Does Firm Strategy Explain the Growing Gap between CEO and VP Pay?

In recent years, the gap between the compensation of CEOs and their vice presidents (VPs) has been increasing, especially equity compensation (i.e., stock and stock options). Scholars have proposed several explanations. First, the pay differential may relate to the varying risks those executives face in managing their firm. Second, it may be the result of tournament incentives: The senior executive with the highest relative output will typically win the tournament, get promoted to the rank of CEO, and receive the promotion prize. Third, a large pay gap could simply reflect inadequate internal governance of the firm, which will benefit the entrenched CEO but is detrimental to firm value.

In a recent study, we examine whether CEO−VP pay differentials are associated with firms’ strategy, as strategy is a significant consideration when a firm decides to promote or otherwise reward its executives. Firms are managed by the top management team (TMT), where CEOs are always involved in strategic decisions and are less likely to fully delegate these decisions to other members in the TMT. The choice to share the decision authority of the CEO with VPs is partially determined by the speed required in strategic decision-making. Arriving at a consensus between CEO and VPs on these decisions could be time-consuming, while concentrated decision-making authority will accelerate the process.

A firm’s need for timely strategic decision-making is derived from its strategy. Prospector-type firms (i.e., those aggressively pursuing new opportunities by rapidly changing their product-market mix) often face a competitive market and need to react quickly to changing environments, whereas firms pursuing defender-type strategies (i.e., those that concentrate on existing products or services and strive to maintain organizational and operational stability) would have less demand for quick decisions. Strategic decisions determine the core of a firm’s business, guide a wide range of decisions throughout the firm, and have a substantial effect on firm performance. Given that the performance effect of strategic decisions is often captured in executive compensation, we predict a larger CEO−VP pay differential in prospector-type firms, considering their demand for timely strategic decisions and, in turn, CEO dominance in their authority structure. More specifically, we predict that pay differentials will primarily derive from equity compensation as equity pay is more sensitive to firm performance.

Using a large sample of U.S.-listed firms over the period 1998–2016, we find that firms pursuing prospector-type strategies do have larger CEO−VP pay differential in equity compensation. Furthermore, prior literature suggests that the coherence between authority allocation and knowledge distribution underpins an optimal authority structure. We confirm this notion in our sample and show that there is a significantly positive association between CEO−VP equity pay differentials and the aptitude of the CEO relative to her VPs. We also demonstrate that firm value increases when equity pay differentials match a firm’s strategic needs; that is, the value of prospector-type firms is higher when a large CEO−VP equity pay differential exists. We also show that proxy advisers and shareholders react to the confluence of CEO−VP equity pay differentials and firm strategy when issuing say-on-pay recommendations and casting votes. Although large equity pay differentials, on average, receive unfavorable responses from the market, the negative effect is attenuated for prospector-type firms.

Our study sheds new light on the determinants of pay differentials in the TMT. Economists posit that CEO−VP pay differentials can be explained by  a promotion system’s tournament incentives for VPs, corporate governance factors, and the risks individual executives face. We base our theory on the organizational strategy literature and show that the distribution of authority in strategic decision-making between the CEO and VPs may also explain the pay gap.

What is more, our findings add to debates regarding pay inequality/inequity within firms. There are growing concerns that pay differences between the CEO and VPs serve as a red flag for unchecked CEO power and weak internal governance. Our findings, however, suggest that CEO−VP pay differentials could reflect a firm’s strategic priorities and authority structure in strategic decision-making. Empowering a CEO and compensating her accordingly can represent a choice that adds value to a firm, while restricting pay without considering the context may, in fact, be harmful to firm value.

This post comes to us from Margaret A. Abernethy, Yunhe Dong, Yu Flora Kuang, Bo Qin, and Xing Yang at the University of Melbourne, Australia. It is based on their recent paper, “Firm Strategy and CEO−VP Pay Differentials in Equity Compensation,” available here.