CEO Gender and Downward Pay Rigidities as Rent-extractions

Introduction

The literature on gender differences in CEO pay indicates that female CEOs are generally underpaid relative to male CEOs (Bonin et al., 2007; Croson & Gneezy, 2009). Some scholars interpret this finding to suggest that women are selfish, lacking in work ethic, or low performers, whereas others suggest that non-cognitive aspects, such as emotional stability, conscientiousness, aggression, and antagonism, might explain the gaps between men and women (Mueller & Plug, 2006; Watson & McNaughton, 2007). This study provides a different view on this issue by focusing on the literature on CEO power theory. Bebchuk and Fried (2004, 2006) argue that pay-without-performance is a widespread and persistent pay arrangement because the pay-setting process has often deviated from arm’s-length contracting. The power that CEOs derive from their positional advantages can encourage them to influence their own pay contracts and, thus, induce pay-without-performance. We operationalize the pay-without-performance construct by incorporating downward pay rigidities and then investigate whether these rigidities display gender differences.

The literature on traditional agency theory emphasizes the role of pay-for-performance in aligning the interests of management and shareholders (e.g., Core, Holthausen, & Larcker, 1999; Grossman & Hart, 1983; Holmström, 1979; Jensen & Meckling, 1976; Jensen & Murphy, 1990; Murphy, 1998).¹ However, the literature on CEO power theory indicates that some pay arrangement features, rather than efficiently incentivizing CEOs, seem to reflect CEOs’ rent-seeking behavior (e.g., Bertrand & Mullainathan, 2001; Blanchard, Lopez-de-Silanes, & Shleifer, 1994; Yermack, 1997). In particular, recent studies show that a CEO’s pay is downwardly rigid, meaning that a CEO’s annual pay increases when a firm’s performance increases but does not decrease to the same extent if the firm’s performance declines (Adut, Cready, & Lopez, 2003; Chen et al., 2014; Garvey & Milbourn, 2006; Gaver & Gaver, 1998; Jackson, Lopez, & Reitenga, 2008; Kim, Yang, & Lee, 2017). Downward pay rigidities as a form of pay-without-performance reflect rents² that CEOs extract. According to the CEO power approach, CEOs can influence the board’s pay decision by exerting their power. Bebchuk and Fried (2003) propose the board capture mechanism, by which CEOs can capture the board and extract rents using their positional advantages.

This study measures downward pay rigidities using a regime-switching model and examines CEO gender differences in pay rigidities. We use 23,760 firm-year observations of U.S. companies covering 1993 to 2013. We observe downward pay rigidities under managerial settings. We also find that the pay rigidities of male CEOs are greater than those of their female peers. Our findings support our theoretical prediction that male CEOs influence the board’s pay-setting process more aggressively than female CEOs do to maintain their pay levels when the firm’s performance declines.

This study contributes to several current debates in the literature. First, the agency problem derived from the dominance of managerial power is becoming a central issue for business and scholarship. The agency literature has investigated the association between CEO pay and firm performance (pay-for-performance sensitivity). However, these studies have neglected to incorporate the pay-without-performance problem in their linear models. Only a few empirical studies have investigated the pay-performance link using asymmetric specifications with complex interactions (e.g., Kim, Yang, & Lee, 2017). As these prior asymmetric specifications have many interaction terms, their results might not be robust, and their interpretations may vary. To correct these biases and to further capture the actual distributions of pay changes accurately over the observation period (see Bauer et al., 2007), we measure downward pay rigidities by employing regime-switching estimation. Our study therefore contributes to the agency literature from the viewpoint of econometric methodology.

Finally, our study complements the literature on gender pay inequality by suggesting that male CEOs adhere to pay-with-performance as a means of rent extraction but that female CEOs are likely to bear a pay reduction under the cardinal principles. We highlight a significant distortion in CEO pay by gender, which may impose substantial costs that ultimately damage shareholders’ interests.

Theory and Hypothesis

The literature on agency theory indicates that CEO compensation should be aligned with firm performance in order to encourage executives to work harder and, thus, enhance shareholder value (Core, Holthausen, & Larcker, 1999; Grossman & Hart, 1983; Holmström, 1979; Jensen & Meckling, 1976; Jensen & Murphy, 1990; Murphy, 1985). Agency theory posits that strong pay-for-performance arrangements encourage executives to work harder and thereby ensure shareholder wealth. Related studies provide direct evidence that greater sensitivity of performance-related pay is linked to higher stock returns. Masson (1971) finds that higher executive rewards in response to firm performance are associated with greater stockholder wealth. Abowd (1990) finds that operating performance is positively associated with CEO pay and that higher pay-for-performance sensitivity is linked to higher stock performance. McConaughy and Mishra (1996) suggest that increased pay-for-performance sensitivity induces risk-adjusted excess returns for firms.

However, studies have recognized that the application of performance-related pay faces several challenges and limitations, such as those involving CEO power and personal relationships, unclear appraisal criteria and scales, limited knowledge of performance, and the lack of a link between appraisal results and pay (Maaniemi, 2013; Salimäki & Jämsén, 2010). Gaps may also appear between the intended performance-appraisal system and the realized system (Maaniemi, 2013).

Furthermore, CEO power theorists argue that some pay arrangement features do not efficiently incentivize CEOs but rather reflect CEOs’ rent-seeking behavior (e.g., Bertrand & Mullainathan, 2001; Blanchard, Lopez-de-Silanes, & Shleifer, 1994; Yermack, 1997). CEO power theorists posit that, although most CEOs contractually require greater pay when the firm outperforms, they tend to avoid pay reductions when firm performance deteriorates. Recent research reveals the pervasiveness of downward pay rigidities in managerial settings (e.g., Adut, Cready, & Lopez, 2003; Chen, Liu, & Peng, 2014; Chen et al., 2014; Garvey & Milbourn, 2006; Gaver & Gaver, 1998; Jackson, Lopez, & Reitenga, 2008; Kim, Yang, & Lee, 2017). Downward pay rigidities cannot be accounted for within the optimal contracting approach based on maximizing shareholder value; rather, they must be attributed to managerial influence (Bebchuk & Fried, 2003; Bebchuk, Fried, & Walker, 2002).

Agency theory emphasizes cardinal principles for pay schemes that are optimal for shareholders. The board, acting at arm’s length, should independently select the CEO pay arrangement that maximizes shareholder wealth (Bebchuk, Fried, & Walker, 2002). However, CEO power theorists posit that management tends to dominate the compensation committee by influencing the appointment of directors. Contrary to the common perception that directors are responsible for monitoring CEO activities, they may instead operate under the top manager’s power and support the CEO (Bebchuk & Fried, 2003; Bebchuk, Fried, & Walker, 2002). CEOs who are involved in the appointment of directors tend to influence the board’s setting and adjusting of executive compensation schemes. As CEOs engage in rent-seeking behavior by using their positional advantages, they happily accept pay increases when firm performance increases but avoid pay reductions when performance declines. Doing so induces weaker pay-for-performance sensitivity when the firm underperforms than when the firm over-performs, thus suggesting downwardly rigid CEO pay. We thus propose the following:

Pre-Hypothesis: Pay-for-performance sensitivity is lower when the firm’s performance declines than it is when performance improves.

The overall gender pay gap seems to be wide and is consistent over time as well as across national and cultural boundaries (Gray & Benson, 2003). Studies on gender differences in pay (or wages) report relatively low pay (or wages) for women (e.g., Bell, 2005; Bertrand & Hallock, 2001; Croson & Gneezy, 2009). Gender inequalities are derived from a variety of mutually reinforcing mechanisms, such as discriminatory social norms, indirect discrimination concerning educational background and occupational choice, and other negotiated wage outcomes that reflect power relations (European Commission, 2001; Sandberg, 2017).

It has been assumed that performance-related pay systems promote equal pay (e.g., Ministry of Social Affairs and Health, 2007, 2016). However, performance-related pay faces challenges as a tool for promoting equal pay (Maaniemi, 2013; Sandberg, 2017). Maaniemi (2013) mentions unclear appraisal criteria and scales, limited knowledge of performance, and navigating personal relationships as several of the challenges in the application of performance-related pay, and she finds a gap between the intended performance-appraisal system and the realized system.

CEO power theory attributes the gap between intended and realized performance-based pay to managerial influence on the board’s compensation setting and adjusting. Insofar as men exert more (or less) power on the board’s pay evaluation decisions than women do, we expect gender differences in realized CEO performance-related pay schemes.

Regarding the exertion of power, the gender gap can be explained in terms of attitudinal and behavioral variables such as business ethics, stereotypes, risk aversion, and overconfidence. The literature on gender differences posits that men tend to be less ethical (Eynon, Hills, & Stevens, 1997; Francoeur, Labelle, & Sinclair-Desgagne, 2007; McCabe, Ingram, & Dato-on, 2006; Shaub, 1994). In the context of CEO pay contracts, several studies posit that female CEOs are more likely than male CEOs to refrain from using their power for their private interests and to consider shareholder value as being important (Francoeur, Labelle, & Sinclair-Desgagne, 2007; Krishnan & Parsons, 2008). Related studies also find consistent evidence that women in managerial positions tend to display more ethical behavior, thus enhancing shareholder wealth (Francoeur, Labelle, & Sinclair-Desgagne, 2007; Gul, Srinidhi, & Tsui, 2007; Krishnan & Parsons, 2008).

In a similar vein, traditional stereotypes describe women as being communal in the sense of having “soft” and “warm” traits (Kulich et al., 2011, p. 7). These stereotypes may imply that women are more likely than are men to be punished when their behavior differs from the generally accepted expectation and, thus, may feel more pressured to meet these expectations (Eagly & Karau, 2002; Eagly, Karau, & Makhijani, 1995). Supporting this view, the evidence suggests that female CEOs are more likely to be punished for being overly competitive in pay negotiations (Bowles, Babcock, & Lai, 2007).

Some studies on gender differences posit that women are more risk averse than men are (Barsky et al., 1997; Byrnes, Miller, & Schafer, 1999; Croson & Gneezy, 2009; Eckel & Grossman, 2002; Hartog, Ferrer-i-Carbonell, & Jonker, 2002). Croson and Gneezy (2009) find that women are, indeed, more risk averse and socially oriented even though their social preferences are more or less situationally specific. Above all, dismissal is considered one of the most severe risks that a CEO faces (Kim, Yang, & Lee, 2017). The threat of dismissal may restrain a female CEO from extracting pay-rents and exerting her power on the board, thereby forcing her into a defensive stance (Bebchuk & Fried, 2004; DeFond & Park, 1999; Kim, Yang, & Lee, 2017). Thus, women are less likely than men are to engage in profit-seeking behavior in the workplace in order to gain financial rewards.

Men have been described as confident in a wide variety of domains (Niederle & Vesterlund, 2007; O’Laughlin & Brubaker, 1998; Pajares & Miller, 1994), especially those related to financial matters (Barber & Odean, 2001; Estes & Hosseini, 1988; Wu, Johnson, & Sung, 2008). Unprovoked attacks and wars are more often initiated by men, which may be attributable to overconfidence in their abilities (Johnson et al., 2006). If male CEOs are overconfident about their future performance, they may consciously ignore the guilty feeling related to receiving excessive compensation despite their low performance.

Considering gender differences in light of business ethics, stereotypes, risk aversion, and overconfidence, we expect that male CEOs have more incentives to resist pay cuts and engage in rent-seeking behavior than female CEOs have since male CEOs are more likely to capture the board, believing that they can camouflage rents and render them undetectable without fearing punishment. Accordingly, male CEOs will not bear pay reductions when firm performance worsens, but they are very willing to receive performance-related pay when the firm outperforms. This difference leads to greater downward pay rigidities for male CEOs than for female CEOs. We therefore propose the following hypothesis:

Hypothesis: Downward pay rigidities are greater for male CEOs than for female CEOs.

Research Design and Data

CEO Pay and Gender Data

We obtain CEO pay and gender data from the S&P ExecuComp database, financial statement data from the annual COMPUSTAT Industrial File, and stock return data from the Center for Research in Security Prices (CRSP). Firms with SIC codes 6000 to 6999 (financial institutions) are excluded from our study. We also require that firm-year observations have the necessary data to compute the control variables in the regressions. This sample selection procedure generates 23,760 firm-year observations between 1993 and 2013.

Panel A of Table 1 reports our variable definitions. Our variable of interest, ΔPay, is based on total pay, including salary, bonus, other annual pay; the total value of restricted stock granted that year; the Black-Scholes value of stock options granted that year; long-term incentive payouts; and all other compensation for up to five top-level executives (as reported in ExecuComp item TDC1). Cash pay comprises salary plus bonuses, and equity pay includes restricted stock granted and stock options. We restrict the sample to firm-years in which the CEO was in office for two consecutive years to avoid capturing spurious relationships between different CEOs’ pay. The descriptive statistics of the regression variables are reported in Panels B and C. Panel B shows that the number of female CEOs in the sample is 480.

Table 1.

Definitions of Variables and Descriptive Statistics

Results

Estimates of Downward-sticky Pay

We first test the incidence of downward pay rigidities in managerial settings. Figure 1 presents the degrees of downward pay rigidities for 23,760 firm-year observations between 1993 and 2013. In Panels A and B of Figure 1, we use returns on assets) and stock returns (Return) to represent in Eq. (4), respectively. Both panels show a significant separation between the flexible and rigid regimes. The line with the lower (higher) slope represents the rigid (flexible) regime. We use a two-state Markov regime-switching model to estimate the probability of an observation being in the rigid regime for poor performance and use this probability as the dependent variable in Eq. (5).

Figure 1.

Two regimes in the regime-switching model

Table 2 presents the estimates of the regime-switching regression in Eq. (4). Panel A of Table 2 shows the association between ΔPay and ΔROA, and Panel B shows the association between ΔPay and RET. Both panels show that one βm is insignificant and the other βm is significantly positive, indicating that the former (latter) represents a rigid (flexible) regime. Accordingly, the low sensitivity of pay to firm performance, which is manifested in a low slope line, indicates that CEO pay does not drop to the expected level when firm performance declines.

Table 2.

Regime-switching Regression

Effects of CEO Gender on Downward-rigid Pay

Using the downward pay rigidities previously estimated by the regime-switching regression, Table 3 reports the panel regression results from estimating Eq. (5). In Model A, we use the downward pay rigidities estimated based on the association between △CEO pay and △ROA as the dependent variable; in Model B, we use those based on the association between △CEO pay and Return. Both models show that the coefficients on Gender are significantly positive, suggesting that male CEOs avoid pay reductions more aggressively than do female CEOs when firm performance declines. In other words, CEO pay is more rigid under poor economic conditions for firms with male CEOs. This evidence is consistent with male CEOs engaging in rent-seeking behavior to maintain their previous pay level when the firm’s performance worsens, and it therefore supports our hypothesis. The coefficient on CEO age (Age) is significantly positive in Model A but not in Model B. The coefficient on CEO duality (Duality) is significantly positive, suggesting that it has a positive impact on downward pay rigidities. This result supports the assertion that a single individual serving as both CEO and board chair may have more power and may dominate the board’s pay decision (e.g., Bebchuk, Fried, & Walker, 2002). Our conservative model controlling for CEO duality may result in an underestimation of the effects of CEO gender on downward pay rigidities and, thus, may capture the pure gender effects.

Table 3.

Impact of CEO Gender on Pay Rigidities (N=23,760)

Results of Pay Rigidities Using Level Estimation

In this subsection, we present the results from the level analysis of the pay–performance association. In the preceding tests, we employed the change specification to estimate pay-for-performance sensitivity while exploring whether male CEOs avoid pay reductions to a greater extent when current performance declines than do female CEOs. Here, we test whether male CEOs are paid more highly than female CEOs when firm performance declines. In other words, this analysis is more of a cross-sectional comparison than a within-firm comparison. Table 4 shows the results, which mirror those shown in Table 3.

Table 4.

Level Estimation

Analysis on a Subsample of Firms with at Least One Female CEO

Firms with only male CEOs could differ from those with both female and male CEOs in terms of downward pay rigidities and other dimensions. To mitigate this concern, we analyze a subsample of firms with at least one female executive (N = 1,446) and find that the results of Table 5 are qualitatively the same as those for the whole sample.

Table 5.

Analysis for a Subsample of Firms with at Least One Female Executive (N=1,446)

Robustness Test Using Cash Pay

We retest the effect of CEO gender on downward pay rigidities by using cash-based pay (salary plus bonuses) as an alternative proxy for total pay in Eq. (5). Several studies on compensation postulate that cash-based pay might capture the managerial power effect more effectively than equity-based pay (i.e., Bebchuk & Fried, 2004; Zheng, 2010). The results based on the cash-based pay model, shown in Table 6, robustly confirm the prior results based on the total pay model.

Table 6.

Pay Rigidities for Cash Pay (N=23,760)

Conclusions

After retesting the incidence of downward pay rigidities in managerial settings, this study investigates whether downward pay rigidities are more prevalent in firms with male CEOs than in those with female CEOs. Drawing on prior evidence regarding gender differences, we find that downward pay rigidities are greater for male CEOs than for female CEOs. This result suggests that female CEOs bear pay reductions stemming from declining firm performance, whereas male CEOs influence the board’s pay-setting process to maintain their pay level when firm performance worsens. Our results imply that male CEOs are more likely to exhibit rent-seeking behavior in situations where pay-for-performance systems work against their interests.

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