Pensions as a Form of Executive Compensation

• DOI: http://doi.org/10.1111/jbfa.12162
• Published date: 01 November 2015
• Date: 01 November 2015

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 42(9) & (10), 1154–1187, November/December 2015, 0306-686X

doi: 10.1111/jbfa.12162

Pensions as a Form of Executive

Compensation

LISA GOH AND YONG LI∗

Abstract: This paper investigates the role of pensions as an element of total executive

compensation, and the relationship between pensions and performance-based compensation

in executive pay. Using hand-collected data on FTSE 100 CEOs and senior executives from

2004−2011, we document that pensions function as a substitute for performance-based com-

pensation (primarily bonuses) in both cross-sectional and time-series settings. We also examine

the effect of corporate governance characteristics on executive pensions. We find that corporate

governance characteristics associated with stronger board monitoring play a constraining role

on the magnitude of pensions. Our evidence of substitution effects between pensions and

performance-based compensation is consistent with a managerial power view of executive

compensation-setting, and the use of pensions as a ‘stealth’ element of compensation. Our

findings are robust to considering different types of pensions, product market competition, and

cross-listing. Sub-period analysis shows that pensions decrease and substitution effects weaken

following the 2008 financial crisis. Moreover, we find no evidence that the use of compensation

consultants with potential conflicts of interest is associated with higher pensions. Overall, our

study contributes to a greater understanding of the role of pensions in executive compensation,

and shows the importance of including pensions in analysis of executive compensation.

Keywords: pensions, executive compensation, performance-based compensation, corporate

governance, managerial power

1. INTRODUCTION

This paper examines the role of pensions, a frequently overlooked element of

compensation, as part of the overall executive compensation package. Pension awards

to executives have come under increased public scrutiny, in light of concerns following

high profile corporate failures. Compensation disclosures from firms such as the

∗The first author is from the Hong Kong Polytechnic University, School of Accounting & Finance, Hung

Hom, Kowloon, Hong Kong SAR. The second author is from King’s College London, Department of

Management, London, UK. The authors thank an anonymous referee, the Editors, and Konstantinos

Stathopoulos, Wim A. van der Stede, Martin Walker,Martin Glaum, Jeff Downing (EAA discussant), and the

faculty at the London School of Economics and Political Science for their helpful comments. The authors

also thank seminar participants from Cambridge Judge Business School, Cranfield School of Management,

Manchester Business School, Shanghai University of Finance and Economics, University of Giessen, and

the 2011 European Accounting Association Congress. Thanks are also given to Osman Ghani for research

assistance. (Paper received December 2012, revised version accepted September 2015).

Address for correspondence: Lisa Goh, Hong Kong Polytechnic University,School of Accounting & Finance,

Hung Hom, Kowloon, Hong Kong SAR.

e-mail: lisa.goh@polyu.edu.hk

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Royal Bank of Scotland and BP highlight the economic significance of pensions,

revealing total pension values of £16 million and £11 million for their CEOs, respec-

tively, departing in the wake of disaster (Daily Telegraph, 2009a; The Independent,

2009).

In practice, pensions are important to investors, corporate governance analysts,

regulators and firms. Compensation committees consider pensions as an important

element of compensation (Weight, 2013), and executives are known to negotiate their

pension benefits (Treasury Committee, 2009).1Evidence also shows that investors are

concerned with pensions as part of the larger debate on executive pay (Deloitte,

2004). Leading institutional investors in the UK, such as the Association of British

Insurers (ABI), express concerns about sizeable pension awards to executives and the

potential for pension payouts on termination to provide a mechanism of rewards for

failure (PIRC, 2010). Pensions to executives are also on the agenda of policymakers:

new executive compensation disclosure regulations require listed UK firms to include

pensions in their calculation of total executive pay, effective from 2014.2

We are motivated to examine pensions as relatively little is known about the

role they play in executive compensation, despite their prevalence and economic

magnitude. Much of prior research focuses on cash-based and equity compensation;

few studies directly address the topic of executive pensions, and have done so mainly

in the US setting (Bebchuk and Jackson, 2005; Cadman and Vincent, 2014; Edmans

and Liu, 2011; Gerakos, 2010; Sundaram and Yermack, 2007; Wei and Yermack, 2011;

and Cassell et al., 2012). Omission of pensions from prior research suggests that

not only has total compensation been consistently underestimated, but that incentive

effects of compensation packages are more complex when including pension-related

incentives.

Academic literature offers competing views of the role of pensions in executive com-

pensation. A growing stream of research examines the incentive effects of executive

pensions and their relationship with equity holdings from an agency-based perspective,

where pensions form debt-like incentives in optimal compensation contracts, and help

to alleviate agency costs of debt vis-`

a-vis equity incentives to induce efforts (Jensen and

Meckling, 1976). Consistent with the ‘optimal contracting’ view, empirical evidence

shows that higher executive pensions serve to reduce overly risky managerial actions

from equity incentives (Cassell et al., 2012) and align executives’ interests with those

of debtholders (Edmans and Liu, 2011; and Sundaram and Yermack, 2007). This

line of research suggests that executive pensions, as inside debt, represent a form of

efficient contracting. Other studies examine the relationship between pensions and

total compensation with mixed findings (Cadman and Vincent, 2014; and Gerakos,

2010).

The lack of quality and transparent disclosures on executive pensions highlights

their opacity, and contributes to our limited understanding of different types of

1 We use the term ‘executive’ to refer to a Chief Executive Officer (CEO) and other executives such as

the Chief Financial Officer (CFO), who are members of the board of directors. UK firms typically have a

unitary board composed both of executive and non-executive directors, commonly referred to in the US as

‘inside’ and ‘outside’ directors, respectively. Our primary focus in this paper is on executives; we consider

non-executives only as a governance mechanism in our empirical analyses.

2 Large and Medium-sized Companies and Groups (Accounts and Reports) (Amendment) Regulations

2013, Schedule 8: Quoted Companies Directors’ Remuneration Report.

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pensions, across various corporate governance regimes. An alternative ‘managerial

power’ view (Bebchuk and Fried, 2004a) suggests that executive compensation is

subject to agency conflicts and is influenced by other factors such as executive

power and discretion. The implication of this view is that pensions, due to their

lack of visibility and complexity in valuation, provide a mechanism for executives

to obscure and extract additional, largely performance-insensitive compensation, as

they are ‘under the radar’. Consequently, pensions may represent a form of stealth

compensation to executives, particularly susceptible to managerial power influences.

Overall, the role of pensions in total executive compensation is inconclusive,

given the competing theoretical views and mixed empirical results. We extend this

literature by examining executive pensions in an international setting where disclosure

requirements and governance of pension arrangements differ from those in the US.

Several institutional features of the UK setting enable us to perform more powerful

tests of the managerial power hypothesis. First, disclosures required by UK law and

governance codes allow us to obtain a unique dataset of disclosed, audited and

actuarially estimated executive pension values. Second, in the UK, executives, as well as

other rank-and-file employees, can transfer defined benefit pension entitlements out

of employer-sponsored pension plans and into private pension plans. Such transfer-out

entitlements potentially mitigate the strength of inside debt incentives to reduce risk.

Indeed, anecdotal evidence from media reports, practitioners and financial advisors

suggests that inside debt incentives provided by pensions can be and have been

circumvented when there is concern over prospects of the pension fund, and the

ability of its sponsoring firm to contribute towards future deficits (Daily Telegraph,

2009b). This is particularly relevant for executives, who have inside information

on the firm’s ability and willingness to fulfill future pension obligations, effectively

providing an option to withdraw their pension holdings before other claimholders.

Third, UK pension legislation allows scheme members to withdraw 25% of their total

accumulated value tax-free immediately on retirement, thus further reducing the

strength of debt-based incentives.

Using a sample of UK-listed FTSE 100 CEOs and senior executives during the 2004–

2011 period, we examine whether pensions function as substitutes or complements to

performance-sensitive elements of the compensation package. In our cross-sectional

analyses, we find evidence that pensions function as a substitute for performance-

sensitive compensation (primarily bonuses), and excess compensation, after control-

ling for the mechanical relationship between pension and salary. We are cautious

about drawing strong inferences about causality on this cross-sectional substitution

effect, as it may reflect variations in firm characteristics or what is considered ‘optimal’

between firms.

We therefore extend our analysis to examine the effect of corporate governance on

executive pensions. Prior research finds that CEOs of firms with weaker governance

receive higher compensation (Core et al., 1999). We find that stronger governance

is associated with lower pensions and mitigates the substitution between pension and

performance-sensitive pay. This result is consistent with Bebchuk and Fried (2004a)’s

managerial power hypothesis, where pensions can be used to extract rents and weaken

pay-performance sensitivity, and is in line with expectations of weaker shareholder

control over less transparent elements of compensation (Craighead et al., 2004).

We then extend the analysis of executive pensions and performance-sensitive pay to

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