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What Drives the CEO Pay Ratio? a Comparison of Firms on Europe’S Main Stock Exchanges

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What Drives the CEO Pay Ratio? a Comparison of Firms on Europe’S Main Stock Exchanges What drives the CEO pay ratio? A comparison of firms on Europe’s main stock exchanges Master Thesis by R. Hulshof MSc Supply Chain Management Student number S1260519 In partial fulfillment of the requirements for the degree of Master of Science in Finance At the Tilburg School of Economics and Management Tilburg University, November 2018 Supervisors: Prof. dr. L.D.R. Renneboog Tilburg University E.J.P Engesaeth PhD Korn Ferry ABSTRACT This study is developed in light of the revised Dutch Corporate Governance Code which stipulates that Dutch listed firms as per 2018 (reporting year 2017) should disclose their CEO pay ratio. This ratio captures the compensation of the CEO relative to an average employee. So far, studies on this topic have mainly focused on the impact rather than the determinants of this ratio, besides being strongly focused on the US. In this research, we focus on identifying the determinants of the CEO pay ratio within a context of nine European countries. We find that the CEO pay ratio is determined by both country as well as firm-specific variables. Results indicate that firms with less dispersed ownership tend to have a lower CEO pay ratio, because they are likely more capable of controlling their CEO. Moreover, firms that are more innovative or active in the business-to- consumer market have significantly higher CEO pay ratios. In line with the general expectation that unions increase the bargaining power of employees, we find that higher levels of unionization indeed decrease the CEO pay ratio. Next to these firm characteristics, regulation plays also a significant role. Both highly regulated industries (such as the financial sector) and countries with better regulation on shareholder protection have lower CEO pay ratios. Lastly, we find support for the claim that societal characteristics matter, as higher inequality and individualistic cultures result in higher CEO pay ratios. Keywords: CEO pay ratio; CEO compensation; employee compensation; corporate governance. 2 © Copyright 2018, Korn Ferry PREFACE First and foremost, I want to thank Korn Ferry and in particular, Eric Engesaeth. I am truly grateful for the opportunities you have given me. Your passionate way of speaking about executive remuneration and all its aspects has been a huge inspiration. Professor Renneboog, thank you for all the helpful comments, insights and your patience throughout the process. Furthermore, I thank my colleagues within the Executive Pay & Governance team for their support, understanding and insights throughout my time as an intern. You made the end of my student life a rewarding and interesting period. Lastly, my parents, sister and friends. Thank you for the constant support and belief, throughout this project but even more in my entire time as a student. You all mean so much to me. Rick Hulshof Amsterdam, November 2018 3 © Copyright 2018, Korn Ferry TABLE OF CONTENTS Abstract ------------------------------------------------------------------------------------------------------------------------- 2 Preface -------------------------------------------------------------------------------------------------------------------------- 3 Table of Contents ------------------------------------------------------------------------------------------------------------ 4 1 Introduction ------------------------------------------------------------------------------------------------------------ 5 2 Dynamics of the CEO pay ratio ------------------------------------------------------------------------------------ 7 2.1 Institutional frameworks and corporate governance ----------------------------------------------- 7 2.2 The CEO pay ratio -------------------------------------------------------------------------------------------- 11 2.3 CEO compensation ------------------------------------------------------------------------------------------- 17 2.4 Employee compensation ----------------------------------------------------------------------------------- 25 2.5 Back to the CEO pay ratio ---------------------------------------------------------------------------------- 30 3 Determinants of the CEO pay ratio: hypotheses ----------------------------------------------------------- 33 3.1 Determinants of the CEO pay ratio between countries ------------------------------------------- 33 3.2 Determinants of the CEO pay ratio within countries ---------------------------------------------- 38 4 Data and methodology -------------------------------------------------------------------------------------------- 41 4.1 Sample and data sources ----------------------------------------------------------------------------------- 41 4.2 Variable description ----------------------------------------------------------------------------------------- 42 4.3 Methodology --------------------------------------------------------------------------------------------------- 47 5 Results ------------------------------------------------------------------------------------------------------------------ 50 5.1 Descriptive statistics ---------------------------------------------------------------------------------------- 50 5.2 Regression results -------------------------------------------------------------------------------------------- 58 5.3 Robustness tests ---------------------------------------------------------------------------------------------- 64 6 Conclusions ----------------------------------------------------------------------------------------------------------- 68 6.1 Discussion ------------------------------------------------------------------------------------------------------ 68 6.2 Limitations ----------------------------------------------------------------------------------------------------- 71 6.3 Future research ----------------------------------------------------------------------------------------------- 72 References ------------------------------------------------------------------------------------------------------------------- 74 Appendix A – Sample constituents -------------------------------------------------------------------------------------- Appendix B – Variable list ------------------------------------------------------------------------------------------------- Appendix C – Descriptive statistics ------------------------------------------------------------------------------------- Appendix D – Regression results ---------------------------------------------------------------------------------------- Appendix E – Robustness tests ------------------------------------------------------------------------------------------- 4 © Copyright 2018, Korn Ferry 1 INTRODUCTION According to the revised Dutch Corporate Governance Code (2016), as of fiscal year 2017 Dutch listed companies are required to report the CEO pay ratio in their annual report. In practice, this ratio captures the compensation of the CEO relative to an average employee. With this regulation, the Netherlands was a first-mover in Europe, although the European Commission intends to establish guidelines for all their members regarding CEO pay ratio disclosure within the broader set of policy guidelines called the Shareholder Rights Directive. More recently, also the United Kingdom (in early 2018) and France (in October 2018) have proposed legislation on the disclosure of the CEO pay ratio, but these laws/ codes are not finalized yet. Outside Europe, the United States have introduced the disclosure of the CEO pay ratio as part of the Dodd-Frank act (developed in 2010 but effective as of fiscal 2017). CEO compensation has been subject of public debate for a few decades. One topic of interest has been the comparison of what a CEO earns relative to a rank-and-file employee. Now, with the introduction of legislation on CEO pay ratio disclosure, the topic receives increased attention. Especially, the ‘fairness question’ seems to get quite some attention: is the CEO pay ratio fair? This is a question that strongly relates to broader societal question about social (in)equality. It often feeds both public outcry over excessive executive compensation on the one hand and the reluctance of companies/ executives to disclose these ratios (Helmore, 2018) on the other. Our research may not be able to answer these heated questions but aims to contribute to understanding the drivers of the CEO pay ratio. In an emotional debate we try to objectify by bringing facts into the equation. What creates the differences in CEO pay ratios between firms and countries? Initial answers may help us in understanding the disclosed ratios and provide insight to assess whether certain ratios are in line with expectations or not. This is also question that comes up in Dutch general media (Tamminga, 2018), e.g. does it make sense that supermarket Ahold-Delhaize has a CEO pay ratio of 114, brewer Heineken a ratio of 215 and oil storage firm Vopak a ratio of 17? And if yes, what determines these differences? In conclusion, the CEO pay ratio is a hot topic in the public and political debate. So far only limited academic research on its determinants exists (Faleye, Reis & Venkateswaran, 2013). Moreover, the research that does exist is mainly focused on US companies (Shin, Kang, Hyun and Kim, 2015). Examples are Balsam, Choi and Ju (2016) and Faleye et al. (2013) who use a combination of country level and firm level variables to determine the CEO pay ratio and This study has the objective to contribute to the literature, based on European data. Given the role of the Netherlands as first-mover, in terms of the CEO pay
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