Executive compensation practices and performance outcomes

Executive Compensation

The role of compensation in organizational behavior is an important one as it is used as a key tool by management to achieve social control over its employees (Pfeffer, 1997, p.102), the primary assumption being that compensation packages affect attitudes and behavior. This is seen as particularly true of executive level compensation on the grounds that management must be sufficiently motivated if organizational objectives are to be met and so that, they in turn, succeed in motivating the rest of the organization: "Because of the importance of money as a motivational factor, the compensation function is quite significant. Its performance involves developing a philosophy of what wages should be; developing theories as to the source of wages...relating compensation to individual jobs; arriving at individual differentials in pay...." (Megginson, 1972, p. 50)

Though compensation may undeniably be an important factor, several research studies have shown that the role of compensation may vary within the context of markets, organizational or individual behavior. For instance, the role of compensation in attracting and retaining employees and management talent was seen to increase in importance in the tight labor market of 1996-97 when wages and salaries grew at a pace not seen in many years. In addition, the increasingly competitive business environment of the last few decades has necessitated that organizations control labor costs, while focusing simultaneously on increasing productivity, quality, and enhanced customer service. Other trends such as flatter organization structure, more fluid organizational design have also required new strategies for employee compensation, particularly as employee compensation is deemed to be critical to financial success (Schuster).

The impact of environment on organizational behavior is evident given research, which shows that a typical CEO in the U.S. earned total compensation that was around 35 times the pay of an average manufacturing worker in 1974, as compared to around 120 to 150 times that of an average worker in the manufacturing and services sector in the late 1990s. This is attributed to the changing environment for corporate control, changing size distribution of firms, changing wage dispersion within organizations, and dramatic changes in the governance of employment relations (Pfeffer, 1997, p. 23). Changes in executive level compensation of this magnitude have largely risen due to the emergence of high performance, high commitment work systems (Schuster). Another basic dimension of this trend is the growing emphasis on variable pay or pay that changes depending on the performance (or skill) of the individual, work group, or organization (Pfeffer, 1997, p. 104).

The dominance of the economic model of behavior in the United States is seen as the underlying basis of the importance given to the role of compensation in influencing behavior. However, research studies, which have tried to establish a correlation between executive level pay and organizational performance, reveal that the link is, at best, a tenuous one. This is particularly true of CEO compensation packages, which seem to be more determined by company size, and a complex process shaped by several political, economic and social factors. The influence of factors such as the relationships between the board, leadership, and ownership characteristics and organizational outcomes have led several scholars to conclude that when CEO compensation fails to correlate with performance, boards can be viewed as forsaking their obligations to shareholders or, at the least, failing to use compensation as a mechanism of control. In other words, the findings of such studies do not support the notion of the agency and managerial hegemony theories that independent directors enhance the governing effectiveness of the board (Hopkins et.al., 1995).

Thus, it is important to note that one of the historical challenges to the economic model has been the relatively small relationship between pay and performance, even for senior level executives. Perhaps, this is the reason why reward practices vary dramatically across companies and cultures. The other determinant, which indicates that there may not be a very strong correlation between pay and performance, is the existence of several, highly successful corporations such as Mars and Southwest Airlines that use virtually no merit pay (Pfeffer, 1997, p. 105).