Compensation Consultants and CEO Pay: UK Evidence

• Published date: 01 November 2010
• Author: Martin Walker,Georgios Voulgaris,Konstantinos Stathopoulos
• Date: 01 November 2010
• DOI: http://doi.org/10.1111/j.1467-8683.2010.00822.x

Compensation Consultants and CEO Pay:

UK Evidencecorg_822511..526

Georgios Voulgaris*, Konstantinos Stathopoulos, and

Martin Walker

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This paper provides new evidence on the effect of compensation consultants on CEO pay.

Research Findings/Insights: We produce new evidence on the managerial power approach (MPA) to corporate governance

by examining the inf‌luence of compensation consultants on CEO pay structures and the decision to hire a compensation

consultant in the UK. We f‌ind evidence that is not consistent with the MPA. Contrary to the MPA predictions, we f‌ind that

the positive effect of consultants on CEO pay levels mainly stems from an increase in equity-based compensation. We show

that consultantsexert a negative inf‌luence on basic (cash) pay. In addition, we illustrate that the choice of hiring a consultant

can be explained by economic determinants, e.g., f‌irm governancecharacteristics. The existence of a powerful CEO does not

increase the likelihood of hiring a payconsultant. Theresults are robust to several model specif‌ications and tests for selection

bias.

Theoretical/Academic Implications: The results indicate that compensation consultants may have a positive effect on the

structure of CEO paysince they encourage incentive-based compensation. We also show thateconomic determinants, rather

than CEO power, explain the decision to hire compensation consultants. Overall, our results cast doubts on the conclusions

of the MPAregarding the role of compensation consultants. Theirrole can be better explained within the optimal contracting

framework.

Practitioner/Policy Implications: This study offers insights to the positive effect the hiring of a pay consultant could have

towards the design of a CEO pay contract.

Keywords: Corporate Governance, Compensation Consultants, Executive Compensation

INTRODUCTION

Compensation consultants play a signif‌icant role within a

corporation’s governance structure. Their widespread

use seems to indicate that f‌irms recognize there is value in

the services offered by them. Policy makers also appear to

acknowledge the importance of paid consultants and have

recently called for more information disclosure regarding

their role within organizations. Even though market partici-

pants agree that pay consultants have now become key

players for f‌irms’ internal corporate governance strategies,

their effect on the pay contracts remains ambiguous and

highly contested. The debate turns on whether consultants

either enhance the ability of shareholders to offer optimal

contracts or collude with the management to allow the latter

to expropriate shareholders’ wealth. This paper offers evi-

dence regarding this debate. We investigate the effect con-

sultants have on both the levels and structure of CEO pay.

Wealso examine whether it is CEO power or other economic

reasons that determine the choice of hiring a compensation

consultant.

From an optimal contracting perspective an eff‌icient

managerial compensation contract should assure the align-

ment of interests between risk-averse managers and the

shareholders of the f‌irm. However, the determination of the

level and structure of an executive pay package is a process

that is complicated and requires expert knowledge. One

might expect f‌irms to hire expert outsiders to offer their

advice on this process. With the use of a number of

tools (e.g., surveys, valuation methods) and their expert

*Address for correspondence: Manchester Business School, Crawford House, Mezza-

nine Floor, MBS Crawford, Booth St East,M15 6PB, Manchester, UK. Tel: 44-161-275-

6863; E-mail: georgios.voulgaris@postgrad.mbs.ac.uk

All three authors are based at Manchester Business School, The University of

Manchester. Voulgarisis a Ph.D. candidate of Accountingand Finance, Stathopoulos is

a Lecturer of Finance and Walkeris a Professor of Accounting and Finance.

511

Corporate Governance: An International Review, 2010, 18(6): 511–526

© 2010 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2010.00822.x

knowledge on market-wide compensation practices, paid

consultants can help f‌irms determine an optimal executive

compensation package and avoid costly mistakes.

Recent studies though offer an alternative explanation for

the use of pay consultants. The managerial power approach

(MPA) (Bebchuk, Fried, & Walker, 2002) argues that com-

pensation consultants help the management team of a

company camouf‌lage the extraction of rents, i.e., excessive

pay. Consultants, who are considered by the markets to be

independent of the company, offer legitimacy to sub-optimal

compensation plans and allow managers to expropriate

shareholders’ wealth by awarding themselves above optimal

levels of pay. This happens for two reasons. First, managers,

especially CEOs, have mutually supportive relationships1

with their boards of directors, which allow them to gain

power within the f‌irm. CEOs may abuse this power and,

among other things, try to control the design of the compen-

sation package in order to achieve excessive pay in the form

of rents. Second, consultants are inf‌luenced by the intra-

company power relationships and try to please the CEO and

not the shareholders, since they understand the CEO has

more inf‌luence in the hiring decision than shareholders.

In this study, we f‌ind that CEOs of companies that employ

compensation consultants enjoy higher levels of total com-

pensation but we also demonstrate that this is due to a

higher proportion of performance-related, equity-based

compensation. This result shows that even though the exist-

ence of a consultant is indeed related with higher levels of

top-executive pay, this extra pay is incentive related. In addi-

tion, we model the choice of hiring a pay consultant. Based

on the managerial power hypothesis, one would expect

more powerful CEOs to increase the likelihood of the f‌irm

hiring a pay consultant. We f‌ind no evidence to support this

argument. In particular, more entrenched CEOs either have

no effect or decrease the likelihood of f‌irms hiring pay con-

sultants. Other “rational” economic determinants, e.g., cor-

porate governance and ownership structure among others,

help explain the hiring choice. Finally, we examine whether

the effect of compensation consultants on CEO pay still

exists after incorporating the selection issue in our initial

analysis, thus controlling for potential selection biases. Our

results cast doubts on the managerial power perspective on

the role of compensation consultants and in particular on the

claim that powerful CEOs hire consultants to help them

extract rents.

This paper contributes several original f‌indings on the

relationship between CEO compensation and the use of

compensation consultants. First, using a more comprehen-

sive sample compared to prior UK studies in the area, we

f‌ind an increasing effect of consultants on totalCEO pay; this

f‌inding is consistent with the “ratcheting-up” effect pre-

dicted by the managerial power hypothesis. We f‌ind this

effect, unlike prior UK studies, because we use a larger

sample that is more representative of the UK population.

This allows more variation both in the levels of CEO pay and

in the choice of hiring a consultant. Second, our analysis

shows that compensation consultants have an increasing

effect on the equity-based portion of compensation.

However, in contrast to other studies we show that they also

have a decreasing effect on the salary portion of top-

executive pay contracts. This result is important because it

indicates that compensation consultants have an effect on the

structure of CEO compensation, which is consistent with the

calls from market participants for more pay for performance.

We appropriately control for potential selection bias issues

and our results remain statistically signif‌icant.

Finally, our study contributes new insights into the selec-

tion process of consultants and the reasons that drive f‌irms

to hire them. Different proxies of CEO power appear to be

insignif‌icantly or even negatively related to the probability

of hiring a pay consultant. In contrast, we show that the

complexity of the pay package is a signif‌icant factor in the

decision to hire a consultant. These results point towards the

conclusion that compensation consultants are not consid-

ered as part of the agency problem, as argued by the mana-

gerial power hypothesis, but as part of the solution, i.e.,

contribute towards the achievement of an optimal contract.

PRIOR RESEARCH

The majority of the relevant literature studies the role of

compensation consultants on the determination of the levels

and structure of executive pay. Bebchuk et al. (2002) provide

a “managerial power” perspective on the determination of

executive pay, where consultants play a sinister role.

Company executives achieve excessive remuneration in the

form of rents, based on the power that they have within a

f‌irm and consultants are hired to assist them to “camou-

f‌lage” (p. 791) and justify their pay. This camouf‌lage comes

mostly through the use of tools thatconsultants are using for

the determination of executive pay, e.g., remuneration

surveys and compensation peer groups, as a number of

studies claim (Baker, Jensen, & Murphy, 1988; Bizjak,

Lemmon, & Naveen, 2007; Murphy, 1998; Wade, Porac, &

Pollock, 1997).

There are only a few studies empirically examining this

line of argument. In the US, managerial compensation levels

are higher for f‌irms that use consultants compared to those

that do not, after controlling for other economic determi-

nants of executive pay (Armstrong, Ittner, & Larcker, 2009;

Conyon, Peck, Read, & Sadler, 2009a). However, this result

does not seem to hold for UK f‌irms (Conyon et al., 2009a).

Moreover, compensation consultants have an increasing

effect on the equity-based part of executive pay both in the

US and the UK (Conyon et al., 2009a). With the use of match-

ing pairs for economic and corporate governance character-

istics, Armstrong et al. (2009) show that the higher pay in

f‌irms with consultants can also be attributedto differences in

corporate governanceand not solely to the choice of hiring a

consultant.

An issue that has also concerned two studies is the incen-

tives of compensation consultants and whether their advice

could be biased in the presence of potential cross-selling

interests. Cadman, Carter, and Hillegeist (2010) f‌ind that

f‌irms that hire consultants with higher conf‌licts of interest

(i.e., consultants that also offer non-compensation related

consultancyservices to their clients) do not have higher levels

of totalpay or lower payperformance sensitivity.Their results

do not change signif‌icantly after controlling for selection

biases. Unlike Cadman et al. (2010), Murphy and Sandino

(2010) f‌ind some evidence that CEO pay is higher in US f‌irms

512 CORPORATE GOVERNANCE

Volume 18 Number 6 November 2010 © 2010 Blackwell Publishing Ltd