In Western industrialized countries, the remuneration of top managers has increased dramatically in recent years. At present, this circumstance has become the subject of heated discussions both in scientific circles and in society as a whole. From the economic point of view, this phenomenon is attempted to be explained as the result of the development of market processes. A higher price for managerial services in a well-functioning market reflects either their relative scarcity, or an increase in their marginal productivity.
It was hypothesized that managers themselves often get the opportunity to influence demand in the market of management services (van Essen, Otten, Carberry, 2015). According to the latest empirical research, managers really manipulate the process of paying for their own labor, creating conditions in which they can very successfully pursue their own self-serving goals (van Essen, Otten, Carberry, 2015). The current salary of managers is often higher than the level that corresponds to their marginal productivity. In other words, market forces are working inefficiently. But this alone does not explain why the salary of managers has increased particularly strongly in recent times.
In 1992, the US Securities and Exchange Commission (SEC) imputed to corporations the obligation to publish data on the remuneration of top managers. This step by the US authorities paradoxically affected the market for managerial services, launching into practice the method of calculating the salary of manager based on its size by the so-called reference groups. This method initiated a steady and rapid increase in average compensation for managerial work in the United States (Wang & Singh, 2014).
Level and structure of remuneration of managers
Three main features have recently characterized the dynamics of managers’ wages. Firstly, the absolute level of average payments to top managers has greatly increased. In the US, the average income of a top manager (CEO) in the 500 largest firms in the country increased from $ 2.5 million in 1992 to $ 7.9 million in 1998.
Secondly, there is an increase in the gap between the salaries of managers and other employees working for hire. If in 1970 the ratio of the average salary of top managers (including proceeds from the exercise of the stock option) and industrial workers was 26:1, in 1999 it reached 475:1.
Thirdly, the share of the variable component in the remuneration of managers has sharply increased. The share of salary’s constant component in the total amount of wages of top managers in 1998 was only 24%.
These trends are most pronounced in the US market, but are also typical for other Western countries. Thus, the analysis shows that in Germany the income of members of the board of companies in 1987-1996 increased more than the wages of other employees, although not in the same proportion as in the United States. On average, remuneration of managers increased during the indicated period by 6.7% per year.
These trends can be explained, at least in the US, by the increasing use of the stock option as a tool for payment of managerial services. Despite the growth of main wages and bonuses, it is the option that is the main form of considerable increase in managers’ income, and thus the reason for the gap with the remuneration of other categories of employees, as well as the tendency to increase the share of the variable component. Thus, there is an obvious and close connection between the development of the structure of remuneration (a sharp increase in the variable component) and the level of wages. Therefore, it must be borne in mind that the assessment of wages cannot be carried out without taking into account the type of remuneration for labor. Payment for managerial services mainly in the form of a share option, for example, is fraught with risks for managers much more than fixed payments. This circumstance some researchers cite as an argument in favor of the fact that the level of wages of modern managers is excessively overestimated. In addition, managers have little opportunity to diversify their personal risks, if they have to keep most of their funds in the form of shares of their own enterprise. But even taking into account the increased risks, their wages have significantly increased in recent years.
Empirical research shows that a top-level manager (CEO) of a large US firm estimates his share option on average 70% below its market value. Nevertheless, theorists and practitioners allege that managers still have the opportunity to diversify their risks in a shareholding package, and therefore valuing their option at market value is an accurate approximation in determining the amount of wages.
Management Services Market
In the entrepreneurial world, as well as among economists, it is widely believed that the managerial labor market is a well-functioning market. In this regard, the trend of growth in the compensation of managers can be presented primarily as a result of the development of the market process.
In a well-functioning market, the compensation of managers corresponds to the marginal productivity of management services. Therefore, the growth in their remuneration in the US, as well as in Europe, should reflect the higher marginal productivity of managers. Does it really?
To answer this question it is necessary to think about the phenomenon of an option to buy shares at a reduced price as a tool for paying managers. In a well-functioning market, high payments in the form of an equity option are justified, as they serve as a guarantee that the manager will focus on increasing the cost of equity. The higher marginal productivity of management services, resulting from the orientation towards shareholder value, would have to be reflected in the higher contribution of managers to the increase in the value of the enterprise. This point of view has a very wide circulation: the revival in the US economy, which in the 1990s led to the longest economic boom in the country’s history, is often linked with focusing on the value of enterprises.
Increased demand for managers focused on shareholder value should be understood as a shift in the structure of demand in the market of managerial work. Some authors attribute this to the growing importance of capital markets, which in turn is the result of two trends: the deregulation of the 1980s on a national and international scale and the increased role of institutional investors. Later, the development of new information and communication technologies was added to this. The new situation strengthened the orientation towards shareholder value with support for managers being bought by generous programs for granting preferential stock options.
It should be recognized that the former forms of compensation for labor costs to managers no longer met the goals of maximizing the value of the enterprise. In the early 1980s, pay was not foreseen for large incentives for good results, nor for financial sanctions for failures. The exchange boom made it easier for the outlined strengthening of the binding of “agents” (in this case managers) to “principals” (owners of enterprises), i.?. subjects of principal-agent model. The trend towards granting options reflects the growth of a positive attitude towards them from top management in connection with the constant increase in the share price for almost 20 years.
The content of this explanation depends on whether the incremental granting of options has actually led to an increase in the marginal productivity of managerial services. An analysis of the relationship between incentive wage systems and enterprise achievements makes it doubtful. Researches show that the results of firms’ activity are only 5% explained by changes in the remuneration of managers. On the whole, a positive, but far from convincing, link between the provision of stock options and the success of enterprises is confirmed. But even if such a relationship is observed, it remains unclear whether the options are really a strong incentive leading to increased sales and income from equity or successful firms simply pay more to their top managers. There are numerous indications that the latter interpretation is correct. The company’s profit margins, which for the manager mean increasing the income from the option, often depend on external circumstances, and not on the work of managers. Therefore, in general, it can be argued that the exemplary stories about the successes of the American system of incentives for managers are not consistent with the results of research in the field of their remuneration. Previous discussions also show that the observed pay trends of managers reflect simply a rise in wages rather than a transition to an effective incentive system.
Excessive increase in the wages of managers may also be due to a lack of supply in the market of related services. Firms were engaged in search of new forms of a payment of labor to manage to employ managers who become more and more scarce. A sharp increase in labor costs compensation could mean from this standpoint that demand for managers has increased significantly, and their supply has dramatically decreased.
In the course of discussions on the so-called war for talent, the opinion is often expressed that the reason for the supply deficit here is a decrease in the birth rate. As confirmation of this point of view, a very controversial assumption is made that managerial abilities are of an exclusively innate character, i.e. the necessary human capital cannot be obtained even when the increased demand gives a powerful incentive to that. This explanation sounds particularly unconvincing for the current generation of top managers, who were mostly born during the post-war baby boom.
More convincing are the approaches that put human capital at the center of the problem from a slightly different angle. The supply deficit of management services can be correlated with the fact that in connection with the globalization and development of information and communication technologies, a significant portion of the human capital of managers has very quickly depreciated. The scarcity of managerial personnel can also be a result of the fact that very few managers are preparing at the enterprises themselves. This, in turn, is because the top management is afraid of internal competition and prefers, if possible, to restrain the inflow of managers from outside. But such failures in the internal market of managers seem all the same unlikely. In the literature there are no explicit empirical indications either in support or against such an assertion.
Until now, management services have been presented as a homogeneous product or two of its homogeneous parts: traditional managerial human capital and new managerial human capital for working in the conditions of new technologies and globalization. It should be emphasized that the economic analysis of the managerial work market is based on the fact that managers and management services are interchangeable. From this it follows that the manager on a flawlessly functioning market receives a fee not for his individually added value. On the contrary, the level of wages of all managers in the market determines the marginal productivity of the marginal “manager”, i.e. the “quasi-manager”, who is hired last.
Approaching the problem from alternative positions, we can talk about a set of managerial abilities or talents, which at least partially are not interchangeable. At the same time, it is not difficult to prove that it is precisely such managerial abilities that predetermine the success of a firm. The best (in comparison with others) solution in large markets gives the enterprise competitive advantages, which provide it with higher income. This theory can explain the increase in labor costs compensation to top managers in industries where the relative managerial abilities become increasingly important over time. For example, for the telecommunications industry in which globalization leads to a strong expansion of markets and purchases this theoretical argument seems convincing. But since this theory should be expected to reduce compensation for less talented managers, it cannot explain the rapid increase in the average level (median) of remuneration to managers.
Remuneration of managers as a result of their self-serving behavior
Until now, it was assumed that the forces of a flawlessly operating market determine the size of the remuneration of managers or at least the stimulating contracts that the enterprises offered. However, one can question the widely held view that the interests of managers are optimally consistent with the goals of the owners of firms due to the influence of market forces or incentive contracts. Managers as providers of management services can often influence the demand for these services with profit for themselves and manipulate the process of paying for their labor. More important, however, is that the conditions that enable managers to successfully realize their interests depend primarily on the overall institutional environment. Recent empirical evidence shows that the level and structure of remuneration of managers is determined by the scale of control with which they come across as agents hired by the principal. Thus, the remuneration of managers depends on the quality of corporate governance.
When designing a remuneration system for top managers, it is also important to know what has a greater impact on the firm’s performance: the work of managers or external factors relative to the firm. Usually the effect of the productive work of managers becomes more significant as the duration of the time interval increases. If in the short term the contribution of top managers is largely determined by external circumstances and market conditions, then the consequences of the strategic decisions taken by them can already be considered on a longer time interval.
Analysis of the latest developments shows that the trend towards an increase in the remuneration of managers remains. It was not even slowed down by the collapse of the stock market in 1999. Moreover, in 2000 the average income of managers of the 200 largest American firms increased by 25% compared to the previous year.