THE EFFECT OF REMUNERATION
COMMITTEE QUALITY ON THE
ASSOCIATION BETWEEN CEO PAY AND
FIRM PERFORMANCE
by
Gineke Jager
University of Groningen
Faculty of Economics and Business
June, 2013
Wordcount: 12826 (excluding appendix)
Streek 21
8464 NB Sintjohannesga
06-14848234
Gineke.jager@gmail.com
1
ABSTRACT
The purpose of this study is to gain insight on the influence of the remuneration committee quality on the association between firm performance and CEO pay, i.e. the pay-performance sensitivity. A sample that consists solely of U.K. firms, using a one-tier board structure, from 2006 to 2009, led to a maximum of 950 observations. Results show that firm performance is positively associated with CEO pay, when firm performance is measured as ROE, ROA and Tobin’s Q. We also find that the proportion of independent directors among all remuneration committee members negatively influences the pay-performance sensitivity, when ROE and ROA are used as the measure of firm performance. The number of meetings held by the committee also negatively influences the pay-performance sensitivity, when firm performance is measured as ROA. Moreover, the proportion of female directors on the remuneration committee is positively associated with the pay-performance sensitivity, when stock market returns is used to measure firm performance.
Key Words: Corporate governance, remuneration committee quality, pay-performance
sensitivity.
2
ACKNOWLEDGEMENTS
Hereby I proudly present my master’s thesis. In the past five months I have worked with pleasure and effort on this research. This master’s thesis is part of my master’s degree in Business Administration with the specialization Organizational and Management Control. I would like to express my appreciation and gratitude to my supervisor Drs. Abdul Rehman Abbasi and my second supervisor Dr. Bo Qin for their time and effort. The helpful feedback, the advice and expertise that were provided, have helped me in all the time of research and writing of this thesis.
3
1 INTRODUCTION
Following the ‘classic’ agency theory, the interests of the firm’s shareholders and the CEO could be aligned through the remuneration package of the CEO (Anderson & Bizjak, 2003; Carter, Simkins & Simpson, 2003; Jensen & Meckling, 1976). If both shareholders and CEO are utility maximizers, we may believe that the CEO may not always act in the best interests of the shareholders. The shareholders can reduce divergences from his interest by determining appropriate incentives for the CEO (Jensen & Meckling, 1976). Another view is the three-tier agency model, which adds an extra layer in between the CEO and the shareholders by a supervisory board (Kofman & Lawarrée, 1993). In this model, it is expected that the interests of the supervisory board are aligned with the interests of the shareholders. However, according to the managerial approach, this alignment may not naturally exist (Bebchuk & Fried, 2003). The interests of the shareholders and the CEO, who performs services on behalf of the shareholders, may not always converge. What seems to be the best option for the shareholder is not always the best option for the CEO (Noe, Hollenbeck, Gerhart & Wright, 2010), therefore CEOs receive a remuneration package. When the supervisory board’s interests are not aligned with the shareholder’s interests, the CEO may be able to influence the supervisory board, consequently, influence his or her own compensation. Whenever the remuneration committee governance quality is low, this could indicate that the CEO is able to influence his or her own remuneration and thus could extract rents. Therefore, it is important to study the governance quality of the committee, as remuneration committee quality differs due to committee size and other factors related to the committee and its members (Sun & Cahan, 2009). Newman and Mozes (1999) also provide evidence that the composition of the remuneration committee matters, since it influences CEO remuneration practices and thus firm value. These authors also state that since the remuneration committee plays such an important role in setting the remuneration of the CEO, and since certain factors affect a firm’s decisions, it is important to explore whether the composition of the committee influences CEO remuneration practices. Accordingly, the purpose of this paper is to research what factors have an affect on the quality of the remuneration committee, which in turn can influence the association between CEO pay and firm performance. More specifically, this research will give us an inside whether the composition and structure of the committee actually matters. Do independence, efficiency, and diversity among the remuneration committee members have influence of the association between CEO pay and firm performance?
4 the measure of remuneration committee quality is incomplete or too narrow. Broader measures that are related to the composition and structure of the committee might be better for measuring the quality of this committee.
Therefore, the following research question will be addressed in this thesis: ‘What is the
influence of remuneration committee quality on the association between CEO pay and firm performance?’
My research will contribute to the literature in the following ways. First, most previous research (Anderson & Bizjak, 2003; Newman & Mozes, 1999; Vafeas, 2003a) only included remuneration committee independence as a measure of remuneration committee quality. In my research, however, I will use a broader measure, which also includes efficiency and diversity. The combination of these three measures has not been used before. It is important to include both efficiency and diversity. A committee that is efficient and effective is more competent and effective in its decision-making. In this research, this is measured by the size of the committee and the number of meetings the committee has held. According to Conger, Finegold and Lawler III (1998), the efficiency of the board is increased by board meeting time. The size of the committee matters due to the fact that the CEO is less likely to impact a larger committee (Sun, Cahan & Emanuel, 2009). Diversity also matters as it improves the decision-making process (Carter, Simkins & Simpson, 2003). The review (2003), commissioned by the British department of trade and industry, provided recommendations regarding governance, i.e., about gender diversity. The report called for more gender diversity among boards, since it positively impacts board effectiveness. Second, my study contributes to the literature as it is based on a sample of UK listed firms. This is unique because many previous studies concerning this topic are based on U.S. samples (Anderson & Bizjak, 2003; Newman & Mozes, 1999; Perry & Zenner, 2011; Sun & Cahan, 2009; Vafeas, 2003a). This research may be of particular interest in the U.K. context, in which remuneration committees are advised by the Cadbury Code (1992) to comprise of independent directors and should be chaired by an independent director. Do the individual firms follow the advice of the Cadbury code (1992) and what is the influence on the association between CEO pay and firm performance and is there a difference with firms that do not follow the advice?
In the upcoming sections the relevant literature will be discussed. In section two, the different theories and main articles will be discussed, and also an overview will be given on the regulations for U.K. one-tier boards. In the section thereafter the quality of the remuneration committee is defined and hypotheses are formed. Section four will be the methodological section. Section five will present the results, followed by the discussion and conclusion in section six.
2 THEORETICAL BACKGROUND
5
2.1 Board structure and U.K. regulations
Most of the previous studies presented above retrieved data from the United States. Regulations and legislation differ between the U.K. and U.S. In the U.S. the chairman of the board and CEO are in many cases the same person, however, in the U.K. this happens infrequently. Also, in the United Kingdom, the U.K. combined code provides suggestions, e.g., that the remuneration committee is completely staffed with independent directors. Since this research focuses on the U.K., the most important U.K. regulations will be discussed below.
Regarding the structure of the board, U.K. firms adopt a one-tier board system, like U.S. firms; while in some countries like the Netherlands and Germany most firms operate a two-tier board structure. This two-two-tier board is used as a means to improve corporate governance. The executive board, which includes the firm executives, normally run the day-to-day operations, while the supervisory board, which include only non-executive directors, hire and fire the members of the executive board, determine their compensation, and review important firm decisions. In a one-tier board all directors (executive directors and non-executive directors) form one board and take combined decisions. Within this system, many boards include several executives from the firm (who are ex officio members of the board). Non-executive directors hold crucial positions, including remuneration committees. With regard to corporate governance, the U.S. and the U.K. differ in an important respect as mentioned above. In the U.K., the CEO normally does not serve as Chairman of the board, where in the U.S., the CEO can also be the chairman of the board. The U.K. combined code recommends that the roles of the chairman and CEO should be separated. This is only a recommendation though, it is up to individual firms to comply or explain their choice. In a two-tier board there is a clear split between the CEO and the chairman (Mertens & Knop, 2010).
6 committee should comprise at least three, or in case of smaller firms1 two independent
non-executive directors.
The Combined Code is the main document directing U.K. listed firms in determining their corporate governance structures and practices and it forms part of the listing requirements for the London Stock Exchange (Shaukat & Padgett, 2005). A particular section about the remuneration is mentioned in the U.K. Corporate Governance Code, Financial Reporting Council, September 2012:“Levels of remuneration should be sufficient to attract, retain and
motivate directors of the quality required to run the company successfully, but a company should avoid paying more than is necessary for this purpose. A significant proportion of executive directors’ remuneration should be structured so as to link rewards to corporate and individual performance”. “There should be a formal and transparent procedure for developing policy on executive remuneration and for fixing the remuneration packages of individual directors. No director should be involved in deciding his or her own remuneration”.
2.2 Theories
The agency theory explains the relationship between principles (shareholders) and agents (firm executives) (Anderson & Bizjak, 2003; Carter et al., 2003; Jensen & Meckling, 1976). The theory deals with two issues, namely that the goals of the principles and the agents might conflict, and the principles and agents reconcile dissimilar acceptances for risk. As soon as the interests of the principle are not in line with the interests of the agent, the goals of the principle might not be realized since the agent strives for different goals. This lack of goal alignment should be limited, by compensating the agent with the correct incentives. According to the optimal contracting theory, remuneration could be a solution to the agency problem, where remuneration should offer optimal schemes of managerial compensation to the agent in order to maximize shareholder’s wealth (Bebchuk & Fried, 2003). The above shows that it is important for a firm’s shareholders to provide the firm’s executives with the correct incentives for both short-term and long-term.
A different approach, which could be used to solve the agency problem, is the managerial power approach. In this approach executive remuneration is not solely viewed as a solution, but it is also part of the agency problem itself. Instead of the provision of efficient incentives, certain pay arrangement features seem to reflect managerial rent seeking (Bertrand & Mullainathan, 2001; Blanchard, Lopez-de-Silanes & Shleifer, 1994).
The three-tier agency model provides an extra level between the principal and the agent: the supervisor. The value of this three-tier model is that it pays attention to the supervisor’s incentives to promote shareholder value. The idea behind this model is that shareholders (the principles) assign monitoring authority to an independent supervisor (e.g., remuneration committee) who assesses the agent (e.g., executive board). Depending on its interests, the supervisor can either work in the shareholder’s best interest, or ‘conspire’ with management (Conyon, 2006). Besides conspiring, the supervisory board might also have an incentive to take decisions in favor of the executive board. Usually, the supervisor would like to be reappointed; therefore this could be an incentive to not develop a reputation for haggling with the CEO (Bebchuk & Fried, 2003).
7 These theories above use personal self-interest as the basis; however, the stewardship theory shows an alternative perspective regarding the behavior of management. This theory holds that the executive is a steward who is interested in the goals of the firm and inherently seeks to do a good job, and maximize shareholder’s value (Donaldson & Davis, 1991).
2.3 Previous research
8
3 HYPOTHESIS DEVELOPMENT
In previous studies, attention has been paid to the quality of remuneration committees and supervisory boards. The key features that provide an indication of quality are scaled into several key groups namely independence, efficiency, and diversity. These factors will be explained below. When the remuneration committee quality increases, this should have a positive impact on the association between CEO pay and firm performance. Hypotheses are formed concerning the expected influence of the single quality indicators on the association between CEO pay and firm performance.
3.1 Independence
Many studies have been done on insiders and affiliated directors on remuneration committee and supervisory boards, and their influence on CEO compensation (Anderson & Bizjak, 2003; Vafeas, 2003a), and consequently firm performance. Following the rather broad definition of Anderson and Reeb (2004), an independent director, sometimes also known as an outside director or a non-executive director, is defined as a director that does not have employment, family of business relationships with the company that they serve as a director. Inside directors may be more closely tied to the CEO, and therefore might feel obliged to offer the CEO a remuneration package that keeps him satisfied, instead of offering compensation that would give him the right incentives. Therefore, the expectation is that the proportion of independent directors will have a positive impact on the association between CEO pay and firm performance.
3.2 Efficiency
Certain remuneration committees are more efficient than others. A committee that is more efficient is more effective in its decision-making and is therefore hypothesized to increase the quality of the remuneration committee and consequently the association between CEO pay and firm performance. Two factors are considered regarding efficiency: the size of the committee and the number of meetings held by the committee.
3.2.1 Committee size
9
3.2.2 Number of meetings
A high frequency of committee meetings might signal good monitoring and large adjustments of the remuneration of the CEO, and consequently a high committee quality. Besides, it has been contended that regular meetings allow directors more time to discuss, set strategy, and to evaluate managerial performance (Vafeas, 1999). This could assist directors to stay informed and up-to-date about important developments within the company, and thus place them in a better position to timely address emerging critical issues (Mangena & Tauringana, 2008). Further, Lipton and Lorsch (1992) state that regular meetings can form and strengthen cohesive relationships among directors, and thereby positively influence firm performance. An opposing view is that a high number of meetings could also signal inefficiency and do not benefit the shareholders. Vafeas (1999) claims that usually the limited time directors spend with each other is not used for the meaningful exchange of thoughts and ideas among themselves. Instead, presentation of management reports and several formalities take up much meeting time, and therefore this reduces the time that directors would use to monitor management (Lipton & Lorsch, 1992). Besides, board meetings are expensive in the form of managerial time, directors’ meeting fees, directors’ travel expenses and refreshments (Vafeas, 1999) that could negatively impact firm performance. Number of meetings has not been used before as a proxy for remuneration committee quality, however, it has been investigated in relation to the board of directors. Conger, Finegold and Lawler III (1998) stated that board-meeting time is an important resource in increasing the efficiency of the board. These findings of Conger et al. are followed in formulating the hypothesis. The number of meetings is expected to have a positive impact on the quality of the remuneration committee. The number of meetings is measured as the number of meetings in person as mentioned in the annual report.
3.3 Diversity
Diversity is defined as the degree whether there are similarities or differences between teams and groups (Jackson, Joshi & Erhardt, 2003). Taking diversity of the committee into consideration, certain advantages and disadvantages of diversity have to be considered. First, teams or groups that are more heterogeneous give access to more resources. This is in line with the resource dependency theory, which suggests that board members, and therefore also remuneration committee members, are expected to provide the firm several resources like expertise, guidance connections, counsel, and the ability to link the firm to key stakeholders (Hillman & Dalziel, 2003). And second, a diverse committee suffers less from so-called groupthink, due to the different perspectives and creativity within the board. According to Watson, Kumar and Michaelson (1993), board diversity, and subsequent committee diversity may become a competitive advantage, since it conducts to a larger knowledge base, and it increases innovation and creativity. An opposing view would be that due to committee diversity directors have different ideas and perspectives which could lead to more conflicts and coordination issues (Carter, Simkins & Simpson, 2003), and thus a more time consuming decision-making process.
3.3.1 Gender diversity
10 committee; only half of the female directors available serve on the remuneration or audit committee (Conyon & Mallin, 1997). Singh, Vinnicombe & Johnson (2001) stated that non-executive directorship is uncommon among women. The percentage of female directors on the board in the U.K. is on average 15%, which is larger than the average in Europe, however, this percentage has not increased after 2005 (Heidrick & Struggles, 2009).
Even though the number of female non-executives is low, the presence of women on the supervisory board may have benefits for the firm. According to Bilimoria and Wheeler (2000) and Mattis (2000) female directors deal effectively and efficiently with diversity in product and labor markets, which leads to a competitive advantage, and improves firm performance. Also, female directors are the leaders for change, since they are more open-minded to new ideas and approaches of doing business (Bilimoria & Wheeler, 2000). Adams and Ferreira (2009) concluded that female directors are less likely to miss meetings, and when there are more woman seated on the board, male directors are less likely to miss meetings as well. Also, the authors found that boards with more gender diversity provide their directors with higher pay-for-performance. Following the above findings in formulating a hypothesis, it is expected that the presence of female directors on the remuneration committee will be most efficient. Therefore, the proportion of female directors serving on the committee is used to determine gender diversity. It is expected that gender diversity has a positive influence of the association between firm performance and CEO pay.
Based on previous literature presented above, I expect a positive relationship between remuneration committee quality and the association between CEO pay and firm performance. Therefore, the following hypothesis are formulated:
H1: Firm performance is positively associated with CEO pay.
H2: There is a positive interaction effect of the proportion of independent directors on the
remuneration committee on the association between firm performance and CEO pay. H3: There is a positive interaction effect of the size of the remuneration committee on the
association between firm performance and CEO pay.
H4: There is a positive interaction effect of the number of meetings held by the
remuneration committee on the association between firm performance and CEO pay. H5: There is a positive interaction effect of the proportion of female directors on the
remuneration committee on the association between firm performance and CEO pay.
3.4 Conceptual framework
11 Figure 1 Conceptual framework
4 METHODOLOGY 4.1 Data collection
The sample includes 245 listed firms from the U.K., from both FTSE 350 and FTSE SmallCap from 2006 to 2009. The FTSE 350 is the stock index of the 350 most highly capitalized U.K. firms listed on the London Stock Exchange (LSE). The FTSE SmallCap is an index of the 351st to the 619th largest listed organizations on the LSE. Financial and utility
firms were excluded from the sample, since these firms differ from other organizations and industries and the research would be biased if they were included. Information on the composition of the remuneration committee is obtained from annual reports of these firms. Information on the financial performance of these firms is obtained using databases available at the Rijks Universiteit Groningen (RUG).
4.2 Model
For the individual variables that indicate the quality of the remuneration committee, holds that the impact on the association of CEO pay and firm performance has to be determined separately for each variable, namely proportion of independent directors, committee size, committee meetings and gender diversity. The proposed multiple regression model is:
CEO pay = β0 + β1 Firm performance + β2 Remuneration committee quality + β3 (firm
performance * Remuneration committee quality) + β4 Firm size + β5 Leverage + β6 Growth
and investment opportunity + Σ Dummy industry + Σ Dummy year + ε.
Where β0 denotes the constant, β1 through β6 denote the coefficients to be estimated and ε is
the error term. In order to control for industry-specific effects and time-specific effects that might impact the association between CEO pay and firm performance, industry and year dummies are added in the regression analysis.
4.3 Measurements
In this section an explanation will be given about the above presented dependent, independent, moderator and control variables and how they will be measured in this thesis.
12
4.3.1 Dependent Variable
In this thesis, pay-performance sensitivity will be used to measure the association between CEO pay and firm performance. Following the agency theory, and assuming that the shareholder is a utility maximizer, we could state that the interest of the shareholder is to maximize its own payoff. Consequently, a firm’s financial performance should be as high as possible, which will also benefit the shareholders by a higher payoff. Therefore, the association between CEO pay and firm performance will be measured as the degree to which pay is related to performance: pay-performance sensitivity. In line with Jensen and Murphy (1990), pay-performance sensitivity is defined as the pond change in the CEOs wealth associated with a pond change in the wealth of shareholders. Higher pay-performance sensitivity can be interpreted as a closer alignment of interests between the shareholders and CEO. Since it is hard to measure pay-performance sensitivity directly, CEO pay is used as the dependent variable. Instead of using bonus or salary as a separate measure for CEO cash compensation, following Leone, Wu and Zimmerman (2006) and Sun and Cahan (2009), total cash compensation including the sum of bonus and salary, will be used as a measure of CEO compensation. This is a better measure for CEO cash compensation than its component, since not all firms have a bonus plan and might therefore adjust CEO salary to compensate for this. The natural logarithm of cash compensation will be used, in order to reduce impact of skewed distribution. Besides, differences in the magnitude of remuneration across firms may be reduced using the log transformation (Sun & Cahan, 2009).
4.3.2 Independent variables
13 divided by its total assets. This ratio shows how profitable a firm is comparative to its total assets. Tobin’s Q is determined by the total market value of the firm + total liabilities divided by the total book value of the firm + total liabilities. Stock market returns are the earnings gained from the stock market by making money out of trading shares in the secondary market.
4.3.3 Moderator variables
In order to measure the proportion of independent directors on the remuneration committee, the number of independent directors on the committee is divided by the total number of directors on the committee (Vafeas, 2003a). The committee size is measured as the amount of remuneration committee members, as mentioned in the annual report. The number of meetings is determined as the number of meetings held by the remuneration committee, as mentioned in the annual report. And last, a typical method to measure gender diversity is to calculate the proportion of female directors on the remuneration committee. This is determined by dividing the number of female directors on the committee by the total number of directors on the committee (Carter et al., 2010), as can be found in the annual report.
4.3.4 Control variables
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Table 1
Industry classifications
Code Industry
SIC 1 Consumer non-durables – food, tobacco, textiles, apparel, leather, and toys.
SIC 2 Consumer durables – cars, TV’s, furniture, and household appliances.
SIC 3 Manufacturing – machinery, trucks, planes, off furn, paper, and com printing.
SIC 4 Energy – oil, gas, and coal extraction and products.
SIC 5 Chemicals and allied products.
SIC 6 Business equipment – computers, software, and electronic equipment.
SIC 7 Telephone and television transmission
SIC 8 Utilities
SIC 9 Shops – wholesale, retail, and some services (laundries, and repair shops).
SIC 10 Healthcare, medical equipment, and drugs. SIC 11 Money finance.
SIC 12 Other – mines, construction, bldmt, transportation, hotels, bus service, entertainment.
Table 2 summarizes the variable definitions.
Table 2 Variable definitions
Variable Definition
LN (CEO pay) The natural logarithm of total cash compensation including the sum of bonus and
salary.
ROE Return on equity, measured by net income divided by total equity.
ROA Return on assets, measured by net income divided by total assets.
Tobin’s Q Measured by total market value of firm + total liabilities divided by the total book
value of firm + total liabilities.
Stock market returns Returns gained from the stock market by making profit out of trading shares in the
secondary market.
Proportion independent directors
The proportion of independent directors among all remuneration committee members.
Size of committee The total number of remuneration committee members.
# of meetings The total number of meetings per year held by the remuneration committee.
Proportion female
members
The proportion of female directors among all remuneration committee members.
LN (total assets) The natural logarithm of book value of total assets.
Leverage The ratio of total liabilities to total assets.
MtB Growth opportunity measured by the ratio of market value of equity to book value of
equity.
Year dummy A dummy that accounts for differences in year.
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5 RESULTS
5.1 Descriptive Statistics
Table 3 shows the descriptive statistics of the 245 firm from 2006 to 2009 before winsorizing and includes the number of observations, the mean, the standard deviation, the 1st, 25th, 50th,
75th and 99th percentile.
Table 3 Descriptive statistics
The table above shows the discrepancy of the dependent variable LN (CEO pay), implying that there is a big difference in cash compensation among CEOs. The 1st percentile is 11.362
and the 99th percentile is 15.049. The mean is 13.512, and the median is 13.488, and this
implies that the distribution is positively skewed.
The independent variable firm performance, measured by ROE, has a 1st percentile of -2.328
and a 99th percentile of 3.50321. The negative number can be explained by large differences
between net income and shareholders equity with often a minus sign. The large number for the 99th percentile can be explained due to firms that have a high net income but use a minimum of owner’s equity. The mean is .139 and the standard deviation of 1.886, which is much lower than Newman and Mozes (1999) found in their study. These authors presented a mean of .58 and a standard deviation of 25.99 for outsider-influenced firms. Firm performance measured by ROA has a 1st percentile of -0.155 and a 99th percentile of 0.2633.
The mean is 0.064, and the median is 0.058, thus the distribution is positively skewed. These numbers are higher than the statistics that Kuang and Qin (2009) found in their study. The statistics of Tobin’s Q show that the 1st percentile is 0.200 and the 99th percentile is 4.2. The mean is 1.238, and the median is 1.000, indicating that the distribution is positively skewed. Stock market returns, also a measure of firm performance, has a 1st percentile of 0.109, and a
99th percentile of 5.0866. Its mean is 1.1453, and the median is 1.0307, and is positively
skewed.
The first moderator variable is the proportion of independent director. The mean proportion of independent members on the remuneration committee is 99.38% and a standard deviation of 4.023%. This extremely high percentage indicates that most firms comply with the suggestion of the Cadbury report (1992) and Greenbury report (1995) that the remuneration committee should comprise of non-executive directors. The second moderator variable is the size of the
Variable N Mean Std.
Dev.
1st perc. 25th perc. Median 75th
perc. 99th perc. LN (CEO pay) 947 13.5119 .690 11.3616 13.1184 13.4884 13.9404 15.0490 ROE 689 .1387 1.8858 -2.3279 .0809 .1713 .2642 3.5032 ROA 893 .0637 .0672 -.1552 .0323 .0575 .0933 .2633 Tobin’s Q 689 1.238 .7988 .200 .700 1.000 1.600 4.200 Stock market returns 893 1.1453 .8248 .1088 .7184 1.0307 1.3556 5.0866
Prop. ind. memb. 950 99.38% 4.023% 75,0% 100,0% 100,0% 100,0% 100,0%
16 remuneration committee. The mean of this variable is 3.753 and it has a standard deviation of .9623. The 1st percentile is a committee of 2 members and the 99th percentile is a committee
of 6 members. This infers that the individual firms comply with the Combined Code that the committee should comprise at least three, or in case of smaller firms2 two independent non-executive directors. The third moderator variable is number of meetings held per year by the remuneration committee. The mean is 4.49 meetings and it has a standard deviation of 1.946. The 1st percentile is 1 meeting, and the 99th percentile 10.49, which indicates that there is
quite a difference regarding the number of meetings held by the individual firms. The last moderator is the proportion of female directors on the remuneration committee. The mean is 9.803% female directors and the standard deviation is 15.54%. The 1st percentile is 0%, and
the 99th percentile is 58.168, representing that there are remuneration committees that
comprise more female than male directors.
The first control variable is firm size measured by the natural logarithm of total assets. The mean found in this research is 7.144, the standard deviation is 1.625, and the median is 6.959. This indicates that the distribution is positively skewed. These numbers are a little higher than the statistics Kuang and Qin (2009) reported. Another variable used as control variable is leverage. The mean is .620, the standard deviation is .206 and the median is .632. This implies that the distribution is negatively skewed. These figures are again slightly higher than the numbers presented by Kuang and Qin (2009). Last control variable is growth and investment opportunity measured by market-to-book ratio. The mean is 1.133, the standard deviation is also 1.133, and the median is .858, indicating that this distribution is positively skewed.
5.2 Pearson correlation analysis
The following part presents the results of the correlation analysis. This analysis is done to give insight in the linear relationship between the variables. In order to reduce the influence of outliers, the continuous variables are winsorized. With winsorizing, all data below the 5th
percentile is set equal to the 5th percentile, and all data above the 95th percentile is set equal to
the 95th percentile. The Pearson correlation matrices are presented in the appendices.
Using a significance level of 0.10, we can see in appendix 2 that firm performance measured by ROE, has a positive significant correlation with the dependent variable CEO pay (r=0.073, p-value=0.058). The moderating variable proportion of independent directors on the remuneration committee has a negative significant correlation with CEO pay (r=-0.057, p-value=0.078). The size of the remuneration committee has a positive significant correlation with CEO pay (r=0.319, p-value=0.000). The number of meetings held by the remuneration committee has a positive significant correlation with CEO pay (r=0.218, p-value=0.000). It can be seen that the proportion of female directors on the remuneration committee has a positive significant correlation with CEO pay (r=0.125, p-value=0.000).
Also, we will take a look if the product terms are significantly correlated with the dependent variable CEO pay. The interaction effect ‘proportion of independent directors on the committee * ROE’ has a positive significant correlation with CEO pay (r=0.073, p-value=0.057). The product term ‘size of the remuneration committee *ROE’ has a positive significant correlation with CEO pay (r=0.075, p-value=0.048). The interaction predictor
17 ‘number of meetings held by the remuneration committee * ROE’ has a positive significant correlation with CEO pay (r=0.083, p-value=0.030). The product term ‘proportion of female directors on the remuneration committee * ROE’ is not significantly correlated with the dependent variable CEO pay (r=0.028, p-value=0.457).
Appendix 3 shows the results of the correlation analysis using ROA as a measure of firm performance. ROA has a positive significant correlation with CEO pay (r=0.118, p-value=0.000). The product term ‘proportion of independent directors on the committee * ROA’ has a positive significant correlation with CEO pay (r=0.115, p-value=0.001). The interaction effect ‘size of the remuneration committee *ROA’ has a positive significant correlation with CEO pay (r=0.191, p-value=0.000). The interaction predictor ‘number of meetings held by the remuneration committee * ROA’ has a positive significant correlation with CEO pay (r=0.194, p-value=0.000). The interaction effect ‘proportion of female directors on the remuneration committee * ROA’ has a positive significant correlation with CEO pay (r=0.158, p-value=0.000).
In appendix 4 the results can be found of the Pearson correlation analysis having used Tobin’s Q as the determinant of firm performance. Tobin’s Q has a positive significant correlation with CEO pay (r=0.095, p-value=0.013). The product term ‘proportion of independent directors on the committee * Tobin’s Q’ has a positive significant correlation with CEO pay (r=0.091, p-value=0.017). The interaction predictor ‘size of the remuneration committee * Tobin’s Q’ has a positive significant correlation with CEO pay (r=0.209, p-value=0.000). The product term ‘number of meetings held by the remuneration committee * Tobin’s Q’ has a positive significant correlation with CEO pay (r=0.209, p-value=0.000). The interaction effect ‘proportion of female directors on the remuneration committee * Tobin’s Q’ has a positive significant correlation with CEO pay (r=0.124, p-value=0.000).
Appendix 5 shows the correlation analysis with stock market returns as the factor of firm performance. The measure stock market returns has a positive significant correlation with CEO pay (r=0.105, p-value=0.002). The interaction effect ‘proportion of independent directors on the committee * market returns’ has a positive significant correlation with CEO pay (r=0.102, p-value=0.002). The product term ‘size of the remuneration committee * market returns’ has a positive significant correlation with CEO pay (r=0.199, p-value=0.000). The interaction predictor ‘number of meetings held by the remuneration committee * market returns’ has a positive significant correlation with CEO pay (r=0.194, p-value=0.000). The product term ‘proportion of female directors on the remuneration committee * market returns’ has a positive significant correlation with CEO pay (r=0.142, p-value=0.000).
18 remuneration committee * ROE’ with ROE has reduced from r=0.532, p-value=0.000 to r=-0.158, p-value=0.000. High collinearity between the independent variable and moderator variables can also lead to serious complications. The correlation of proportion of independent directors on the committee with ROE is r=-0.009, p-value=0.806. The correlation coefficient of size of the remuneration committee with ROE is r=-0.005, p-value=0.897. The correlation of number of meetings held by the remuneration committee with ROE is r=0.056, p-value=0.148. And the correlation coefficient of proportion of female directors on the remuneration committee with ROE is r=-0.006, p-value=0.883. The absolute value of Pearson correlation is not greater than 0.8, and this implies that collinearity is not very likely to exist. Having done this centering methodology, this has reduced the correlation ‘proportion of independent directors on the committee * ROA’ with ROA to r=-0.015, p-value=0.661. The correlation ‘size of the remuneration committee * ROA’ with ROA has reduced to r=-0.161, p-value=0.000. The correlation ‘number of meetings held by the remuneration committee * ROA’ with ROA has reduced to r=0.071, p-value=0.034. And last, the correlation ‘proportion of female directors on the remuneration committee * ROA’ with ROA has reduced to r=-0.057, p-value=0.091. The correlation coefficient of proportion of independent directors on the committee with ROA is r=-0.074, p-value=0.027. The correlation of size of the remuneration committee with ROA is r=0.036, p-value=0.277. The correlation of number of meetings held by the remuneration committee with ROA is r=-0.080, p-value=0.016. And the correlation of proportion of female directors on the remuneration committee with ROA is r=-0.017, p-value=0.620. The Pearson correlation values are not close to 0.8, and this indicates that collinearity is not very likely to exist.
Using Tobin’s Q as an independent variable, this centering methodology has reduces the correlation ‘proportion of independent directors on the committee * Tobin’s Q’ with Tobin’s Q to r=--0.201, p-value=0.000. The correlation ‘size of the remuneration committee * Tobin’s Q’ with Tobin’s Q has reduced to r=--0.033, p-value=0.390. The correlation ‘number of meetings held by the remuneration committee * Tobin’s Q’ with Tobin’s Q has reduced to r=-0.071, p-value=0.063. And last, the correlation ‘proportion of female directors on the remuneration committee * Tobin’s Q’ with Tobin’s Q has reduced to r=-0.116, p-value=0.002. The correlation of proportion of independent directors on the committee with Tobin’s Q is r=-0.097, p-value=0.011. The correlation of size of the remuneration committee with Tobin’s Q is r=0.032, p-value=0.394. The correlation of number of meetings held by the remuneration committee with Tobin’s Q is r=0.039, p-value=0.304. And the correlation coefficient of proportion of female directors on the remuneration committee with Tobin’s Q is r=0.091, p-value=0.017. This shows that there is no problem with multicollinearity.
19 number of meetings held by the remuneration committee with market returns is r=0.034, p-value=0.314. And the correlation of proportion of female directors on the remuneration committee with market returns is r=0.001, p-value=0.968. Multicollinearity is not likely going to be a problem, since the correlation coefficients between the independent variable and moderator variables is less than 0.8.
5.3 Moderated multiple regression
In order to test the hypothesis mentioned above, a moderated multiple regression was conducted. Table 4a, 4b, 4c and 4d show the results of the analysis. In all four tables, model 1 consists of the control variables, in model 2 the independent variable is added, and in model 3 the moderator variables and the interaction terms between the independent variable and each of the remuneration committee quality measures are added. Concerning multicollinearity, the VIF (variance inflation factor) values of all variables in the regression analysis are below 10, so there is indeed no problem with multicollinearity.
Table 4a
Regression analysis – Independent variable ROE
(1) (2) (3)
Prop. ind. Members - - 0.003
Size of committee - - 0.041**
# of meetings - - 0.007
Prop. female members - - 0.000
Prop. ind * ROE - - -0.153***
Size * ROE - - -0.038
# meetings * ROE - - -0.003
Prop. female * ROE - - -0.001
ROE - 0.031 0.084*** LN (total assets) 0.274*** 0.273*** 0.261*** Leverage 0.116 0.105 0.071 Growth opportunity 0.124*** 0.119*** 0.107*** Constant 11.374*** 11.386*** 11.512*** Adj. R² 0.467 0.467 0.472 ∆ R² - 0.001 0.010 F-value (ANOVA) 37.620*** 35.538*** 24.892***
Year dummies and industry dummies are included in the regression.
***. indicate significant at the 0.01 level (2-tailed). **. indicate significant at the 0.05 level (2-tailed). *. indicate significant at the 0.1 level (2-tailed).
20 ROE’ ‘proportion of female directors on the remuneration committee * ROE’ and CEO pay. Thus, hypothesis 3, 4 and 5 are rejected when using ROE as the measure of firm performance.
Table 4b
Regression analysis – Independent variable ROA
(1) (2) (3)
Prop. ind. Members - - 0.009
Size of committee - - 0.035
# of meetings - - 0.008
Prop. female members - - 0.000
Prop. ind * ROA - - -0.413***
Size * ROA - - -0.105
# meetings * ROA - - -0.290**
Prop. female * ROA - - 0.023
ROA - 0.985*** 1.132*** LN (total assets) 0.274*** 0.271*** 0.261*** Leverage 0.116 0.164* 0.139 Growth opportunity 0.124*** 0.086*** 0.065** Constant 11.374*** 11.388*** 11.498*** Adj. R² 0.467 0.474 0.479 ∆ R² - 0.008 0.011 F-value (ANOVA) 37.620*** 36.480*** 25.646***
Year dummies and industry dummies are included in the regression.
***. indicate significant at the 0.01 level (2-tailed). **. indicate significant at the 0.05 level (2-tailed). *. indicate significant at the 0.1 level (2-tailed).
21
Table 4c
Regression analysis – Independent variable Tobin’s Q
(1) (2) (3)
Prop. ind. Members - - -0.001
Size of committee - - 0.034
# of meetings - - 0.008
Prop. female members - - 0.000
Prop. ind * Tobin’s Q - - -0.001
Size * Tobin’s Q - - -0.007
# meetings * Tobin’s Q - - 0.015
Prop. female * Tobin’s Q - - 0.000
Tobin’s Q - 0.048* 0.051* LN (total assets) 0.274*** 0.273*** 0.264*** Leverage 0.116 0.071 0.037 Growth opportunity 0.124*** 0.106*** 0.099** Constant 11.374*** 11.408*** 11.506*** Adj. R² 0.467 0.469 0.466 ∆ R² - 0.002 0.003 F-value (ANOVA) 37.620*** 35.702*** 24.317***
Year dummies and industry dummies are included in the regression.
***. indicate significant at the 0.01 level (2-tailed). **. indicate significant at the 0.05 level (2-tailed). *. indicate significant at the 0.1 level (2-tailed).
The regression analysis results with Tobin’s Q as the independent variable are presented in table 4c. The adjusted R² is 46.6%, which measures the amount of the variation in the dependent variable accounted for by the explanatory variables. The F-test (F=24.317, p-value=0.000) indicates that the model is valid.
As can be seen, there is a positive significant association between the independent measure Tobin’s Q and CEO pay (B=0.051, p-value=0.076). Thus, hypothesis 1 is confirmed. Furthermore, no significant relationship was found between any of the interaction effects and CEO pay. Accordingly, hypothesis 2, 3, 4 and 5 are rejected when using Tobin’s Q as the measure of firm performance.
Table 4d
Regression analysis – Independent variable stock market returns
(1) (2) (3)
Prop. ind. Members - - -0.004
Size of committee - - 0.025
# of meetings - - 0.009
Prop. female members - - 0.000
Prop. ind * market returns - - 0.003
Size * market returns - - -0.027
# meetings * market returns - - 0.009
Prop. female * market
returns - - 0.003 * Market returns - -0.011 -0.015 LN (total assets) 0.274*** 0.274*** 0.267*** Leverage 0.116 0.116* 0.084 Growth opportunity 0.124*** 0.126*** 0.128** Constant 11.374*** 11.363*** 11.434*** Adj. R² 0.467 0.466 0.467 ∆ R² - 0.000 0.007 F-value (ANOVA) 37.620*** 35.369*** 25.415***
Year dummies and industry dummies are included in the regression.
22
*. indicate significant at the 0.1 level (2-tailed).
Looking at table 4d, the regression analysis results having used stock market returns as the independent variable, it can be seen that the adjusted R² is 0.467, implying that the model explains 46.7% of the dependent variable, and 53.3% of the model remains unexplained. The F-test (F=24.317, p-value=0.000) indicates that the model is valid.
The analysis reveals that there is no significant association between the independent measure stock market returns and CEO pay (B=-0.015, p-value=0.633). Thus, hypothesis 1 is rejected. Observing the coefficients of the interaction effects, the table shows that there is a positive significant relation between ‘proportion of female directors on the remuneration committee * market returns’ and CEO pay (B=0.003, p-value=0.041). Therefore, hypothesis 5 is confirmed. Unfortunately, no significant relationship was found between ‘proportion of independent directors on the committee * market returns’ ‘size of the remuneration committee * market returns’ and ‘number of meetings held by the remuneration committee * market returns’ and CEO pay. Consequently, hypothesis 2, 3 and 4 are rejected when using stock market returns as the measure of firm performance.
6 DISCUSSION AND CONCLUSION
In this study, the effect of remuneration committee quality on the association between firm performance and CEO pay, the pay-performance sensitivity, in U.K. boards was researched. In this research a sample of 245 listed firms from 2006 to 2009 was used, which led to a maximum of 950 observations.
23 No significant results are found that confirm the influence of the size of the remuneration committee on the association between firm performance and CEO pay. Therefore, hypothesis 3 cannot be confirmed. This is not in line with the results that Sun & Cahan (2009) presented. These authors concluded that the association between firm performance and CEO pay is lower when the size of the committee is larger, although the results are marginally significant. Yermack (1996) found similar results. The author states that boards of smaller sizes offer compensation packages with greater pay-performance sensitivity.
We may also conclude that the association between firm performance and CEO pay is negatively influenced by the number of meetings held by the remuneration committee when firm performance is measured as ROA. This infers that a higher number of meetings does not benefit the alignment of interests between shareholders and CEO. This contradicts hypothesis 4. The annual number of meetings is inversely related to pay-performance sensitivity. This could be due to, as Vafeas (1999) stated in his study, the high costs related with meetings, like managerial time, directors’ travel expenses and meeting fees. Another explanation could be that directors have a lack of time to perform their duties and obligations, and meetings take up too much time that directors better use to monitor management (Lipton & Lorsch, 1992). Number of meetings has not been used before as a proxy for remuneration committee quality that influences the pay-performance sensitivity. However, Vafeas (1999) used board meeting frequency as a proxy for firm performance and stated that the number of annual meetings has a negative influence on firm performance.
When firm performance is measured by stock market returns, the pay-performance sensitivity is positively influenced by the proportion of female directors on the remuneration committee, implying that more female directors on the remuneration committee bring the CEO pay more in line with the firm performance. Therefore, hypothesis 5 is confirmed. These findings are in line with Adams and Ferreira (2008). These authors concluded that in firms with more gender-diverse boards, the sensitivity of pay to performance is greater.
This study has made several contributions to the existing literature. This research is conducted among U.K. boards, while most previous studies are done in among U.S. boards. As mentioned above, regulations between these countries differ. Besides, different remuneration committee quality measures are being used. Besides independence, a measure that was included in most previous studies, efficiency and diversity were also added. Especially diversity is such a hot topic at the moment, and a fundamental challenge for many firms and their board and committees, since these are often homogeneous and U.K. regulations advice to make boards and committees more diverse and heterogeneous.
Limitations and future research
24 e.g., the tenure of the directors serving the remuneration committee. Future research could add other committee measures to those three used in this study. Furthermore, the definition of the remuneration committee quality is solely quantitative. For future research, it would be interesting to combine such a research with qualitative research. This could be done by performing interviews with committees with high quality, and committees with low quality. Due to these conversations, it can be addressed if committees with low quality are indeed perceived as less valuable, and committees with high quality are perceived as more valuable. Last, this study is done within a timeframe of five months. This limited amount of time has caused me to set priorities.
Practical and theoretical implications
Besides the limitations, there are also some practical implications regarding the results that are gained from this study. During the last decade, there have been made many changes with regard to regulations of supervisory boards and thus remuneration committees. For example, a certain target percentage of independent directors and female directors should be part of the remuneration committee. Though, the question is whether these regulations are needed for a firm, in order to have a closer alignment of interests between the shareholders and CEO. This research presented evidence that the proportion of female directors on the remuneration committee positively influences the pay-performance sensitivity, when stock market returns is used to measure firm performance. And therefore we could state that shareholders should care about the proportion of female members on the committee because it influences the quality of the committee. On the other hand, this study has shown that the proportion of independent directors among all remuneration committee members negatively influences the pay-performance sensitivity, when ROE and ROA measure firm pay-performance. Consequently, even though the fact that remuneration committees are advised to be fully independent, this study shows that this has a negative impact on the alignment of interests between shareholders and CEO.
25
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