Essays on executive compensation: examining pay and performance associations, choice of performance measures and the use of relative performance evaluation in compensation contracts

This thesis contributes to our understanding of executive compensation schemes in the United Kingdom (UK). On one hand, the study focuses on the effectiveness of long-term incentive plans (LTIPS) which has come under scrutiny in the recent past. On the other hand, it tests within various settings whether compensation contracts are designed optimally. It also looks in detail at the contractual features of long-term incentives which have received little attention in the literature to date. The first empirical chapter analyses the effect of firm performance on Chief Executive Officer/ Chief Financial Officer (CEO/CFO) pay by employing a sample of non-financial FTSE 350 firms during 2010-2014. We test this association by differentiating between the impacts of short-term and long-term performance on short and long-term compensation. The short and long-term compensation components consist of cash (salary and bonus), equity (performance share plan, share option, matching plan and others) and total realized pay (salary, bonus and total equity vested) of CEO and CFO compensation. We also explore the effectiveness of LTIPs awarded to executives by examining the impact of different numbers, amounts and types of long-term plans on the long-term pay-performance responsiveness. The results indicate that CEO long-term pay, total realized pay and total remuneration are determined by a firm’s three-year performance. These results also hold true for CFO but the relationship is not as strong as that for CEO. Also, for CEOs and CFOs, companies that use three or four separate LTIP plans award higher realized pay and total remuneration than companies that do not award any LTIP. However, for CEOs, companies that operate one, two or three plans in a compensation package, align the interests of CEOs with those of the shareholders. Basic plans in compensation packages tend to increase the pay-performance responsiveness. Within these LTIPs, the more valuable the grants are, the stronger the pay-performance relationship becomes. However, for CFOs, greater number or amounts of LTIPs correspond to higher total compensation and realized pay and greater pay-performance responsiveness. These findings suggest that higher grants encourage greater CFO effort, leading to higher equity vesting because of the attainment of performance targets. For CFO, the pay-performance responsiveness differs in number and amount of long-term incentives awarded than that of CEO. Finally, these findings remain consistent with the use of market adjusted TSR, further strengthening the conclusion of the research question. Next, we analyse the influences on and the effects of the choice of performance measure in CEO compensation contracts, for a sample of 3400 plans from 2007 to 2015. We investigate the link between the choice of performance measure and the volatility of earnings per share (EPS) and total shareholder return (TSR), taking into account four different performance categories, in that a firm may use either EPS or TSR, both, or neither. This allows us to utilize a comprehensive cross-section of plans and accounts for when both EPS and TSR are jointly employed. We find that EPS in combination with TSR is the most common performance metric employed by firms. The findings show that firms with higher EPS volatility and lower TSR volatility are more likely to choose TSR as a performance measure and that firms with higher EPS volatility are less likely to choose EPS alone; we argue that these results are in line with optimal contracting theory. Our results are robust to controlling for plan types, industry and time fixed effects. We control for the effect of the identity of the advising compensation consultant and also for industry on the category of performance measure, and find that some consultants, and some industries, have marked preferences for one measure over another. This, we argue, is an evidence of institutional isomorphism. The final empirical chapter analyses the effect of common shock on the selection of relative performance evaluation (RPE) based plan in the construction of CEO compensation packages. The results indicate that firms implement RPE based measures exclusively when a performance measure contains significant shocks which are common amongst peer companies and are consistent with the predictions of agency theory. These results are robust after controlling for the identity of the remuneration consultant and alternate proxies for common risk, for example, r-square and correlation. We provide a novel analysis of the breakdown of RPE characteristics, namely, different peer choices, threshold targets, and the equity vesting pertaining to these threshold targets by industry in compensation contracts as set by the firms. The findings reveal that firms are very distinct in their peer group selection and the choice of performance targets. Furthermore, we assess the relationship between common risk and the characteristics of the RPE. We identify that firms facing greater common risk tend to employ tougher performance targets in the shape of wider target spread and a lower percentage of equity vesting at the median and upper quartile threshold targets, where target spread is the difference between median and maximum performance required for equity vesting. Finally, we find that vesting percentages vary in characteristics of RPE