This proposal explores the association between the national culture and CEO compensation contract design. In our definition of culture in this document we will be referring to national culture rather than the corporate culture of the firm. Thus the cultural dimension will be related to several compensation metrics which include, the proportion of variable pay to total compensation, total CEO pay and the ratio of CEO pay to the lowest level employees. Therefore, this thesis will examine the influence of the CEO’s national cultural background on compensation contract design (CCD) and attempt to realise if the CEO’s national cultural background significantly affects the compensation contract design.
RQ: Does the CEO’s cultural background affect the compensation contract design?
Becker and Murphy, (1988) postulates that a thorough understanding of internal incentives is crucial to developing a viable theory of the firm, since they largely determine how individuals behave in organizations. Executive compensation is, therefore, a crucial aspect as it is designed to incentivize the CEO to ensure that the company’s goals are met while the shareholders’ value increases (Center on Executive Compensation n.d.).
The compensation plans vary with different firms and their performances. However, in most cases, the pay packages consist of standard components namely, the salary, long term incentives, annual incentives, severance and change in control agreements, short term incentives, perquisites, performance shares and others (Center on Executive Compensation n.d.). In this regard, there is a vast literature on compensation plans for CEOs and the determinants and fairness of these plans. Additionally, there are various studies on the compensation plans based on the CEO’s performance as well as their cultural background on the company’s performance. However, little has been studied to show how the CEO’s national cultural background may influence their CCD.
To provide an answer to this question, I will make comparisons of the compensation packages based on cultural background characteristics such as uncertainty avoidance, power distance, individualism, and masculinity-femininity. These characteristics influence the CEO’s behavior and performance, thereby affecting their compensation packages. Executive compensation has been a controversial issue primarily because investors use it as a metric to measure the quality of a company’s governance (Singh, 2006). Thus, by addressing it from this perspective, this thesis will provide more insights to investors, shareholders, board of directors, policymakers, aspiring CEO’s, researchers and academics on how CCDs can be created and improved with regard to cultural background of a CEO to motivate them into delivering what is expected of them
2. Related literature
Abernethy et al (2015) in his paper posits that CEO’s appointments are due to attributes and skills they bring to the company and some of these correlate with their cultural background. Further, compensation design adopted by a particular firm is based on a performance measure since it is easily determined by how the CEO’s sail through difficult moments experienced by the company. Decision-making ability translates to performance and the CEO’s power to make necessary decisions that may impact the shareholders’ decisions over CCDs. Companies with powerful CEOs attach fewer challenging targets in the initial PVSOs they grant to the CEOs.
Pan et al. (2019) also argues that the ethnic composition of a CEO’s early life environment plays a significant role in the cultural transmission process. Thus, cultural heritage influences the CEO’s attitudes towards uncertainty, which in some cases impacts corporate acquisition decisions. He further explained that the design of executive compensation provides a powerful mechanism to align the traditionally divergent interests of CEOs and owners, especially since firm outcomes such as performance tend to interact non-uniformly with the various elements of executive compensation.
However, Becker (2006) further argued that CEOs age carries with it a portfolio of personal values, experiences and mindsets that shape his or her attitudes and behaviors, which are eventually reflected in organizational actions and outcomes. There are certain psychological changes that are associated with aging. This includes changes in values, needs, expectations and mindsets. These changes could eventually affect the attitudes and preferences that an individual holds toward various strategic issues and options facing the organization hence the cultural background will matter less.
3. Hypothesis Development
H0: CEO’s cultural background significantly affects the contract compensation design
H1: CEO’s cultural background does not significantly affect the contract compensation design
H2: CEO’s cultural background significantly affects the contract compensation design which is directly proportional to the outcome of the firm.
According to Nguyen et al (2018), CEOs whose cultural heritage is characterized by lower individualism, higher uncertainty avoidance and higher restraint are more likely to outperform under pressure. It also suggests that cultural heritage plays a larger role in explaining competitive performance relative to genetic differences between people in their countries of origin. The differences in CEO incentives across cultural backgrounds can be driven by systematic differences in skill. Therefore, the culture of CEOs ancestors has an impact on their decision making and performance. Thus CEO compensation should be structured based on their cultural background.
Cultural origins can affect the CEOs’ risk attitudes (Holmstrom,1979).Higher performance pay not only induces greater effort exertion from the agent but also increases the risk of wage contract since performance measures are noisy indicators of true effort levels. Risk-taking cultures can be attributed to the CEO’s cultural origins that form a basis for cultural attitudes towards risk management. Thus CEOs from different cultural origins have different risk attitudes that impact on the compensation contract designs.
Deci et al (1975) suggests that individuals respond to intrinsic rewards such as pleasure and satisfaction from doing a task. The relative importance of intrinsic and extrinsic rewards can vary across individuals, partly driven by their personalities and cultural backgrounds that influence their needs and desires (Eisenberger et al, 1999). Thus CEOs from different cultural origins can have different attitudes regarding the intrinsic and extrinsic value of work. This should be considered in the design of the CEO compensation plan.
Also, the work attitudes channel posits that cultural origins can influence CEOs’ attitudes toward the value of work, especially regarding the relative importance of monetary compensation and intrinsic rewards such as feelings of satisfaction and accomplishment derived from the work itself. If intrinsic motivation and extrinsic incentives are substitutes, then CEOs from cultures that emphasize the intrinsic value of work should receive fewer monetary incentives than CEOs from cultures that view work as just a way of making money. If intrinsic motivation and extrinsic incentives are complements, then these CEOs should receive more monetary incentives.
Several studies have pointed out the existence of a positive relationship between the contract compensation design and the organization’s performance. In the study of Jeppson et al. (2009), the contract compensation design revealed to be positively related to the organization’s total sales. The assignment of remunerations that are exclusively fixed has great inconvenience because it does not motivate the mangers sufficiently which will lead to that, consequently, they will not develop enough efforts in order to achieve the maximum profitability for the firm. CEOs put on a lot of efforts in terms of performance when their incentives are more lucrative.
Moreover, cultural attitudes towards risk-taking and work ethics affect the optimal incentive contracts (Liu, 2013). Liu states that CEOs from different cultural origins have not only different cultural attitudes but also different work ethics. Thus, those with higher work ethics place more value on hard work and meticulousness and derive more intrinsic rewards from work itself. In this regard, shareholders provide weaker incentives to CEOs with risk-averse cultures to avoid the cost of imposing risk on them. The avoidance of these costs is because the CEO’s attitude will be exhibited in their performance, which is an accurate indicator of their effort levels especially in regards to risk-taking. Thus, we hypothesize that:
H0; CEOs cultural background significantly affects the contract compensation design
4. Research Design
Independent Variables(X) Dependent Variables (Y)
This is a quantitative study because it measures the relationship between CEO’s cultural background affect and compensation contract design. Therefore, the most suitable research design for this study is correlational research design since this study focuses on examining the relationship between variables. This research design entails the use of continuous and natural variables from the relevant population, where there is no need to manipulate the variables.
5. Data Sources and feasibility of the research
The kind of data used in this proposal is secondary data obtained from https://www.eur.nl/en/library/erasmus-data-service-centre/database-lists. This data will be collected over a period of 5 years for German firms between 2014 to 2019. This will have the positive effect of the use of the most recent data and time series data for different managers thus ensuring the credibility of the results gotten. Also, data on the number of CEOs and their compensation packages are available on the websites and profiles of large publicly listed German firms. Data on the cultural backgrounds including ethnicity and socioeconomic status of the CEO is available on company profiles which they are currently working on. The personal profiles of the CEOs were mainly on whose cultural origins are identified based on their country of birth.
Due to a large amount of data acquired on German companies, and from personal and professional profile accounts of the CEOs, I anticipate some challenges with processing the data. Thus, the use of (statistical programs) will help to merge and to process large sets of data.
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Deci, E.L., Cascio, W.F. and Krusell, J., 1975. Cognitive evaluation theory and some comments on the Calder and Staw critique.
Eisenberger, R., Pierce, W.D., and Cameron, J., 1999. Effects of reward on intrinsic motivation—Negative, neutral, and positive: Comment on Deci, Koestner, and Ryan (1999).
Graham, J, R., Si L, and Jiaping Q (2012). Managerial Attributes and Executive Compensation. Review of Financial Studies 25 (1), 144-186. https://doi.org/10.1093/rfs/hhr076
Liu, X 2013. Cultural origins and CEO incentive contracts (pp. 307-327). Unpublished working paper. Retrieved from https://www.aeaweb.org/conference/2014/retrieve.php?pdfid=504
Nguyen, D.D., Hagendorff, J. and Eshraghi, A. 2018. How a CEO’s Cultural Background Impacts Firm Performance. Harvard Law School Forum on Corporate Governance. Retrieved from https://corpgov.law.harvard.edu/2018/04/02/how-a-ceos-cultural background-impacts-firm-performance/ (Accessed on 5th February 2020).
Pan, Y., Siegel, S. and Wang, T.Y. (2019). The Cultural Origin of CEOs’ Attitudes Towards Uncertainty: Evidence from Corporate Acquisitions. https://doi.org/10.1093/rfs/hhz109
Singh, R. (2006). Board independence and the design of executive compensation. EFA 2005 Moscow Meetings Paper; Harvard NOM Working Paper No. 673741. http://dx.doi.org/10.2139/ssrn.673741