Changes in Executive Compensation following an Environmental Shift: The Role of Top Management Team Turnover Author(s): Theresa S.

Cho and Wei Shen Reviewed work(s): Source: Strategic Management Journal, Vol. 28, No. 7 (Jul., 2007), pp. 747-754 Published by: Wiley Stable URL: http://www.jstor.org/stable/20142475 . Accessed: 05/02/2013 07:21
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Strategie
Published online 24 April 2007 inWiley InterScience Received

Management
DOI: revision

Journal
(2007) 10.1002/smj.600 25 July 2006

Streit. Mgmt. (www.interscience.wiley.com) 5 November 2003; Final

./., 28: 747-754

received

RESEARCHNOTES AND COMMENTARIES CHANGES INEXECUTIVE COMPENSATION AN ENVIRONMENTALSHIFT:THE ROLE FOLLOWING OF TOP MANAGEMENT TEAM TURNOVER
THERESA S. CHO1* andWEI SHEN2
1 Rutgers Business
New

School ?Newark
U.S.A.

and

New

Brunswick,

Rutgers

University,

Piscataway,

2 Warrington

Jersey,

College

of Business,

University

of Florida, Gainesville,

Florida, U.S.A.

In

(TMT)

at the top management team in executive the changes study we examine compensation an environmental level following in the airline the context shift. Using of deregulation that: (I) a dramatic environmental that heightens discretion industry, we find change managerial leads to greater level and performance and (2) the greater pay sensitivity of TMT compensation; the magnitude TMT members the environmental the greater among of turnover following shift, this

the compensation change. Copyright ? 2007 JohnWiley & Sons, Ltd.

role in motivating its important Recognizing to maximize shareholder value, many managers researchers have studied the factors influencing executive during the past several compensation decades. Most of these studies employ a cross sectional research design and focus on explaining in executive between compensation a few studies have industries. Only examined in executive changes compensation over time as a response to environmental shifts such as industry deregulation Ezzell and (e.g., Hubbard and Kole Miles, Palia, 1995; 1995; and Lehn, and Finkelstein, 1999; Rajagopalan differences firms or
team; executive compensa Keywords: top management tion; turnover; deregulation * to: Theresa S. Cho, Business Correspondence Rutgers School?Newark and New Brunswick, 94 Rutgers University, Rockefeller Road, Janice H. Levin Building, Piscataway, NJ 08854-8054, U.S.A. E-mail: cho@rbs.rutgers.edu

is that both the level 1992). A general finding of pay and the proportion of performance based pay for CEOs increase after deregulation. no to our knowledge, However, study has examined such mechanism, any organizational as executive that facilitate turnover, might help in executive the changes compensation following a major no environment shift. Furthermore, has examined whether the above study changes in executive compensation, including both the level of compensation and the proportion of at observed the CEO level, pay performance-based can be found at the top management team (TMT) level. The TMT, as the nexus of organizational decision making, has been increasingly recognized as a valuable unit of analysis in strategy research 1996). A recent study (Finkelstein and Hambrick, and Sanders shows that (2002) by Carpenter a TMT is of stronger predictor compensation firm performance, and the effect of CEO pay

*?

*
Copyright ? 2007 John Wiley & Sons, Ltd. %% d-tf0vER

?WILEY

iTit ?rSc??Tic?@
somethTttittt-t

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748
on firm

T. S. Cho and W. Shen

performance is dependent on TMT In addition, information-processing ability. the top demand information-processing facing in increases rises, resulting managers appropriate in executive and (Henderson compensation A few studies have Fredrickson, 1996). reported an increase in both the level and the performance after dereg sensitivity of executive compensation ulation at the CEO level (Ezzell and Miles, 1995; and and Palia, 1995; Kole and Lehn, 1999; and of Finkelstein, 1992). Because Rajagopalan the importance of the TMT in influencing firm (Hambrick and Mason, strategies and performance and Sanders, 2002), firms will 1984; Carpenter not CEO pay but also TMT pay only likely align with the changes in their environments. Thus, we see to the in CEO expect changes compensation reported in prior studies will other members of the TMT. also happen to the Hubbard

compensation.

In this study we extend research on executive the effects of execu compensation by exploring in TMT compensation tive turnover on changes following Industry deregula industry deregulation. tion represents a significant shift in the competitive environment (Levine, 1987; Kole and Lehn, 1997). turnover has been proposed as a crucial Executive to adapt to changes mechanism for organizations in competitive environments (Pfeffer and Salancik, to To environmental 1978). respond changes, firms to their managerial make adjustments capitals and their TMT reconfigure compositions through exec utive turnover (Tushman and Rosenkopf, 1996). While research on the organizational implications turnover has primarily of executive focused on firm performance and Cannella, (Shen 2002), we believe that it also has important impacts on the industry changes in TMT compensation following as firms strive to adapt to the environ deregulation we propose that a high mental shift. Specifically, turnover TMT of increases magnitude significantly the level of TMT compensation and the proportion of performance-based pay. in executive compensa By exploring changes shift (i.e., industry tion following an environmental at the TMT level and the role of deregulation) TMT turnover in the process, our study makes two to the literature. First, it important contributions turnover into research of the issue executive brings on executive compensation, and provides evidence turnover as an important orga regarding executive nizational mechanism that helps facilitate changes in executive compensation after industry deregula tion. Second, our study examines whether changes in the compensation scheme of a TMT are iso a in CEO compensation, with morphic changes exam but that is often assumed relationship rarely ined in existing research on executive compensa tion (Carpenter and Sanders, 2002).

la: The level of TMT compensation Hypothesis will increase following deregulation. lb: The proportion of outcome-based Hypothesis TMT compensation de will increase following
regulation.

The

role of TMT

turnover

in compensation

change turnover often reflects organi Because executive zational effort in adapting to the changed strate it is highly gic context following deregulation, of a firm's TMT turnover likely that the magnitude affects the changes in executive compensation. a high level of TMT turnover Firms experiencing a more dramatic likely perceive impact of the environmental shift on their operations than firms a turnover. of TMT low level These experiencing firms are therefore more likely to adjust executive compensation environment. are responsive a power shift the demands of the changed in TMT composition that Changes cause to changes in the environment within to meet

THEORYAND HYPOTHESES
Compensation changes following deregulation of an industry represents a significant Deregulation environmental shift for the firms in that indus discre try and increases the level of managerial and Boyd, tion (Kole and Lehn, 1997; Finkelstein environment after 1998). The new competitive more executives strategic deregulation provides options and demands
2007 John Wiley

the team favoring the new newcomers the tend to be those comers, because to cope with the new criti who have capabilities in the environment cal contingencies (Pfeffer and as a reflec Salancik, 1978). Their compensation, tion of their human capital (Carpenter and Wade, 2002), will be higher than that of their predecessors at the firm. a high-level at firms experiencing Meanwhile, TMT who
Ltd.

greater cognitive
&

complexity
Sons,

remain
Strut.

turnover following executives deregulation, on the top team may receive higher
Mgmt. 7., 28: 747-754 (2007) DOI: 10.1002/smj

Copyright ?

This content downloaded on Tue, 5 Feb 2013 07:21:33 AM All use subject to JSTOR Terms and Conditions

Research they are likely their firms and task complexity demands and information-processing (Henderson and Fredrickson, 1996; Sanders and Carpenter, 1998). Further, as the new recruits enter the firm than before because remuneration to possess skill sets valued by there is an increase in managerial with the social comparison higher pay packages, and the TMT process within (O'Reilly, Main, 1988) will put an upward pressure on Crystal, Given these remaining members' compensation. to see a higher the above reasons, we expect increase in TMT compensation among firms with a higher turnover following the level of TMT deregulation. association 2a: There is a positive Hypothesis between TMT turnover and the increase in the level of TMT compensation following deregula
tion.

Notes

and Commentaries

749

previous pay structure. Lastly, a higher level of TMT turnover, no matter whether or not it is due to dismissal, helps to overcome the resistance and inertia of the incumbent executives regarding the
adoption tion of a more performance-based compensa system.

2b: There is a positive association Hypothesis between TMT turnover and increase in the pro TMT compensa portion of performance-based tion following deregulation.

METHODS
Sample and data

we chose the air To test the above hypotheses, line industry as our focal industry for several rea sons: deregulation in the industry provided a rela tively clean distinction between the pre- and post deregulation periods (Levine, 1987); and almost all of the companies were single or dominant busi ness to firms, an ideal setting to study response an environmental shift. In addition, it enables us to compare our results directly with previous stud in CEO compensation follow ies of the changes our we For selected 30 sample, ing deregulations. at least with annual sales of public companies

of TMT turnover is also likely The magnitude to affect the increase in the proportion of per formance-based deregu following compensation a necessitates environment lation. A deregulated more reward system due to performance-based decisions influence of managerial the increased on firm performance Finkel and (Rajagopalan stein, 1992; Kole and Lehn, 1999). We believe to adopt this be relatively easier that it will structure for the compensation performance-based incumbent than the recruited executives newly
executives. Performance-based pay increases man

that operated in 1973 and continued $100 million at least until 1986. In order to test Hypotheses la and lb (and only for these two hypotheses) our airline sample by examining we supplemented two additional industries: branded foods (28 firms) and natural gas (35 firms). These served as con trol industries for high- and low-discretion context,
respectively.

(Jensen and Murphy, agerial compensation exec 1990), and is not favored by risk-averse and Hoskisson, utives (Baysinger 1990). Incum bent executives who are used to low compensa tion risk may either strongly resist the adoption of a performance-based pay scheme that imposes on them, or elect to exit risk higher compensation in anticipation of inevitable the firm voluntarily
change. In contrast, the newly recruited execu

risk

All data used in this study were derived from archival sources. Information on TMT compensa from the annual proxy state tion was collected ments. Information on TMT turnover was collected from the 10-K corporate filings of individual firms. Information on firm size, performance, and slack was collected from COMPUSTAT. Measures TMT compensation We defined the TMT as executives who are at or above Senior Vice Present level and any other executives who served as directors of the firm. was measured as the average Total compensation each of the top five highest paid total compensation TMT members received, including: (1) base salary
Strut. Mgmt. J., 28: 747-754 DOI: (2007) 10.1002/smj

tives

self-select with

themselves

into

such

an envi

heightened actually prefer a performance-based tem (in addition to greater overall compensa and Mil (Holmstrom tion) for self-motivation some of them Further, 1990). may come grom, from other high-discretion industries with a com parable degree of turbulence and complexity, and compensation subsequently, performance-sensitive and Boyd, scheme (Finkelstein 1998). Therefore, their pay at the new firm is likely to reflect their
Copyright ? 2007 John Wiley & Sons, Ltd.

ronment

discretion.

They may incentive sys

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750 in cash, income,

or share

T. S. Cho

and W. Shen we conducted a generalized TMT compensation, least squares (GLS) regression on the two compen sation variables of interest. The results are reported in Table 2. Hypothesis la predicts an increase in the level of TMT compensation following dereg ulation. In the first model (1) with total compen sation as the dependent variable, the results show that the coefficient for the interaction term, AIR LINE X (1979-84), is positive and significant ? relations 32375, p < 0.05). Strong positive (b were also found between TMT compensation and the three firm-level control variables: firm size, the results suggest that, profit, and slack. Overall, after controlling for secular trends as well as firm and profit, TMT compensation in the was airline post-deregulation industry significantly la is sup higher than before. Thus Hypothesis size, slack,
ported.

(2) cash bonus, (3) long-term or deferred unit including stock options, performance
plans and long-term management incen

was tive plans; this measure to then converted natural log. In incorporating long-term compensa model to estimate tion, we used the Black-Scholes the value of stock options, as detailed in Hubbard and Palia (1995). Proportion of performance-based pay was measured by the average of the propor tion of outcome-based received by compensation the top five highest paid TMT members, in which com each member's of outcome-based proportion as the following: (total pensation was calculated ? base compensation salary)/total compensation. TMT turnover In order to measure in the TMT, we changes included both executives who stepped down and TMT turnover was calcu newly hired executives. lated by summing the number of departed exec utives and the number of newly hired executives of during each observation period as a percentage the number of executives on the TMT at the begin ning of that period. Control variables changes firm size size was

lb predicts a significant increase in Hypothesis the proportion of performance-based TMT com In the second pensation following deregulation. model the proportion of (2) of Table 2 where is the variable, pay performance-based dependent results show that the coefficient for the interaction term AIRLINE X (1979-84) is positive and sig nificant (b = 0.035, p < 0.01). While the dummy variable FOOD was significantly and positively related to the proportion of performance-dependent = 0.068, its interaction with p < 0.05), pay (b the dummy variable denoting post-deregulation was not significant. period, FOOD X (1979-84), the results suggest that after controlling Overall, for secular trends as well as firm size, slack, and the proportion of performance-based performance, TMT compensation in the post-deregulation air line industry was significantly higher than before. lb is supported. Therefore, Hypothesis The effects of TMT turnover on TMT

To control for their potential impacts on we included both in TMT compensation, and performance in our analysis. Firm as the logarithm of the firm's calculated

number was cal of employees in thousands. Performance culated as the ratio of the firm's returns to its total equity (ROE). We thus included organiza tional slack as a control variable, calculated as the

ratio of the firm's current assets to its current liabil ities. In our regression analysis testing Hypotheses was la and lb, a dummy variable, (1979-84), used to denote the period following deregulation in industry. The variable was coded 1 for the years 1979-84 and 0 for the years 1973-78. In our analyses of Hypotheses 2a and 2b, we the airline change in the proportion of performance based pay, previous year's values for total pay, pay, and TMT size as control performance-based
variables.

compensation the remaining hypotheses regarding of TMT turnover, we developed panel data to reflect the temporal order of the operative we envision, as well as to enhance mechanisms effects the robustness of the results. For each of the 1980 and 1985 years between post-deregulation turnover the of within the inclusive, magnitudes TMT were measured the by considering changes that occurred between the focal year (t) and two ? years prior (t 2). The two dependent variables, the level and the structure of compensation sys in year t. The TMT turnover tem, were measured
Strut. Mgmt. J., 28: 747-754 (2007) DOI: 10.1002/smj

To

test our

included

ANALYSIS AND RESULTS

Effects Table of deregulation on TMT compensation

1 shows the descriptive statistics for the vari on ables. To examine the effects of deregulation
2007 John Wiley & Sons, Ltd.

Copyright ?

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Research

Notes

and Commentaries
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Strut. Mgmt. J., 28: 747-754 (2007) DOI: 10.1002/smj

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752

T. S. Cho

and W. S hen
Table 2. GLS b compensation3 Level of of regression analysis on changes in TMT

as the simple arithmetic variable was calculated difference between the base and the focal years so that a positive value indicates an increase in a 2-year the variable of interest. Using lag, as a or to shorter allows one, opposed longer ample time for capturing dynamic changes that occur in TMT turnover and compensation while minimizing other factors potentially the relation confounding two between the and Fredrickson, (Carpenter ships time series data 2001). Pooling of cross-sectional is discussed by Kmenta (1986). Our use of change scores for our independent and control variables is consistent with prior studies (e.g., Feitler, Corsi, and Grimm, 1998). Table 3 presents dependent variables the GLS results for the two

Proportion performance

TMT
compensation (d 122,645"

based pay

(2)
(28,152) (42,220) (28,568) (23,901) (14,214) (16,980) (0.02) (0.01) (13,290)
0.104*

Intercept

(1979-84) AIRLINE FOOD AIRLINE X (1979-84) FOODX (1979-84)

Firm size

56,214 34,472 42,208+

32,375*

0.032
0.026+ 0.068* 0.035**

(0.051) (0.045) (0.014) (0.032) (0.014) (0.045)

18,620
0.12*** 0.04*** 28,546*

0.023

Profit (ROE) Slack

of interest:

the level of TMT

0.021* (0.010) 0.001 (0.002) 0.012* (0.006)

0.124 43.20*

(CA/CL)
Adjusted R2 F
a

and the proportion of performance compensation 1 and 3 include only the con based pay. Models trol variables. Models 2 and 4 add TMT turnover between the base and focal years to test Hypotheses 2a and 2b. in the regression

0.289
62.46*

Standard errors appear in parentheses. bIn 1984 constant dollars. * ** N = 180 +p < 0.10; p < 0.05; p < 0.01;

**;

:0.001;

2a and 2b predict that the mag Hypotheses related to nitude of TMT turnover is positively the level TMT TMT and structure of and performance-sensitive In Model where total 2, compensation. variable, results show pay is the dependent (b

for TMT turnover is positive = 0.05, p < 0.01), significant rendering for 2a that predicts a posi support Hypothesis that the coefficient tive association level TMT between TMT turnover and the compensation following
the effects

4, where TMT pay structure (the pro of portion pay) is the depen performance-based dent variable, the results show that the coefficient turnover is also positive for TMT and signifi cant (b = 0.06, p < 0.05), rendering support for In Model 2b, which predicts a positive associa Hypothesis tion between TMT turnover and the performance sensitivity of TMT compensation following dereg
ulation.

deregulation.
turnover

Table

3.

GLS

regression:

of TMT

on TMT

compensation A

change3 of performance-based

Level 1

of TMT

compensation

Proportion

pay

Intercept

0.11** 0.02* pay 0.08** 0.09** 0.07+ 0.08* pay 0.04*

Prior total pay

Prior AFirm performance-based size

(0.03) (0.01) (0.03) (0.04) (0.07) (0.04) (0.02)

0.08** 0.03* 0.07** 0.06** 0.04* 0.05** 0.03+ 0.05**

(0.02) (0.01) (0.02) (0.02) (0.02) (0.02) (0.02) (0.02)

0.13** 0.04* 0.06** 0.06* 0.03 0.04*

(0.05)

0.11** 0.06* 0.04** 0.05** 0.05* 0.03* 0.06*

(0.04)

Prior TMT size ASlack AProfit

A Proportion of performance-based turnover TMT N

(0.02) (0.02) (0.03) (0.04) (0.02)

(0.03) (0.02) (0.02) (0.02) (0.02) (0.03)

180
12.42*:

180
16.52***

180
13.53**

180
19.34**'

a and heteroskedasticity for serial correlation corrected Because equations least-squares regression generalized are listed with standard errors in parentheses. are not reported in this table. Standardized coefficients regression are not shown. for the years 1979-83 the statistics for the dummy variables pattern existed, *** * ** + p < 0.001 p < 0.05; p < 0.01; p < 0.10; Copyright ? 2007 John Wiley & Sons, Ltd.

are used, R2 statistics no systematic Because

Strut. Mgmt. J., 28: 747-754 (2007) DOI: 10.1002/smj

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Research

Notes

and Commentaries

753

DISCUSSION

AND CONCLUSIONS

of TMT it is evident that the compensation Overall, as a response to underwent changes significant shift. The findings on the increase environmental TMT pay after deregulation in performance-based strongly support our prediction and are consistent with without studies the findings from previous CEO-level and control industries (e.g., Rajagopalan 1992). The proportion of performance Finkelstein, based TMT pay rose only in the airline industry, as a whole adopted rewards in response such change did not occur in food

In sum, the findings of this study are not only consistent with existing research on the relation discretion and executive ship between managerial but also render important insights compensation, in com into the dynamics underlying changes at TMT the level that occur system pensation an environmental shift. The significant following turnover the TMT found between relationship and compensation system in the post-deregulation context suggests that the reconfigu environmental incentive ration and realignment of the managerial strate is a crucial factor for achieving system change. The gic adaptation under environmental results of this study also indicate the importance the reward system of the top man of considering agement team as a whole, as opposed to the CEO
alone.

that the industry suggesting more performance-contingent to deregulation. Since the natural gas or processed the same period, this result

industry during suggests that the air line companies responded to the environmental jolt in executive One compensation. through changes the incentives of managers with way of aligning is to make manage the interests of shareholders to firm performance. sensitive rial compensation increased the Because deregulation simultaneously to deci of firm performance sensitivity managerial sions and the costs of observing managerial per formance, a stronger link between TMT compensa tion and firm performance was probably inevitable in order to control tively. A more and reward top managers effec

Limitations

and future

directions

Because our study was based on firms that under went deregulation in the late 1970s, we were lim sources for collecting all rel ited to secondary of the understanding data the would processes surely be underlying enriched if one could, for example, access the inner committee of the compensation workings through interviews or surveys. Future studies may bene on an ongoing environmental fit from focusing a longitudinal, shift and considering qualitative approach. In addition, there is a need to consider of TMT turnover. We can conditions antecedent the nature of an envi for that instance, expect, data. The theoretical in owner shift may lead to changes control capacity of ship structure, perhaps altering the owners; this may affect the degree to which turnover and pay change occur. both executive ronmental of executive the specific determinants Although turnover were beyond the scope of this paper, future studies may benefit from examining the link structure and age between changes in governance turnover and compensation changes. subsequent to explore As a last note, it will be valuable of these reconfiguration and at team the top management compensation changes in compensation will level. The changes impact the top executives' schema and, sub cognitive the strategic behavior of the firm as sequently, well as its performance. When receive executives on firm's that the perfor compensation depends as opposed to a fixed salary, they would mance, in performing their search become more proactive
Strut. Mgmt. J., 28: 747-754 (2007) DOI: 10.1002/smj

evant

this study makes significant contribution to the literature comes from our second set of results on the hypothesized linkage between execu Our findings offer tive turnover and compensation. new insights into the mechanisms through which occur fol the changes in executive compensation topic that has lowing in previous research. We been rarely addressed turnover of executive found that the magnitude was positively increase in aver associated with which age TMT compensation, suggests that the more the TMTs experienced turnover through dis era from pre-deregulation placement of executives shift?a while in response to dereg hiring new executives in the average total increase ulation, the higher the at anal the TMT level. Additional compensation new was not recruits yses showed that it just the but also the surviving executives who received a amount of pay. For the pay-performance we found a parallel phenomenon. Overall, linkage more became executive dependent compensation on firm performance and more after deregulation, greater
so utive if there team was a greater turnover among the exec members. 2007 John Wiley & Sons, Ltd.

an environmental

the strategic outcomes

Copyright ?

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754

T. S. Cho and W. Shen

Finkelstein S, Boyd B.
matter? of CEO Journal Finkelstein Top Grimm The compensation. 41: 179-199. DC. their

and choice activities. We surmise that those exec utive teams whose pay scheme undergoes adap tive changes in response to an environmental shift with heightened level of discretion are better able to generate and implement strategic actions. Con that fails to pay system undergo reconfiguration would be associated with a misaligned executives with incentive system and possibly an outdated motivational orientation. to generating This, surely, will not be conducive adaptive organizational changes and a superior per formance at the firm level. Although a recent study the link between (2000) examined by Carpenter CEO compensation change and the firm's strate from the industry norm, there is a gic deviance the dynamics of the scarcity of research exploring effects of change in pay scheme and the strategic behavior of the firm. We hope that this paper will serve as an impetus for future research endeav ors exploring the linkages among environmental versely, change, TMT turnover, reward system change, strategic outcomes. and an executive

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