1715

This raises problems for regressions, however. As explained above, LTIP valuation is complex, with bespoke peer groups for performance comparisons and idiosyncratic market-based performance hurdles. Although this complexity can be handled in the valuation of LTIPs for each year, and thus their contribution to total rewards, this extreme heterogeneity means that comparisons of with/without LTIP total pay sensitivities to TSR can only be made through the adoption of an LTIP/no LTIP dummy variable rather than through any more finely-grained variable. With all these conceptual issues in mind, two hypotheses are developed below with a view to subsequent testing. Although some fundamental criticisms of agency theory have already been recognized, it is adopted in this paper for the purpose of hypothesis generation and to maintain continuity with the established executive pay literature. While not wishing to imply that firms are run simply for the benefit of its shareholders, it was decided to persevere with the agency perspective. Thus, it is proposed that executive packages that include LTIPs are designed by shareholders to align the objectives of senior managers more closely with their own. This assumption favours executives in the sense that it disregards any opportunistic executive influence over their own reward packages. Any subsequent rejection of the proposed hypotheses must of course raise doubts about the efficacy of LTIPs and the relevance of agency theory in this context. The first hypothesis concerns absolute levels of executive rewards. If shareholders are to motivate managers, they must expect to have to pay for any incentives. LTIPs, that constitute attempts to align more closely the interests of executives and to induce increased managerial efforts, will, therefore, be associated with increases in total rewards: it is inefficient for shareholders to introduce LTIPs that are associated with (or are expected to be associated with) decreases in absolute total rewards, and package innovations associated with reduced total rewards are likely to increase rather than mitigate agency problems. Furthermore, risk-averse executives are only likely to accept an income with greater risks attached (e.g. through LTIPs) if absolute total pay is increased as compensation. For both these reasons, therefore, it is hypothesized that: Hypothesis 1: The presence of an LTIP component in a package will be associated with higher absolute levels of total executive rewards. Of course, higher total absolute rewards associated with LTIP presence is consistent with managerial ‘skimming’ as well as shareholders attempting to resolve agency problems, and Hypothesis 1 cannot distinguish between these alternative explanations of higher rewards. For this reason, a second hypothesis is proposed. The literature on executive rewards has consistently associated higher sensitivities of total rewards to TSR as evidence of a closer alignment of executives with shareholders (see, for example, the seminal paper by Jensen and Murphy, 1990). In an © Blackwell Publishing Ltd 2003

1716

T. Buck et al.

initial attempt to distinguish between the predictions of agency and ‘power’ theories in the new context of LTIPs, we, therefore, propose: Hypothesis 2: Where an LTIP component is present, total executive rewards will be associated with higher levels of pay-TSR performance sensitivity. The acceptance of Hypotheses 1 and 2 would be consistent with the predictions of agency theory. However, higher absolute executive rewards in line with Hypothesis 1 may also coincide with the rejection of Hypothesis 2 and support for a ‘power’ perspective, i.e. LTIP presence is associated with lower performance-pay sensitivity. This outcome would be consistent with LTIPs as a reward innovation associated with the self-interested diversion of income from shareholders and other stakeholders towards executives themselves, and, as such, an innovation that has failed to demonstrate any improved alignment of shareholder/executive interests. However, a major conceptual problem regarding these hypotheses is that reward outcomes are determined coterminously with TSR performance out-turns, thus offending the usual econometric assumptions regarding simultaneity. Furthermore, while this paper shares the concern of the executive reward literature with the ex post performance-pay relation it is clear from the usual agency perspective that pay packages are designed to motivate executives in the long term to improve the quality of their efforts in relation to decisions that raise firm value. In other words, an ex ante pay-performance relationship may complicate the interpretation of measured performance-pay sensitivities. A fuller picture of these conceptual issues is given by a wider perspective on agency theory that has been developed to accommodate relations between corporate governance, strategies and performance (Hoskisson and Turk, 1990; Thomas and Waring, 1999); see Figure 1. This figure is presented here, not to develop new hypotheses or refine existing ones, but merely to highlight the problems encountered by the literature in establishing causation and its direction. Managerial strategies (e.g. investment decisions, and even executive reward packages themselves, if senior managers have any significant influence over them) in Figure 1 are now seen to depend upon a firm’s corporate governance but also on managers’ risk preferences and the state of conditions in product, capital and labour markets, including markets for executives. As a further complication (not shown) for Figure 1, market conditions interact with strategies to produce performance outcomes, but performance itself must influence subsequent strategies and governance, e.g. managers seek more shares where performance is high. In fact the exponential association between managerial ownership and share performance (Morck et al., 1988) is one of the most often-replicated regularities in this area of literature, but the direction of causation and lags in this relationship has not been established. © Blackwell Publishing Ltd 2003

Long Term Incentive Plans Corporate Governance Firm-specific variables, including corporate governance: – Ownership of managers, individuals, financial institutions etc – Control = board representation of managers, individuals, financial institutions etc.

Product Market

Investment opportunity set

Strategy

Managerial Package – Value – Responsiveness to share price movements

1717 Performance

H1, H2 Firm’s Financial Performance – Return on firm’s shares – Volatility of firm’s shares

Managerial decisions depend on – Attitude to risk – Managerial focus and effort

Labour Market

Capital Market

Figure 1. Authors’ own design

Indeed, Figure 1 could realistically be further complicated by the inclusion of time-lags. By definition, LTIPs are designed to have a long term influence, and this makes any evaluation problematical, with the introduction of many LTIP schemes around 1995 leading to awards of shares or cash to executives over the period 1995–98. The annual issue of new tranches of three-year LTIPs in many companies each year (e.g. 1996, 1997, 1998, etc) complicates the issue further. Valuation problems mean that the executive reward literature has never been able to exploit fully panels of longitudinal data in stock market/total executive reward regressions, and there is virtually no discussion of time-lags. (Some papers do employ fairly arbitrary, one-year lags; e.g. Abowd (1990) addresses lagged incentive effects but considers only salary-plus-bonus.) A recent survey (Conyon and Sadler, 2000) confirms these features of the literature. Where longitudinal data have been used, it has been necessary either to exclude share options and LTIPs completely or to employ approximations concerning option exercise prices and performance conditions. For example, the best data are in the USA, but David Yermack’s comprehensive data set (widely admired and employed by others, for example, Bertrand and Mulainathan, 2001) omits the changes in the value of options held from the total executive total reward measure; Porac et al. (1999, p. 125) include only realized restricted stock gains and realized option gains, without tackling the valuation of interim, unrealized gains. We have attempted to advance the literature by including comprehensive valuations of all reward components. © Blackwell Publishing Ltd 2003

1718

T. Buck et al.

Thus, cross-section performance-pay sensitivity has been the main indicator of the impact of executive reward packages. For example, Jensen and Murphy (1990) refer to the agency-related ineffectiveness of packages in the light of low sensitivities, and Gregg et al. (1993) cite reduced sensitivity as evidence of a ‘disappearing relationship’ between executives’ pay and company share performance. In the meantime, companies continue to innovate in relation to executives’ packages, e.g. issuing LTIPs and changing comparator groups in relation to performance standards, and academics should be able to provide informed commentary on a subject vital to the motivation of UK senior executives and hence the performance of their companies. This paper, and a literature in general that relies on the analysis of single crosssections, cannot experiment with time-lags or even adopt the already considerably simplified model depicted in Figure 1, which emphasizes that Hypotheses 1 and 2 are only a small part of a wider model. Conclusive tests on ex post performancepay relations and ex ante pay-performance incentive effects would require at least five years of dynamic panel data,[1] which is near impossible to obtain unless reward structures become greatly simplified. We would argue that for such an important remuneration innovation as LTIPs, the publication of interim results based on the usual single cross-section data is justified. DATA AND RESULTS This paper, therefore, reports tests on a cross section for 1997–98 from a study of total rewards for each individual executive director (n = 1602) in 287 UK nonfinancial companies in the FTSE-350. While relying on a single cross-section of data for 1997–98, the results effectively represented LTIP reward components with a lag of between one and three years since their announcement, with the first rounds of LTIP schemes announced in 1995. Information on all forms of executive reward (see the rubric to Table II) was collected from companies’ annual reports supplemented by shareholder circulars, by pamphlets on LTIPs prepared by companies for executives themselves, and by telephone enquiries, usually to Company Secretaries or to share scheme administrators. Three models were used for tests on Hypothesis 1 concerning the overall performance-pay sensitivity. Model 1 used a sample of all executive directors (n = 1602). Since Chief Executive Officers (CEOs) may have greater opportunities than other directors for self-serving behaviour in relation to their own reward packages, Model 2 considered CEOs only (n = 287), and Model 3 was based on all executive directors who were not CEOs (i.e. n = 1315). The dependent variable was the log of total rewards comprising flows of salary, bonus, benefits, pensions, dividend income and also changes in the unrealized value of stocks of executives’ wealth,

© Blackwell Publishing Ltd 2003


1719

i.e. the B-S value of ESOs, changes in the value of stocks of executives’ equity, and changes in the estimated value of LTIPs. The main independent variable was TSR for each company during the year, but in addition a number of controls were used that have become conventional in the literature. A Cumulative Distribution Function (CDF) variable was used to represent the riskiness of a company’s share, following Aggarwal and Samwick (1999). The variable represents each company’s value (ranging from zero to unity) in the CDF of the variability of total shareholder return in the sample as measured over performance in the previous 60 months.[2] The value of sales was used as a control for firm size, together with industry dummies ( Jensen and Murphy, 1990) and a measure of research and development intensity. R&D spending as a proportion of total assets is included because technologically advanced firms are less transparent to shareholders, who thus have an incentive to introduce more equity-based rewards to motivate executives rather than attempt to monitor them with incomplete information (Zeckhauser and Pound, 1990). Equity-based rewards have been found empirically to be more important in R&D-intensive firms (Kole, 1997). Various indicators of non-pay governance variables were also included as standard controls for influences on firm value besides executive pay packages. For example, a director who is CEO is attributed a dummy variable, and a dummy denoting Chairman and a dummy capturing the presence of dual role Chairman/CEO posts, since the combined role of chief executive agent (CEO) and representative of shareholder principals (Chairman) provides new opportunities for self-serving behaviour (Murphy, 1999). Of course, not all of these dummy variable are appropriate to all equations. Thus, the estimating equation was: Log (total rewards) = a + b1 (shareholder return) + b2 (controls) + e Descriptive statistics for all executives in the sample are presented in Table I (a and b) where it can be seen that some 41 per cent of these executives benefited from an LTIP. Around 18 per cent of the sample were CEOs and 7 per cent were Chairmen (these were all executive directors and 4.6 per cent of them held a dual CEO/Chair position). OLS regressions for the three models were estimated, and are presented in Table II. Many of the control variables can be seen to be significant, but this analysis focuses on shareholder return and the presence of LTIPs as independent variables.[3] With the focus of this paper on LTIPs, we turn to tests on our two hypotheses. The reasons were explained above for the deployment of a dummy variable indicating the presence of an LTIP scheme in a company. This LTIP dummy (Table


1720

T. Buck et al. Table Ia. Descriptive statistics; mean and standard deviation Variable

Mean

Standard deviation

Ln(total rewards) Shareholder return Ln(sales) CDF of firm’s risk LTIP dummy LTIP dummy ¥ shareholder return R&D/assets CEO dummy CEO and chairman dummy Chairman dummy

13.1855 0.2189 20.9717 0.4915 0.4120 0.0979 0.0326 0.1792 0.0456 0.0705

1.2986 0.2978 1.4000 0.2858 0.4923 0.2083 0.2167 0.3836 0.2086 0.2561

Note: n = 1602.

Table Ib. Descriptive statistics; correlation matrix (prob. value in parentheses) 1. 1. Ln(total rewards) 2. Shareholder return 3. Ln(sales) 4. 5. 6.

7. 8. 9. 10.

2.

3.

4.

5.

6.

7.

8.

9.

10.

1.0000

0.4121 1.0000 (0.0000) 0.1126 -0.0730 (0.0000) (0.0035) CDF of 0.1375 -0.0083 firm’s risk (0.0000) (0.7414) LTIP 0.1466 0.0529 dummy (0.0000) (0.0344) LTIP dummy 0.2398 0.5085 ¥ shareholder (0.0000) (0.0000) return R&D/assets 0.0707 0.0308 (0.0047) (0.2173) CEO dummy 0.2575 0.0177 (0.0000) (0.4790) Dual CEO 0.2021 0.0177 and chair (0.0000) (0.4787) Chair 0.2359 0.0275 dummy (0.0000) (0.2718)

1.0000 0.0987 (0.0001) 0.2170 (0.0000) 0.1187 (0.0000)

1.0000 0.1876 1.0000 (0.0000) 0.0865 0.5618 (0.0005) (0.0000)

-0.1699 0.1219 (0.0000) (0.0000) -0.0531 -0.0188 (0.0335) (0.4513) -0.0664 -0.0028 (0.0078) (0.9098) -0.0291 0.0063 (0.2444) (0.8015)

1.0000

0.0600 0.1223 1.0000 (0.0163) (0.0000) 0.0091 -0.0004 0.0040 1.0000 (0.7150) (0.9881) (0.8714) 0.0056 -0.0030 -0.0205 0.4677 1.0000 (0.8220) (0.9059) (0.4121) (0.0000) 0.0121 0.0092 -0.0133 0.3354 0.7932 1.0000 (0.6280) (0.7117) (0.5944) (0.0000) (0.0000)

II, row 5) shows positive coefficients (significant for Models 1 and 3, though not for Model 2 with a necessarily smaller sample of CEOs, n = 287 compared with n = 1602 for Model 1). Adjusting for logarithms,[4] the presence of an LTIP scheme was, therefore, associated with higher average total rewards for all executives (Model 1) by 31.2 per cent, CEO rewards (Model 2) by a statistically insignificant 17.3 per cent, and other executives’ rewards (Model 3) by 34.7 per cent. These results are consistent with Hypothesis 1, though of course they provide no evi© Blackwell Publishing Ltd 2003


1721

Table II. OLS regressions of performance-pay sensitivity Independent variables

Hypothesis

Constant Shareholder return Ln(sales) CDF of firm’s risk LTIP dummy

H1

LTIP dummy ¥ shareholder return R&D/assets

H2

CEO dummy CEO and chairman dummy Chairman dummy Industry dummies F-test Sample size Adj. R-squared

Model 1 All executives

Model 2 CEO only

Model 3 Other top executives

9.445*** (22.40) 1.985*** (17.31) 0.137*** (6.85) 0.465*** (4.83) 0.312*** (4.39) -0.439** (2.29) 0.384*** (3.01) 0.762*** (9.68) -0.438* (1.95) 1.035*** (6.05) Yes 72.90 (p < 0.001) 1602 0.33

10.611*** (11.30) 2.643*** (10.65) 0.113** (2.53) 0.440** (2.08) 0.173 (1.11) -0.380 (0.91) 0.658** (2.47)

9.344*** (19.93) 1.829*** (14.24) 0.143*** (6.43) 0.464*** (4.31) 0.347*** (4.37) -0.447** (2.08) 0.315** (2.19)

0.57*** (4.20) Yes 23.43 (p < 0.001) 287 0.41

1.036*** (6.00) Yes 51.82 (p < 0.001) 1315 0.26

Dependent variable: log of (salary + annual bonus + benefits + pensions + change in options value + change in options value change in equity value + dividend income + change in value of LTIPs). t-values in parentheses: *** p < 0.01; ** p < 0.05; * p < 0.10.

dence on whether these positive associations are a consequence of reduced agency problems or managerial opportunism. The overall sensitivity of total executive rewards to TSR performance can be obtained from the coefficients shown in rows 2 and 6 of Table II and we now explain their calculation, which is complicated by the fact that TSR has both a direct association with total rewards and also an association as a result of interaction with the LTIP dummy. Thus, for the full estimation of the TSR/total rewards association for those executives with LTIPs, coefficients in row 2 must be summed with those in row 6 of Table II. For example, for Model 1 (all executives) a significant coefficient of 1.985 must be added to a significant (minus) 0.439 to give 1.546. After converting for the total rewards variable being in logarithms,[5] this net coefficient of 1.546 implies that a 10 percentage point increase in TSR yields increases of 15.5 per cent for all executives. In the absence of an LTIP (LTIP = 0), this sensitivity would have been 19.9 per cent. © Blackwell Publishing Ltd 2003

1722

T. Buck et al.

Corresponding pay sensitivities were also calculated for Model 2 (CEOs only) and Model 3 (executives minus the CEOs) to produce estimates of 22.6 per cent with LTIPs versus 26.4 per cent without LTIPs for CEOs (not a statistically significant difference), and 13.8 per cent with LTIPs versus 18.3 per cent without LTIPs for other executives. It is interesting to note that these results reflect the higher responsiveness of total CEO rewards to TSR performance, consistent with CEO pay packages containing higher levels of ESO and LTIP awards. This conclusion is also supported by the significant and positive coefficients on the CEO dummy in Model 1. From an agency perspective, this outcome is consistent with shareholder principals concentrating equity-based rewards on peak officials who make most major entrepreneurial decisions. From a power perspective, however, it is equally consistent with CEOs effectively controlling their own packages in an opportunistic fashion, but needing to conceal this influence from shareholder principals by manipulating the intricate terms of LTIPs rather than by extracting higher salaries. From another perspective, it is possible to examine these sensitivities in terms of absolute rewards for a firm in our 1997–98 sample with the median market capitalization (£1410 m) and the median executive rewards[6] (£967,640), producing a 10 percentage point increase in TSR, hence bringing about an increase in shareholder wealth of £141m. Ignoring the influence of LTIPs for the moment, the results in row 2 of Table II imply that this performance would yield additional pay of (1) £192,077 (2) £255,747 and (3) £176,981. Focusing on CEOs in Model 2, this means in absolute terms that for median CEO total pay of (£967,640) a £1000 increase in shareholder value yields £1.81 for the CEO.[7] Although LTIPs raised total rewards in absolute terms, it can be seen from the interaction of shareholder return with the presence of an LTIP scheme (i.e. the fitted beta times the average value of the descriptor) that LTIPs apparently reduce the sensitivity of total pay to share price performance, significantly so in Models 1 and 3. It should also be noted that, while the coefficient for Model 2 is statistically insignificant, the sign and the dimension of the coefficient is consistent with those of Models 1 and 3. Over the three estimated equations, in terms of the absolute reward per £1000 of shareholder return created the presence of LTIPs reduces the performance sensitivity of the reward from (1) £1.36 to £1.06, (2) £1.81 to £1.55, and (3) £1.26 to £0.95. Results of this magnitude are comparable with other UK studies. For example, Conyon and Murphy (2000, p. 655), with an approximate valuation of LTIPs, report an average performance-pay sensitivity of £2.33 per £1000 in the largest 510 UK companies in the same year as this study. Thus, the broadly comparable results reported here suggest that LTIPs have not transformed UK performance-pay sensitivities, and these remain far below USA levels. For example, our figure of £1.81 (£1.55 with LTIPs) of CEO rewards per £1000 increase in shareholder value compares with the USA estimate of $5.29 per $1000 (Hall and Liebman, 1998). © Blackwell Publishing Ltd 2003


1723

Thus, these findings suggest that the presence of an LTIP reduces performancepay sensitivity, thus leading to the rejection of Hypothesis 2. The obvious conclusion, therefore, is that, as a component of remuneration, an LTIP is associated with higher absolute levels of total executive pay but with lower performance-pay sensitivity. This outcome is not manifestly serving shareholders’ interests. DISCUSSION The association of with-LTIP executive total reward packages with higher levels of absolute reward but lower levels of performance-pay sensitivity has a number of possible explanations. From an agency perspective, shareholders adopting LTIPs deliberately sever the automatic link between share price and executive rewards previously offered by ESOs. Under LTIPs, rewards are often mechanically linked with EPS, with TSR, and with the relative performance of peer groups of companies, rather than to the firm’s absolute share price, as with ESOs. Indeed it is this characteristic that is assumed from an agency perspective to have made LTIPs attractive to many shareholder groups in preference to ESOs. As a reflection of a trade-off between interest alignment and a wish to ensure that executive rewards are ‘earned’, it should be unsurprising, therefore, that LTIPs are associated with lower performance-pay sensitivity. In addition, the bureaucratic nature of LTIP schemes means that they must include ‘flat spots’, i.e. quite wide ranges of TSR within which improved firm performance has no influence on LTIP rewards. The elimination of flat spots is made difficult by LTIP guidelines from institutional investors that insist on no rewards for performance below certain levels. As noted above, the current guidelines published by the ABI specify that share-based performance awards should not be made for less than median performance. Presumably, shareholders adopting LTIPs are prepared to bear the potential cost of higher expected pay packages in order to improve executive incentives. In addition, however, the sheer complexity of many LTIPs, both for executives and specialist researchers, must to some extent dilute any incentive element. From a power perspective, however, LTIPs are a more complex and more bureaucratic incentive than ESOs, but now offer new opportunities for executiveserving packages. While this paper offers no evidence on this question, USA evidence does show that executives have tilted the design of comparator groups, and changes in those groups, in favour of themselves rather than shareholders as a whole. Lower performance-pay sensitivity associated with the presence of LTIPs is understandable in the context of executive opportunism in the design of schemes. From either an agency or a power perspective, it is of course too early to establish trends with only one year’s data, but it seems possible that executive rewards may be subject to changes in fashion and to political cycles. For example, one likely © Blackwell Publishing Ltd 2003

1724

T. Buck et al.

scenario is that: (i) a new remuneration instrument (such as ESOs in the 1980s) is copied from the USA and diffuses across UK companies, but (ii) this gradually attracts media criticism, leading to (iii) tighter regulation by government, and selfregulation by the Stock Exchange, accountancy professions and institutional investors (Blundell and Robinson, 2000), and thus (iv) to more open disclosure of the detailed operation of the instrument and the development of norms for the instrument across firms and industries, to guide both the designers of reward schemes and shareholders wishing to monitor executive rewards. By stage (iv), however, assuming that reward packages serve the interests of managers, instruments that were once novel now become standard items in packages and further innovations may be needed to attract talented executives. Similarly, if packages are manager-serving, the full disclosure of rewards in stage (iv) may attract new criticisms and embarrass recipients. Either way, reward instrument innovations are needed to resume the cycle at (i). While ESOs may have by now reached stage (iv), LTIPs are only approaching (ii). LTIPs and performance conditions for ESOs may have been introduced in 1995 just when ESOs had become transparent, well-understood and controllable by shareholders. Although it is too soon to advocate a return to ESOs our results do question the efficacy of what amounts to the self-regulation of executive rewards through committees formed by accountancy bodies and the London Stock Exchange. Attempts at self-regulation should have anticipated that companies would offer to executives portfolios of ESOs and LTIPs. In terms of the development of theory and future research, a number of observations can be made. Evidence of reduced performance-pay sensitivities raises questions about continued reliance on the agency perspective as a traditional basis for hypothesis generation in relation to executive rewards. At the same time, however, it seems likely that the agency tradition will continue, if only as a source of ‘straw man’ hypotheses to be knocked down in tests. However, results presented here suggest links between this particular topic and the wider literature on governance, monitoring and entrepreneurship. For example, it is legitimate to question LTIPs as an example of the bureaucratization of corporate governance, and thus a potential barrier to entrepreneurial action (Short et al., 2000). A number of future research directions are suggested by the study. Of course data collection beyond a single cross-section is vital, though arduous, if only to establish first differences of variables and to reduce the size of coefficients on constants in regressions. This could establish whether the first year of LTIPs included any ‘one-off ’ element. In the very long term, dynamic panel data could facilitate the identification of directions of causation, and, in particular, estimates of the ex ante incentive effects of executive rewards. Furthermore, since one function of LTIPs is supposed to be an attempt to reward executives for performance improvements under their control, experimentation is needed in relation to the influence of relative performance on executive rewards, where a company’s TSR © Blackwell Publishing Ltd 2003


1725

is related to a variety of alternative indicators of industrial performance. The authors are proceeding with this avenue of research, though problems with levels of industrial disaggregation and the classification of conglomerate firms does raise considerable difficulties. Finally, it should be re-emphasized that regression analysis, or rather the data problems of quantifying all variables, can never give a complete picture of rewards innovations and should be supplemented by parallel surveys of executive perceptions of reward packages and by company case studies. NOTES *The authors wish to acknowledge generous assistance for this project from the Leverhulme Trust. Dr Henry Udueni tragically died in December 2000 when this paper was substantially complete. Professors Bruce, Buck and Main pay tribute to his heroic contribution to the project despite his illness. [1] See Arellano and Bond (1988) for a discussion. [2] This variable was also interacted with shareholder return to provide a risk-adjusted return but the term was insignificant and dropped form the regressions. Attempts to include a variable indicating the presence of a significant institutional blockholder and a variable representing the number of members on a firm’s remuneration committee were also insignificant. [3] These results were checked against robust regression analysis which guards against the influence of outliers. The consequent results are substantially unchanged and we, therefore, feel confident in presenting the ordinary least squares results of Table II. [4] To be specific, and ignoring the indirect influence of LTIPs for the moment, we have:

∂ log( pay ) = (0.312) ∂ ( LTIP ) Dpay \ = (0.312)D( LTIP ) pay if D( LTIP ) = 1.0, i.e., introduce an LTIP scheme, Dpay = 0.312 or 31.2% pay [5] To be specific and including the indirect influence of LTIPs:

∂ log( pay ) = (1.985 - 0.439LTIP ) ∂ (shareholder return ) Dpay \ = (1.985 - 0.439LTIP )D(shareholder return ) pay if D(shareholder return ) = 0.10 and LTIP = 1, Dpay = 0.1546 or 15.5% pay [6] This is actually the sample median figure for CEOs. [7] The corresponding number for all executives is £1.36 and for non-CEOs is £1.26.

REFERENCES Abowd, J. M. (1990). ‘Does performance-based managerial compensation affect corporate performance?’. Industrial and Labor Relations Review, 43, Special Issue, 52–73. © Blackwell Publishing Ltd 2003

1726

T. Buck et al.

Aggarwal, R. K. and Samwick, A. A. (1999). ‘The other side of the trade-off: the impact of risk on executive compensation’. Journal of Political Economy, 107, 1, 65–105. Arellano, M. and Bond, S. (1988). ‘Dynamic Panel Data Estimation Using DPD – A Guide for Users’. Working Paper Series #88/15, London: Institute of Fiscal Studies. Benston, G. J. (1985). ‘The self-serving management hypothesis’. Journal of Accounting and Economics, 7, 2, 67–84. Bertrand, M. and Mullainathan, S. (2001). ‘Are CEOs rewarded for luck? The ones without principals are’. Quarterly Journal of Economics, 116, 3, 901–32. Blundell, J. and Robinson, C. (2000). Regulation without the State. London: IEA. Conyon, M. J. (1998). ‘Directors’ pay and turnover: an application to a sample of large UK firms’. Oxford Bulletin of Economics and Statistics, 60, 4, 485–507. Conyon, M. J. and Murphy, K. J. (2000). ‘The prince and the pauper? CEO pay in the United States and United Kingdom’. Economic Journal, 110, 647, 640–71. Conyon, M. J. and Sadler, G. V. (2000). ‘Executive Pay and Corporate Performance’. Mimeo, University of Warwick Business School. Fenn, G. W. and Liang, N. (2001). ‘Corporate payout policy and managerial stock incentives’. Journal of Financial Economics, 61, 1, 45–72. Gioia, D. A. and Thomas, J. B. (1996). ‘Institutional identity, image and issue interpretation’. Administrative Science Quarterly, 41, 3, 370–403. Gregg, P., Machin, S. and Szymanski, S. (1993). ‘The disappearing relationship between directors’ pay and corporate performance’. British Journal of Industrial Relations, 31, 1, 1–9. Hall, B. J. and Liebman, J. B. (1998). ‘Are CEOs really paid like bureaucrats?’. Quarterly Journal of Economics, 111, 3, 653–91. Hall, B. J. and Murphy, K. J. (2002). ‘Stock options for undiversified executives’. Journal of Accounting and Economics, 33, 1, 3–42. Hermalin, B. E. and Wallace, N. E. (2001). ‘Firm performance and executive compensation in the savings and loan industry’. Journal of Financial Economics, 61, 1, 139–70. Holderness, C. G., Kroszner, R. S. and Sheehan, D. P. (1999). ‘Were the good old days that good? Changes in managerial stock ownership since the Great Depression’. Journal of Finance, 54, 2, 435–69. Hoskisson, R. E. and Turk, T. A. (1990). ‘Corporate restructuring: governance and control limits of the internal capital market’. Academy of Management Review, 15, 3, 459–77. Jensen, M. C. and Murphy, K. J. (1990). ‘Performance pay and top-management incentives’. Journal of Political Economy, 98, 2, 225–64. Kole, S. (1997). ‘The complexity of compensation contracts’. Journal of Financial Economics, 43, 1, 79–104. McKnight, P. J. and Tomkins, C. (1999). ‘Top executive pay in the United Kingdom: a corporate governance dilemma’. International Journal of the Economics of Business, 6, 2, 223–43. Main, B. G. M., O’Reilly, C. A. III and Wade, J. (1995). ‘The CEO, the Board of Directors, and executive compensation: economic and psychological perspectives’. Industrial and Corporate Change, 4, 2, 293–332. Main, B. G. M., Bruce, A. and Buck, T. (1996). ‘Total board remuneration and company performance’. Economic Journal, 106, 439, 1627–44. Monks Partnership (2001). Management Pay UK: Incentives. Saffron Walden: Monks Partnership. Morck, R., Shleifer, A. and Vishny, R. (1988). ‘Management ownership and market valuation: an empirical analysis’. Journal of Financial Economics, 20, 1/2, 293–316. Murphy, K. J. (1998). ‘Performance Standards in Incentive Contracts’. Mimeo, University of Southern California (March). Murphy, K. J. (1999). ‘Executive compensation’. In Ashenfelter, O. and Card, D. (Eds), Handbook of Labor Economics, Vol. 3. Amsterdam: North Holland, 1–89. O’Reilly, C. A. III, Main, B. G. M. and Crystal, G. S. (1988). ‘CEO salaries as tournaments and social comparisons: a tale of two theories’. Administrative Science Quarterly, 33, 2, 257–74. Pettigrew, A. and McNulty, T. (1995). ‘Power and influence: in and around the boardroom’. Human Relations, 48, 8, 845–73. Porac, J. F., Wade, J. B. and Pollock, T. G. (1999). ‘Industry categories and the politics of the comparable firm in CEO compensation’. Administrative Science Quarterly, 44, 1, 112–44. Rediker, K. J. and Seth, A. (1995). ‘Boards of directors and substitution effects of alternative governance mechanisms’. Strategic Management Journal, 16, 2, 85–99. © Blackwell Publishing Ltd 2003


1727

Rosen, S. (1992). ‘Contracts and the market for executives’. In Werin, L. and Wijkander, H. (Eds), Contract Economics. Oxford: Blackwell. Short, H. and Keasey, K. (1999). ‘Managerial ownership and the performance of firms: evidence from the UK’. Journal of Corporate Finance, 5, 1, 79–101. Short, H., Keasey, K. and Wright, M. (2000). ‘Corporate governance: accountability versus enterprise’. Corporate Governance and the Reform of Company Law. Hume Papers on Public Policy, 8, 1, 70–91. Thomas, L. G. III and Waring, G. (1999). ‘Competing capitalisms: capital investment in American, German and Japanese Firms’. Strategic Management Journal, 20, 8, 729–48. Veliyath, R. (1999). ‘Top management compensation and shareholder returns: unravelling different models of the relationship’. Journal of Management Studies, 36, 1, 123–43. Westphal, J. D. and Zajac, E. J. (1998). ‘The symbolic management of shareholders: corporate governance reforms and shareholder reactions’. Administrative Science Quarterly, 43, 1, 127–53. Zeckhauser, R. J. and Pound, J. (1990). ‘Are large shareholders effective monitors? An investigation of share ownership and corporate performance’. In Hubbard, R. G. (Ed.), Corporate Finance and Investment. Chicago: University of Chicago Press.
