Pay dispersion among the top management team and outside directors: Its impact on firm risk and firm performance

• Date: 01 January 2018
• Published date: 01 January 2018
• Author: Haemin Dennis Park,Mingxiang Li,María del Carmen Triana,Pankaj C. Patel
• DOI: http://doi.org/10.1002/hrm.21872

HR SCIENCE FORUM

Pay dispersion among the top management team and outside

directors: Its impact on firm risk and firm performance

Pankaj C. Patel

1

| Mingxiang Li

2

| María del Carmen Triana

3

| Haemin Dennis Park

4

1

Villanova University, Villanova, Pennsylvania

2

Florida Atlantic University, Boca Raton,

Florida

3

University of Wisconsin–Madison, Madison,

Wisconsin

4

University of Texas at Dallas, Richardson,

Texas

Correspondence

Pankaj C. Patel, Villanova University, Villanova

School of Business, 800 Lancaster Ave.,

Villanova, PA 19401.

E-mail: pankaj.patel@villanova.edu

Two key groups central to improving firm performance are the top management team (TMT)

and the board of directors. Executives undertake strategic actions, whereas board members ful-

fill their resource provision and monitoring roles. Drawing on tournament theory and equity

theory, we propose that high pay dispersion among outside directors and the TMT is positively

associated with strategic risk, whereas high (low) TMT pay dispersion and low (high) outside

director pay dispersion are positively associated with firm performance. Our predictor is the

unexplained component of horizontal pay dispersion, or the residual of pay dispersion resulting

from regressing pay on observable firm, industry, period, and individual characteristics. Our

results highlight the importance of unexplained pay dispersion for TMTs, but not for boards of

directors, in improving firm performance.

KEYWORDS

dual-agency framework, pay dispersion, performance, relative deprivation, strategic risk,

tournament theory

1|INTRODUCTION

An important question facing companies today is how to incentivize

organizational leaders to improve firm performance. Two key groups

leading organizations are the top management team (TMT) and the

board of directors. Prior work on executive compensation has drawn

on tournament theory to explain the relevance of pay dispersion

among top-level executives in driving firm performance (Connelly,

Haynes, Tihanyi, Gamache, & Devers, 2013). Disproportionate differ-

ences in pay induce executive tournaments. Referred to elsewhere as

CEO pay slice (Bebchuk, Cremers, & Peyer, 2011), CEO and average

executive pay gap (Henderson & Fredrickson, 2001), or pay variation

among TMT executives (Ji & Oh, 2014), pay dispersion in the upper

echelons is the mainstay in the executive compensation literature

(Gabaix & Landier, 2008).

By contrast, the horizontal variation in pay among board mem-

bers is less explored and could interact with TMT pay dispersion to

influence strategic risk or firm performance. Although board members

fulfill both resource provision and monitoring roles, it is unclear

whether individual board member pay is sufficient or whether hori-

zontal pay dispersion among board members could further improve

firm performance. Board members are less likely to compete with

one another in a tournament setting, and therefore, the tenets of

tournament theory may not apply for board members. However, two

complementary theories to tournament theory that could explain the

value of pay disparity among board members are equity theory and

relative deprivation theory (Crosby, 1976, 1984), which have been

widely used to study pay dispersion (Downes & Choi, 2014). Equity

theory (Adams, 1963, 1965) contends that individuals evaluate the

ratio of their outputs relative to inputs compared to that of similar

persons referred to as referent others. If the individual making the

comparison perceives their ratio to be lower than that of their refer-

ent others, they initiate efforts to equalize the inequity by changing

their level of inputs (e.g., working harder) and/or changing their level

of outputs (e.g., asking for a raise). Similar to equity theory, relative

deprivation theory calls for parity.

Although past work has found mixed support for the association

between TMT pay dispersion and firm performance (Henderson &

Fredrickson, 2001), incentivizing outside board members who may

strive to lower inequity relative to other similar board members could

influence the association between TMT pay dispersion and firm per-

formance. Social comparison induced by outside director (i.e., board

members who are not firm executives) pay dispersion could be a the-

oretical undergird to developing a deeper understanding of the

DOI: 10.1002/hrm.21872

Hum Resour Manage. 2018;57:177–192. wileyonlinelibrary.com/journal/hrm © 2017 Wiley Periodicals, Inc. 177

association between TMT pay dispersion and firm performance. As

such, we pose two research questions based on tournament theory,

equity theory, and relative deprivation theory.

First, we posit that having higher pay dispersion for both the

TMT and outside board members could exacerbate strategic risk.

Greater pay dispersion among TMT members induces greater risk

taking (Boyd, Franco Santos, & Shen, 2012; Kini & Williams, 2011). If

pay dispersion is greater among board members, board members

could strive to increase their value by focusing more on resource pro-

vision roles. It could generally be presumed that board members

would weigh their time and effort between their monitoring role by

watching executives' actions and their resource provision role by

offering resources and advice to executives (Hillman & Dalziel, 2003).

Although we do not posit that pay dispersion reduces the board

members' focus on monitoring, we propose that incentive differences

may prime the board members' resource provision role because those

who have earned the greatest amount from incentives over time will

be motivated to use their networks to provide resources for firms

that have increased their wealth. Likewise, those who have not

earned as much in total compensation may hope to help the firm so

that they may have better prospects for wealth in the future. Disper-

sion in pay among the board of directors could, therefore, prime

board members across the pay dispersion scale to more actively

search for information and resources to improve their odds of reduc-

ing pay gaps. Such priming also puts additional pressure on high rank-

ing board members (in both pay and status) to “up the ante”in their

resource provision roles. Pay dispersion among board members thus

primes competitive behavior—continued cooperation in monitoring,

but also provides necessary competition to fulfill resource provision

roles.

Second, we propose that high (low) TMT pay dispersion and low

(high) outside director pay dispersion will be positively associated

with firm performance. When pay dispersion is high in the TMT,

executives may undertake more strategic actions to improve their

chances of advancing in pay, leading to increased firm risk (Conyon,

Peck, & Sadler, 2001; Kini & Williams, 2011). Although outside direc-

tors do not compete with executives for pay, low pay dispersion

among outside directors should limit the sense of relative deprivation

or inequity within the board, reduce conflict among directors, and

improve cohesion and communication. This in turn can improve the

monitoring and control function of the board when TMT pay disper-

sion is high. In contrast, when TMT pay dispersion is low, greater pay

dispersion among directors could shift the focus of outside directors

from monitoring and controlling to improving their relative pay

through the resource provision and promotion of strategic actions

(cf. Festinger, 1954) that can improve firm performance.

In testing the above research questions, we operationalize “unex-

plained”pay dispersion. As recommended by Downes and Choi

(2014) a “statistical process that objectively evaluates ‘explained’pay

dispersion and creates a residual term that is useful for measuring

‘unexplained’pay dispersion …is excellent for dealing with panel or

archival data”(page 63). To measure unexplained dispersion Mahy,

Rycx, and Volral (2011) computed a residual from an individual-

worker regression using individual-level characteristics as predictors

and included the residual to predict plant-level productivity. The

intuition for using residual is as follows. Publicly traded firms used in

the current sample must meet performance expectations. The princi-

pals can observe outcomes (performance) and given low effort-

outcome correlation contexts, such as the upper echelons, individual

performance cannot be clearly attributed. As such, factors such as

executive (e.g., education, tenure), firm, industry, and period-related

drivers of compensation can be explained by institutional, political,

and social factors. A residual derived after controlling for observable

firm, industry, period, and executive/board characteristics captures

unobserved effort, talent, and abilities that drive performance from

one year to another. Although the residual also includes noise and

luck, the share of these factors would be lower in the upper echelons

due to institutional and social pressures on pay limits and incentives

to reduce perceptions of noise or luck explaining pay dispersion

among high-profile individuals competing in corporate labor markets.

The proposed framework makes two contributions. First, drawing

on equity theory (Adams, 1963, 1965) and relative deprivation theory

(Crosby, 1976, 1984), we provide novel insights on board pay disper-

sion. Although retainers are a major component of board member

compensation, recent work shows that awarding stock options to

directors increases firm risk (Lim & McCann, 2013a, 2013b). For

instance, a study by Yermack (2004) finds that for a $1,000 change in

shareholder wealth, compensation of outside directors goes up by

11 cents after controlling for board and board member characteris-

tics. Moving from the influence of individual to group-level board

member compensation dynamics, we propose and test the influence

of pay dispersion at the board level by examining how pay (total

rewards) dispersion among the board and TMT jointly affect firm

strategic risk-taking behavior and firm performance.

Second, based on the dual-agency framework, high TMT and low

board pay dispersion interact to improve firm performance. In con-

trast to prior work focusing on TMT pay dispersion, this study

assesses the influence of pay dispersion among outside directors on

firm performance and risk. Because both groups have been shown to

influence firm performance, it is important to understand the joint

relationship between TMT pay and director pay on firm risk-taking

and performance. Considering incentives of both groups of agents

(board and TMT) through the dual-agency lens may help us under-

stand when firms improve performance and how to manage incen-

tives among the elites who run organizations.

2|THEORY DEVELOPMENT AND

HYPOTHESES

Compensation is central to eliciting effort and risk bearing

(Eisenhardt, 1989; Jensen & Murphy, 1990). Agency theory focuses

on incentivizing individual agents, whereas tournament theory and

relative deprivation/equity theory explain the influence of relative

incentives on performance (Connelly et al., 2013; Henderson & Fre-

drickson, 2001). Pay dispersion, or the differences in relative pay, are

classified into vertical and horizontal pay dispersion (Shaw, 2014).

Vertical pay dispersion refers to differences in relative pay between

the highest paid executive and an average employee. Vertical pay dis-

persion is elemental to inducing promotion tournaments among low-

178 PATEL ET AL.