The explosion in the remuneration of business leaders in recent decades, in all Western countries, has provoked a number of invectives. But it also gave rise to an important debate in the economic literature. A recent pamphlet from CEPREMAP takes stock of the explanations put forward for this phenomenon and suggests ways to improve the remuneration of bosses in France.
Until the end of XIXe century, family capitalism dominates, characterized by a small number of shareholders who are also managers of the company. From XIXe century and the second industrial revolution, the growing size of companies and the complexity of the production process require ever greater investments. The opening of company capital to new shareholders becomes necessary. This increased dispersion of ownership requires the definition of a new mode of corporate control. This is how managerial capitalism emerges, where power and ownership are dissociated: the company belongs to the shareholders but is managed by a “ manager “. It is then a question of finding the optimal method of remuneration for this manager, on the one hand to encourage him to act in the interest of the shareholder, on the other hand in order to attract the most talented. As executive remuneration has increased significantly since the beginning of the 1980s, both in Europe and in the United States, their method of determination has become a subject of both political and academic debate. Thus, Frydman and Saks (2010) show from an analysis of the remuneration of directors of listed American companies from 1936 to 2005, that if the latter were rather stable until the end of 1975, they increased by more and more quickly thereafter.
Median value of remuneration of the 3 highest positions of the 50 largest American listed companies (ranked in 1940, 1960 and 1990), 1936-2009
In the Cepremap pamphlet How should bosses be paid?Frédéric Palomino presents the results of the economic literature on the level and structure of executive remuneration. Neither competition for talent nor the establishment of new incentive mechanisms seem to fully justify the increase in the level of remuneration since the end of the 1970s. The question then arises of the method of determining remuneration and the limits of the functioning of the organization in charge, the board of directors.
Incentive incentive mechanisms ?
The rise in executive salaries from the 1980s was accompanied by an awareness of the importance of incentive mechanisms in the remuneration structure. The underlying theory is that of agency (Jensen and Meckling, 1976). When the shareholders (the principal) do not have all the information necessary to control the decisions of the manager (the agent), the remuneration structure ensures the alignment of the interests of the latter with those of the shareholders.
Agency theory
Agency theory is part of the school of thought which analyzes the consequences of imperfect dissemination of information on economic life. When in an exchange relationship the contracting parties do not have the same level of information, two phenomena emerge: anti-selection and moral hazard. The latter, which is of particular interest to agency theory, describes a situation in which one of the contracting parties (the agent) carries out an activity on behalf of the other (the principal) while they have divergent interests. If the principal cannot perfectly control all of the agent’s decisions, the latter may not act in accordance with his expectations. Agency theory seeks to define the type of contract that guarantees the convergence of interests. This principal-agent relationship model appears at different levels of the economy: between insurance and the insured, the saver and the bank, the employee and the boss, but also the shareholder and the managers.
The author discusses the advantages and disadvantages of the different remuneration components in terms of incentives: base salary, bonus, stock options, free shares and severance pay. The use of these incentive mechanisms can explain a high level of remuneration. Indeed, the limited liability of the manager, who does not pay the company in the event of failure, requires the use of a reward that is all the higher in the event of success than the wealth gap with the situation of failure, and therefore the incentive effect must be significant. In equilibrium, when the manager acts in the interest of the shareholder, he therefore receives a high salary. However, these incentive mechanisms have limits. In 1990, Jensen and Murphy demonstrated that the sensitivity of executive compensation to firm performance is in fact relatively low. If, as Hall and Liebman (2001) prove, the increasing use of stock options and shares in total compensation since the 1990s has made it possible to increase this sensitivity, the variable part of compensation remains much lower in Europe compared to compared to the United States. Furthermore, the value of stock options may be the consequence of exogenous shocks and manipulation, rather than the performance of the manager. Bertrand and Mullainathan (2001) thus show that the remuneration of managers in the oil sector from 1977 to 1994 in the United States depended considerably on variations in the price of oil over the same period. According to Bebchuk, Grinstein and Peyer (2011), fixing the ex post grant date of stock options has made it possible in many cases to increase their value. Finally, the value of stock options increases with the volatility of the underlying asset, this can encourage the manager to take excessive risks to increase this volatility. It is therefore not certain that the observed increase in executive compensation since the 1980s is the consequence of an improvement in incentives for executive performance.
Compensation and competition for talent
Executive compensation can also be seen as the price of their talent. According to this theory, the company must attract the most competent managers. In this context, two elements would explain the increase in remuneration since the 1980s: on the one hand, the increasing size of companies, and on the other hand, increased competition between companies for the same type of skills. First of all, if we consider that the talent of the manager makes it possible to increase the value of the company in proportion to its size, then the larger a company is, the more it is prepared to pay a high price for a level of talent. higher. Gabaix and Landier (2008) thus show that if there is a market for managers with heterogeneous skill levels in which they are assigned according to a competitive mechanism to companies of heterogeneous size, then their remuneration increases with the median size. of the company. Then, competition is all the stronger if companies value the same type of human capital. Murphy and Zabojnik (2004) thus consider that there are two types of skills: company-specific skills and general managerial skills. With the development of new information technologies and progress in finance, general skills have become more important over the course of the XXe century. This theory of optimal talent allocation, however, has limits. First of all, Terviö (2008) shows that remuneration is determined more by the specific characteristics of the company such as size rather than by a talent scarcity effect. Furthermore, in a second article from 2009, he shows that, paradoxically, the more talent has a significant impact on company profits, the less the population of managers is renewed and the more the average talent is below the optimal level. The cost of failure when hiring a “ novice » is indeed higher. In this context, the talent of a manager has a limited impact on his remuneration.
Corporate governance issues
After having demonstrated the limits of the theories explaining the structure and level of remuneration, it is a question of understanding why these contracts are offered. The author presents the functioning of the board of directors which is the body responsible for the appointment, control and method of remuneration of the manager. Its lack of independence from the company’s management appears to be one of the main obstacles to its proper functioning. First of all, the more diffuse the shareholding, the less effort each shareholder makes to exercise control and the more power the manager has over the board of directors. In addition, the independence of directors is limited by their participation on different boards of directors. Thus, in France, in 2004, 65% of companies in the CAC40 share at least one administrator. Social networks also limit this independence. Kramarz and Thesmar (2006) show that, in France, the probability of being appointed to a board of directors increases when the candidate considered and the manager are part of the same social network. In fact, this is the consequence of the very functioning of the board of directors. Indeed, in France, the manager actively participates in the decisions of the nomination committee in charge of appointing directors. Then, directors’ remuneration is poorly correlated with company performance, with only a limited portion being in shares. Finally, when the board of directors does not fulfill its governance role well and the company is listed, it should be penalized by the financial markets. However, the shareholding structure in France appears to limit the threats of a takeover bid in the event of poor company performance.
The solutions proposed
Measures were adopted in the United Kingdom in 2002 to increase shareholder control over executive remuneration. This is the procedure “ say we pay » which submits the executive’s remuneration to a shareholder vote each year. Ferri and Maber (2009) show that although these measures had no impact on the level of remuneration in general, sensitivity to performance increased.
In the pamphlet CEPREMAPthe author proposes three types of measure to improve corporate governance in France, and therefore the method of determining manager remuneration. First of all, the independence of the board of directors must be strengthened. The manager must in no case participate either in the remuneration committee or in that
appointment of directors. Then, the method of remuneration of directors must be more linked to the performance of the company through the use of stock options for example. Finally, if setting a ceiling on the level of remuneration is not desirable, taxation must make it possible to reduce the inequalities induced, without modifying the incentives of managers.
In this booklet, the author presents the academic debate on executive remuneration in a clear and concise manner. The proposed solutions seem relevant. Since high remuneration is the result not only of dysfunctions in corporate governance but also of market forces, setting a remuneration cap indeed seems futile. This is evidenced by the finance sector, where regulation on the variable portion of remuneration did not prevent remuneration from reaching new heights in 2010. However, the author’s analysis often seems to lack perspective: historical, geographical and even social dimensions are little mentioned. However, the underlying question is not only that of company performance but also of social cohesion, threatened by rising inequalities. Faced with such an issue, a greater diversity of approaches could enrich the debate.