Abstract
Using a sample of 344 non-financial companies from FTSE All-Share Index over financial year 2002 to 2011, this research investigates the determination of executive compensation in the UK. By questioning the underlying assumptions of the optimal contracting approach, we propose our managerial power hypothesis and peer benchmarking hypotheses in the particular UK context, leading to the first level and the second level integrated compensation models to be set in our study. Drawing on the managerial power approach, we combine managerial power with the traditional optimal contracting model to test the impact of managerial power on the level of executive pay. For this purpose, we construct a set of managerial power indexes combining corporate governance attributes via PCA technique to measure the degree of influence that top executives can exert over the board in the pay negotiation process in the UK context. We find that after controlling for firm characteristics, the level of executive pay is not significantly related to the degree of managerial power. Grounded on prospect theory, we further investigate the widespread use of peer benchmarking in pay setting process from a behavioural perspective by incorporating the behavioural elements in terms of the cognitive biases of framing and loss aversion into our first level integrated compensation model. We find that after controlling for managerial power and firm characteristics, the change in pay is positively related to the pay anomaly adjusting towards peer pay benchmarks, and underpaid CEOs and executives receive higher pay increases in the following year. More importantly, we also find that after controlling for managerial power and firm characteristics, in terms of all CEO pay changes and executive cash pay changes, there is a significant asymmetric pay adjustment between underpaid executives and overpaid executives in the sense that underpaid executives receive significant pay increases in the following year, while overpaid executives only receive insignificant pay decreases in the following year, leading to an upward ratcheting of top executive pay levels overtime. A critical insight generated from our results is that the use of peer benchmarking is strongly driven by the behavioural factors, leading to a systematic increase in top executive pay overtime. Firstly identifying the behavioural motives behind the widely use of peer benchmarking in top executive pay setting in advanced market, we therefore reach the conclusion that the behavioural factors play a key role in the determination of executive compensation. Further discussion reveals that after controlling for managerial power and firm characteristics, the use of peer benchmarking has a significantly negative moderating effect on the pay-performance relation of CEO total pay, indicating that the irrational pay decision behaviour weakens the pay-performance sensitivity of executive compensation. We fully address the endogeneity concerns on the explanatory variables arising from unobservable heterogeneity, simultaneity and dynamic endogeneity by applying static and dynamic panel estimation methods. Our results are also robust to several other alternative specifications.