What is a fair amount of executive compensation? Outrage potential of two key stakeholder groups

• Published date: 01 May 2018
• Author: Robert Grasser,Markus C. Arnold
• DOI: http://doi.org/10.1111/jbfa.12309
• Date: 01 May 2018

DOI: 10.1111/jbfa.12309

What is a fair amount of executive compensation?

Outrage potential of two key stakeholder groups

Markus C. Arnold1Robert Grasser2

1Universityof Bern, Institute for Accounting,

Engehaldenstrasse4, 3012 Bern, Switzerland

2Universityof South Carolina, Darla Moore

Schoolof Business, 1014 Greene S t, Columbia,

SC29208, USA

Correspondence

RobertGrasser, University of South Carolina,

DarlaMoore School of Business, 1014 Greene St,

Columbia,SC 29208, USA.

Email:robert.grasser@moore.sc.edu

Fundinginformation

Universityof Hamburg; University of Bern

Abstract

The public discussion of executive compensation often centres on

‘fair’ and ‘unfair’ amounts and the public outrage over compensa-

tion that is deemed too high. The academic literature states that

such outrage can lead to outrage costs, pressuring firms to adjust

compensation levels. However, it is unclear what a ‘fair’ compen-

sation is for various stakeholders and how their fairness concerns

relateto outrage constraints. Based on surveys among two key stake-

holder groups (representative eligible votersand investment profes-

sionals), we provide evidence that fairness is an important criterion

for both groups but that opinions on how large a fair compensation

amount should be are widely dispersed. Moreover,personality traits

systematically influence fairness opinions through self-serving inter-

pretations of distributive justice and personal risk attitudes, indi-

cating that a ‘fair’ amount of executive compensation may strongly

depend on the involved stakeholders. Investigating thresholds for

outrage, i.e., amounts above which compensation is judged ‘unfairly’

high, we show that even though investment professionals care for

fairness as well, ‘capital market outrage’ might not equate to ‘pub-

lic outrage’. Our paper contributes to the literature on outrage con-

straints by linking individual fairness concerns to outrage potential

andhas implications for transparency of executive compensation and

research on shareholder activism.

KEYWORDS

distributive justice, executive compensation, fairness, outrage

constraints, public outrage

1INTRODUCTION

Discussions in the media and politics often claim that the amount of executivecompensation should be ‘fair’ and that

current pay practices are not. Consistent with the increased public criticism peaking during the financial crisis (e.g.,

Page & Jacobs, 2009), the media has covered stories of exceptionallyhigh compensation in general and compensation

scandals in particular (Core,Guay, & Larcker,2008). The question of ‘sufficient’ amounts of executive compensation has

also been raised in research (e.g.,Abowd & Kaplan, 1999; Edmans & Gabaix, 2009). Additionally, institutional investors

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seem concerned about the level of executive compensation (Brandes,Goranova, & Hall, 2008; McCahery & Sautner,

2012). Taken together, this evidence points at increased public pressure from stakeholders in general and investors

in particular to limit the amount of executivecompensation. Our study investigates fairness concerns about executive

compensation of two stakeholdergroups – eligible voters and investment professionals – and the role of such concerns

for ‘outrageconstraints’.

As illustrated by the following quotes, the perceived fairness of executivecompensation seems to play a major role

in outrage about executivecompensation:

Why bonuses feel so unfair – Greed. Inequality. Envy. There's no mystery as to why bankers have overtaken

lawyers in the unpopularity stakes. At the heart of the public's resentment of the bonus cultureis the concept

of fairness (The Telegraph,7 Feb 2012).

Over the last few years, the perceiveddivergence between UK economic and corporate performance and execu-

tivepay levels appeared unjustified and fuelled the public and political outcry over so called ‘payments for failure’

(EY,Into the Light, 2014).

Such public outrage about ‘unfair’ executivecompensation is often referred to as an ‘outrage cost’ or ‘outrage con-

straint’(Bruce, Buck, & Main, 2005; Conyon, 2006). Specifically, the (potential) outrage among the public, employees,or

shareholders is suggested to limit the amount of executivecompensation, as it may hurt executives’ reputation or lead

todecreased shareholder support for executive proposals at the shareholder meeting (Core et al., 2008; Hooghiemstra,

Kuang, & Qin, 2015). Some authors even perceiveoutrage costs as one of the most effective means to limit executives’

power over their own compensation (Bebchuk & Fried,2004). Likewise, increased public interest in disclosure and the

disciplining force of outrage also seem to be the impetus for new regulations about increased transparency of execu-

tive compensation and say-on-pay mechanisms like, for example,the Dodd-Frank Act of 2010, sections 951 and 953,

and UK's Directors’ Remuneration Report Regulations of 2002 (Conyon,Fernandes, Ferreira, Matos, & Murphy,2013).

Increased transparency may help regulate executivecompensation if firms anticipate outrage among informed stake-

holders for high compensation amounts and adjust their executivecompensation accordingly (Bebchuk & Fried, 2003;

Conyon, 2014).

Prior research on the outrage constrainthas provided some evidence that the level and structure of executive com-

pensation responds to (non-binding) shareholder votes (e.g., Alissa, 2015; Ferri & Sandino, 2009) and negative press

coverage (Johnson, Porter,& Shackell, 1997; Kuhnen & Niessen, 2012). Thus, potential stakeholder outrage seems to

matter to firms. Little is known, however,about what constitutes the potential for ‘public outrage’, how fairness pref-

erences of stakeholders could enter into executivecompensation and whether fairness preferences about executive

compensation in the broader ‘public’ opinion differ from ‘market’ views on executive compensation. Prior research

often used either negative press coverage (e.g.,Kuhnen & Niessen, 2012) or levels of shareholder voting dissent (e.g.,

Ferri & Maber, 2013) to proxyfor outrage ex p ost. In contrast, this paper is the first to attempt to measure outrage

potential by investigatingopinions on ‘fair’ and ‘unfair’ executive compensation of two key stakeholder groups, eligible

voters, who represent the public perspective, and investmentprofessionals, who represent the market perspective.

As we will explain in more detail below, the question of what constitutes a fair amount of executive compensa-

tion closely relates to the concept of distributive justice (Adams, 1965; Hoffman & Spitzer, 1985). However, even

though most people claim to care about fairness, individual definitions of fairness are usually ambiguous and subjective

(Cappelen, Hole, Sorensen, & Tungodden, 2005; Konow, 2000). This could imply that opinions among stakeholders

about ‘fair’ executivecompensation amounts may be widely dispersed. If this is the case, it may be difficult to find a sin-

gle fair amount of executivecompensation for each firm that most stakeholders would agree with. Moreover, based on

theory from social psychology,we predict that opinions on the fair amount of executive compensation are not unsys-

tematically dispersed but systematically biased according to stakeholders’ personality traits. This would additionally

complicate the determination of a ‘fair’ compensation amount as it would not only depend on the firm and its charac-

teristics but also on stakeholders’ and shareholders’ personality traits.

Specifically, we examine two paths for personality traits to influence perceptions of fair compensation amounts.

First, individuals could exhibit egocentric fairness biases (Babcock & Loewenstein, 1997), i.e., their opinion on fair

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compensation is motivated by self-serving interpretations of fairness and therefore depends on their perceived sim-

ilarity with executives. Second, based on social projection theory (Krueger & Clement, 1997; Ross, Greene, & House,

1977; Taft,1955), individuals’ own attitudes toward risk-affected variable pay could carry over to their preferences for

executives’compensation structure. As we also expect that fairness considerations include compensation for the risk

associated with a more variable pay structure, personality traits could, again, bias opinions on ‘fair’ amounts.

Because it may be difficult to determine a single ‘fair’ executivecompensation amount that could be used to avoid

outrage costs, and therefore, could be traded off against other costs and benefits of executivecompensation, we also

examinea second way in which fairness preferences may enter into executive compensation. Specifically,we also inves-

tigate outragethresholds. By outrage threshold, we mean an amount above which executive compensation is perceived

as ‘unfairly’ high. While such outrage thresholds are likely to be influenced by personality traitsas well, they might be

less demanding than a strict fairness criterion. That is, to avoid outrage,it might be sufficient that a large enough frac-

tion of shareholders and stakeholders do not perceive the compensation as ‘unfairly’ high. Thus, outragecosts may be

related to the ‘unfairness’ of executivecompensation rather than to its ‘fairness’.

We investigate our research question via two surveys among eligible voters and investment professionals in

Germany. The German setting is particularly apt to analyze our question as it is characterized by a stakeholdercul-

ture, high employeerepresentation, and an active role for the government in regulating executive compensation. Thus,

executive compensation plays an important role for different stakeholdergroups. In the first survey, we gather data

from 671 representative eligible voters in the state of Hamburg as part of a bigger survey on political opinions and

attitudes. Our data comprise opinions on both the fairness of executive compensation and the preferred structure of

variable and fixed executivepay. We also gather data about personality traits of the survey participants. Inthe second

survey,we collect data from 140 investment professionals, primarily located in Germany, about their opinions on fair

executivecompensation and preferred executive pay structures. We use these different groups for two main reasons:

First, as prior research often assumes that investors are mainly interested in economic criteria and corporate gover-

nanceof executive compensation (Core, Holthausen, & Larker,1999; David, Kochhar, & Levitas,1998; Hartzell & Starks,

2003), we explore whether fairness perceptions and corresponding thresholds are relevant to investmentprofession-

als. Second, if investors exhibit fairness preferences related to executivecompensation as well, potential differences

and similarities between voters proxying ‘the public’ and investment professionals proxying ‘market’ opinions, may

generate insights into the relationship between outrage in the media and say-on-pay voting and other shareholder

activism.

The results of our two surveys show that the majority of both groups exhibit fairness preferences related to exec-

utive compensation but that fairness opinions are widely dispersed in both groups. As predicted, opinions are also

related to individuals’ personality traits, suggesting that the emergence of outrage may depend on the personalities

of the involved stakeholders. These results indicate that it seems difficult to find a single ‘fair’ amount of executive

compensation that satisfies all stakeholders. When examining outrage thresholds, we find that the actual CEO com-

pensation amounts in all of the 30 largest exchange-listedGerman firms exceed the outrage thresholds of the majority

ofeligible voters. Yet, only half of these firms exceedthe outrage thresholds of the majority of investment professionals.

This result indicates potential differences in ‘public’ outrage and outrageat the capital market. Finally, as transparency

about executivecompensation is an important prerequisite for outrage to become effective, we also analyze how well

participants estimated the actual amounts of executivecompensation. Our results show that most participants largely

under- or overestimate executives’actual compensation. Thus, despite recent efforts to improve transparency about

executive compensation, our surveys among German stakeholderscast some doubt about the effectiveness of these

efforts in this country.

Our study makes several contributions to research and practice. First, we contribute to the literature on out-

rage costs by providing evidence that a large majority of both eligible voters and investment professionals exhibit

fairness preferences related to the amount of executive compensation. We also add to prior research on say-

on-pay voting dissent (Alissa, 2015; Ertimur, Ferri, & Oesch, 2013; Ferri & Maber, 2013) and negative press

coverage (Core et al., 2008; Kuhnen & Niessen, 2012). While these studies typically capture outrage ex post,

we focus on outrage potential ex ante by studying executive compensation amounts that our participants perceive as