Firm Performance and CEO Pay: Relational Demography as a Moderator *

Abstract

Boards of directors of business firms typically establish committees to deal with their two most pressing problems, limited time and complex issues (Lorsch and MacIver, 1989; Conyon and Peck, 1998). Many of more critical board decisions are made within these smaller, more manageable groups and then ratified by board as a whole (Kesner 1988). One of most critical of board committees is compensation committee in charge of determining compensation of chief executive officer (CEO) (Daily et al., 1998). Considerable public concern has been expressed over possibility that a favorable relationship between compensation committee and CEO may cause compensation committee to look too favorably on CEO's case (Conyon and Peck, 1998; Daily et al., 1998; Fierman 1990). The present study addresses this issue by using relational demography to examine influence of demographic dissimilarity between CEO and compensation committee members on extent to which committee ties CEO pay to firm performance. The term relational demography refers to the comparative demographic characteristics of members of dyads or groups who are in a position to engage in regular interactions (Tsui and O'Reilly, 1989: 403). Prompted by Pfeffer's (1983) call, researchers in last decade have explored effect of relational demography on work-related outcomes in a variety of contexts (Lawrence, 1997). Similarity in demographic characteristics such as age, gender, tenure, education, and race have been shown to influence outcomes such as turnover within executive work teams (Jackson et al., 1991; Wagner et al., 1984; Wiersema and Bird, 1993), superiors' ratings of subordinates' performance (Tsui and O'Reilly, 1989), recruiters' evaluations of applicants (Graves and Powell, 1995), employees' organizational attachment (Tsui et al., 1992), and nature of horizontal and vertical dyadic relationships in Chinese organizations (Farh et al., 1998). In general, individuals seem more inclined to act favorably toward and maintain their association with individuals who are similar to themselves in demographic characteristics than individuals who are dissimilar to themselves. This line of reasoning has been extended to boardroom. For example, Belliveau et al. (1996) hypothesized that high social similarity between a CEO and a compensation committee chairperson would be positively related to overall level of CEO compensation. Similarly, Zajac and Westphal (1995) found that demographic similarity between a firm's CEO and board of directors affects explanation board uses to justify adoption of a long-term incentive plan (stock options, performance shares, and bonuses) for CEO. Specifically, they found that when board of directors is demographically similar to CEO they are more likely to use human resource explanations (e.g., need to attract talented persons) when adopting a long-term incentive plan. On other hand, if board is less demographically similar to CEO, they are more likely to use agency explanations (e.g., need for motivation) when adopting a long-term incentive plan. Finally, Daily et al. (1998) found that composi tion of compensation committee (affiliated directors and CEOs) affect level as well as structure of compensation package that is afforded CEO. This study extends this stream of literature by examining extent to which demographic similarity between members of compensation committee and CEO affect pay/performance link. The remainder of this paper is organized as follows. We begin with a review of theory on corporate governance and CEO compensation, which is followed by a review of relational demography literature. We then develop hypotheses pertaining to each of demographic variables. The next section discusses sample selection, measurement of variables and statistical procedures used to test hypotheses. …

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