Apr 22, 2021 in HRM Papers Sample

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Balancing the Tension: Managerial and Executive Pay

Abstract

Balancing the tension that managerial and executive compensation creates is critical to the performance and sustainability of organizations. The controversy that the disparity between executives and other employees' compensation creates negatively affects both the employees and organizations. The persistence of the disparity originates from the power the executives hold over the board of directors and the compensation decision-making process. The executive's compensation seems unfair to other employees because of its inconsistency with actual performance, and its structure that encourages short-term risk-taking behaviors. The tension that emerges from the controversy reduces the productivity of employees, their willingness to cooperate, and their satisfaction with their work. Their dissatisfaction with the workplace may prompt them to leave. Also, organizations suffer from controversy in various ways. Reduced employee productivity incapacitates firms, making them unable to successfully follow their strategic plans. The tension also disrupts organizational cultures, which reduces innovativeness and competitiveness. High employee turnover that results from workers' dissatisfaction increases the cost of operations and leads to loss of competitive edge. The eventual poor performance of firms reduces their ability to attract capital. Restructuring the executive compensation to include real stocks and allowing shareholders to vote on resolutions affecting the compensation may help reduce the tension.

Introduction

Executive and managerial compensation has been a controversial topic for a long time. The controversy comes from the ever-increasing compensation for executives and senior managers regardless of the performance of the firms for which they work. The problem with high executive compensation is that it hurts the motivation of other employees who compare their compensation with that of the executives. Even when organizations are performing poorly, the management would rather reduce the size of their workforce than the amount of compensation paid to the executives and senior managers. Consequently, workers' motivation may suffer because of perceived unfairness in compensation. The tension that is created by compensation disparity between a company's executives and other employees has the potential to affect the performance of a firm and its productivity negatively because employees' morale, output, and willingness to stay with the firm reduce significantly.

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The Origin and Nature of High Executive Compensation

The relationship between a company's executives, senior managers, and the board of directors is a significant factor that determines executive compensation. The managerial power theory posits that executives have the ability to influence the decisions of the board of directors and receive their desired compensation (Brown Jr, 2008). The compensation committees that determine the compensation of executives are part of the board of directors over which executives and senior managers have control. Executives, especially chief executive officers, participate in the board nomination process for board members. As such, the members of the board in the compensation committees are likely to align their interests with those of the executives because their appointment and compensation rely on the input of the executives. When the members of the board of directors are making executive compensation decisions, they rely on the services of compensation consultants. The executives hire compensation consultants. Consequently, the ability of the consultants to provide the boards with objective and unbiased advice on the optimal level of compensation is questionable. Given that the welfare of both the consultants and the board members depends on the decisions made by executives, the loyalty of the members of the board and consultants belong to the executives. Consequently, the boards accept sub-optimal executive compensation because of self-interests.

The principal agency theory further elaborates on the source of increasing executive pay. According to the principal-agent theory, shareholders are principals while executives are agents. Since the executives have specialized skills and knowledge of running organizations that the shareholders do not have, the shareholders hire the executives to manage firms on their behalf. As such, the role of the agents is to maximize the profitability of the organizations so that the shareholders. One of the assumptions of the principal agency theory is that the motivation of the agents and the principals is aimed at maximization of their self-interest (Geiler & Renneboog, 2011). Consequently, when the interests of the shareholders and those of the executives do not match, a conflict of interest arises. In the case of executive compensation, there is an inherent conflict of interest because the executive's desire to increase their earnings may jeopardize the profitability of firms and the shareholder's earning. The hiring of independent members of the board of directors aims to cure the conflict of interest. The independent board members should represent the interests of the shareholders and should check the power and influence of the executives to ensure they maximize the shareholder's value. However, as previously discussed, the board members act in ways that propagate the interests of the executives and not those of the shareholders.

The compensation of executives does not reflect their performance. According to Kennedy (2009), corporations use industry benchmarks to determine the number of executive compensations. Relying on the benchmarks may have negative consequences for firms because the payment is not commensurate with the performance of the executives. The decision to base compensation on the benchmarks is related to the fact that it creates a positive image of a firm to have a competitively compensated executive and may influence investors' perception and share values. The problem with the benchmarks is that a high-performing organization may set a pace for executive compensation for poorly performing firms. Part of the executive compensation is stock options that allow the executives to buy stocks and sell them at their convenience when the prices are likely to offer them the greatest value. The consequence of using stock options as a part of executive compensation is that it encourages them to take short-term risks that jeopardize the sustainability of firms. The executives have the power to decide the performance metrics on which their performance depends. Consequently, they choose metrics related to accounting because they can manipulate them to gain short-term benefits. For instance, executives may underreport losses in their financial reports to maintain certain share prices as they anticipate selling them to increase the value of their compensation. Therefore, the executives may sell their stock at a price that does not reflect their value because of the manipulated figures in the financial reports.

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The compensation of executives does not encourage them to adopt a long-term perspective of a firm. Including a requirement that executives compensation structure should have a minimum number of real stocks that cannot be disposed over the short term can align the interests of the shareholders with those of the executives. Tying executive compensation to the long-term performance of a firm can discourage the executives and managers from taking unnecessary risks and promote values that can help firms achieve long-term goals (Brown Jr, 2008). However, most executive compensation packages do not encompass real stocks. Therefore, executives are likely to continue receiving large compensation packages because of their power to manipulate information and resources to suit their interests.

The Impact of the Compensation Controversy on Employees

The role of compensation is to motivate employees to increase their performance and productivity. As such, it is vital to ensure that compensation reflects the actual performance of all the workers regardless of their position in the organizational structure. When the payment of lower-level employees depends on their performance while that of the executives does not reflect their productivity, the employees are likely to perceive the difference in compensation as unfair. According to the equity theory, social comparisons play a critical role in influencing how employees evaluate their compensation (Rost & Weibel, 2013). The internal comparison between employees' compensation and that of their executives creates tension because the disparity between the two is large and does not encourage the employees to work hard to earn more (Brown Jr, 2008). Apart from the internal comparison, the workers compare their pay with that of other employees in different organizations in their industry. When a firm's executive compensation relies on industry benchmarks and not on actual performance, it magnifies the difference in compensation among employees of various organizations. For instance, if a firm bases executive compensation on another competitor, it fails to consider its performance relative to that of the competitor. The competitor may have the ability to pay high compensation to its executives because of its performance. As such, it may also afford to compensate its other employees fairly compared to its executives. When the employees of the firm whose executive pay depends on the competitor's compensation compare their remuneration with that of the competitor's employees, they are likely to feel treated unfairly. The effects of unfair treatment on the employees include low productivity, lack of cooperation and cohesion among workers, and low job satisfaction.

Low Productivity

Equity theory suggests that employees compare their contribution and rewards with those of other workers. From an employee's perspective, a contribution may be competence, education, experience, and effort. Rewards may include such aspects as salaries and compensations. Workers compare the outcomes of others and their inputs and make decisions that are likely to reflect their feelings (Noe, Hollenbeck, Gerhart, & Wright, 2016). For instance, employees may feel that the disparity between executive compensation and their rewards does not reflect the input-output expectations. As such, one of the worker's reactions to the perceived inequity in the distribution of compensation is the withdrawal of effort. When employees withdraw their effort, their productivity reduces as compared to previous levels. The withdrawal is consistent with the expectancy theory of motivation. The expectancy theory suggests that outcomes interlink with each other (Noe et al., 2016). As such, when employees receive fair rewards for their effort, they are likely to increase the effort in the expectation of additional rewards. However, when they perceive the reward as not being commensurate with their effort, they may withdraw it. In the case of the disparity between the compensation of executives and other employees, the employees, who perceive the current disparity as unfair, may not increase their productivity in the future because they do not believe that such an effort will attract a fair reward. As such, the tension between the executives and the employees leads to low employee productivity.

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Lack of Cohesion and Cooperation

In modern organizations, teamwork has become a vital competitive advantage. Firms with strong teams have outperformed their competitors because teams improve the problem-solving capabilities of firms and lead to innovations and creativity. One of the factors that motivate employees to collaborate is their shared beliefs that their effort is vital to their organizations and the welfare of all the stakeholders (Rost & Weibel, 2013). The shared values make the workers feel a sense of belonging and are likely to encourage them to be committed to their firms. When the executives receive disproportionate compensation compared to those of other employees, the workers feel like their cooperation benefits only some but not all stakeholders. Consequently, their morale reduces and they may not see the need to cooperate.

Low Job Satisfaction

Job satisfaction is vital to organizations because it determines the length of employment and the employee turnover rate. Fair and attractive compensation has a substantial impact on employee satisfaction. According to Rost and Weibel (2013), fair compensation leads to job satisfaction, loyalty to organizations, and commitment to their goals and objectives. Therefore, when workers perceive compensation as unfair, their job satisfaction reduces significantly. The difference in executive and other workers' compensation is a factor that can contribute to job dissatisfaction and may lead to other unintended consequences. The nature of executive compensation is such that it increases over time regardless of a firm's performance. Although other workers receive compensation when they help the firm improve its performance, they experience layoffs during tough economic times. However, highly compensated executives do not face employment termination or reduction of compensation when their firms are performing poorly. Such a scenario creates discontent because the lower-level workers feel like their effort matters less than that of the executives. Consequently, their job satisfaction reduces. One of the outcomes of low job satisfaction is that the quality of the employee's work may also reduce because they are not committed to their organizations. Additionally, dissatisfied employees are likely to seek alternative employment, thus increasing an organization's turnover rate.

The Impact of the Compensation Controversy on Organizations

Human capital is one of the resources that help firms achieve their goals and gain a competitive edge. According to Geiler and Renneboog (2011), human resources are vital to a corporation's success because they determine the efficiency of other material and financial resources. The impact of the compensation disparity and tension is a result of the reaction of employees to high executive compensation.

Failure to Meet Strategic Goals

When the compensation disparity leads to low employee productivity, firms suffer because they cannot meet their strategic objectives. Corporations depend on front-line employees to implement the strategies that corporate managers have designed to create value for all the stakeholders (Rost & Weibel, 2013). However, when workers initiate effort withdrawal because of the perceived unfair compensation, firms lose their ability to meet their strategic goals. The consequence of not meeting the strategic goals is that firms cannot be sure of their sustainability. One of the strategic goals of many companies is profitability growth that empowers organizations to pay shareholders and meet their financial obligations. Reduced employee productivity leads to losses instead of profits.

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Unsupportive Organizational Culture

Fairness in compensation creates shared values that create a basis for organizational culture. When low-level employees are disgruntled because of disparity in compensation, they are not motivated to foster positive values that define organizational culture. When an organization has no values that encourage collaboration, there is sub-optimal utilization of resources because teamwork maximizes the utilization of available resources. According to Hitkaa, Vetrov, Balov, and Danihelov (2015), organizational culture is the bedrock on which all innovation efforts thrive or fail. When firms have no supportive organizational culture, they lose their innovative ability. Consequently, they may not have the ability to compete in the market and may lose their market share.

High Employee Turnover

Employee dissatisfaction leads to increased employee turnover, which has several consequences for organizations. Corporations that experience high rates of employee turnover incur additional costs. When employees leave an organization, they must be replaced. The replacement process is costly because advertising the vacant positions and interviewing potential candidates require financial resources. Additionally, the employees, who leave, go with tacit knowledge. Tacit knowledge is unique because it is not transferable from one person to another (Rost & Weibel, 2013). As such, organizations with high turnover rates lose tacit knowledge to their competitors. Organizations, whose employees are dissatisfied, face the challenge of attracting and retaining talent because of the tainted reputation. Networking through professional and social media sites has become a source of information among professionals. Those who leave corporations because of dissatisfaction share their experience with peers and potential candidates for replacement. Talent attraction and retention ability is a competitive advantage because employees influence the performance of a firm. As such, compensation disparity leads to employee turnover, which affects organizations financially and competitively.

Inability to Attract Capital

Shareholders are the owners of equity and inject finances into businesses with the hope of earning from positive performance. When executive compensation leads to poor performance, due to reduced employee productivity, investors may not be willing to provide additional finances to help firms grow and improve their competitive abilities (Ungemah, 2015). Shareholders are unwilling to risk their capital and invest in firms where the tension between executives and other employees is high because of compensation disparity. Consequently, the firms affected by the tension may not be sustainable because of capital shortage. Lack of capital can also affect the value of the company in financial markets. As a result, the value of shares may fall, which can further ruin the company's reputation.

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Possible Solutions to Balance the Existing Tension

One of the solutions that can help balance the tension is making the cost of self-interest higher than the benefits. One way to increase the cost is to restructure executive compensation in such a way that real stocks form a significant portion of the compensation (Ungemah, 2015). The condition that allows owning such stocks is that the executives can only sell them after staying with a firm for a specified period of time. Such compensations can discourage executives from seeking short-term gains and focus on the creation of long-term value for the shareholders. Owning a stock can empower the executives to adopt values that are likely to foster sustainability. Consequently, their compensation will reflect performance. As such, employees are likely to perceive justification in executive pay because it will reflect exceptional performance that will add value to all the stakeholders.

The second solution is to allow shareholders to have a binding vote on compensation increment. Empowered shareholders can motivate executives to align their interests with value creation and deter them from adopting behaviors that may reduce the value of a firm. Additionally, the shareholders should have the power to influence the process of nomination and removal of board members to encourage them to be independent when making executive compensation decisions (Ungemah, 2015). Active involvement of shareholders can reduce the rate of collusion among board members and executives and ensure that compensation is competitive and fair as compared to other employees.

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Conclusion

The tension that emerges when there is a great difference between executive and other workers' compensation affects both firms and their employees negatively. The sources of the disparity are the power of the executives and their influence on boards of directors. The executive's participation in the nomination of board members creates loyalty expectations and leads to a conflict of interest. Failure to base executive compensation on actual performance increases the tension because employees view the compensation as unjustified. The structure of compensation packages also encourages executives to seek short-term gains that increase their compensation significantly. The impact of the tension on employees includes reduced productivity, inadequate teamwork, and lack of satisfaction. The effects of the tension on an organization include failure to realize strategic objectives, dysfunctional organizational cultures, high employee turnover, and inadequate capital. The solution to the tension lies in the structuring of executive compensation packages and participation of shareholders in compensation decision-making.

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