Executive Remuneration and the Payout Decision

Corporations rely on dividends, share repurchases, or a combination of both payout methods to return earnings to their shareholders. Over the last decade, the importance of the dominating payout method—dividends—seems to be somewhat eroded at UK firms, with an increasing number of firms combining share repurchases with dividends. What explains the surge in the use of combined share repurchases and dividends in the UK? Is there a link between firm’s payout decision and executive remuneration?

Indeed, along with some other theories that explain the rise in stock repurchases, there is an ever growing literature hinting at the importance of executive pay practices with recent studies providing evidence on both the US (Fenn and Liang, 2001) and Finland (Liljeblom and Pasternack, 2006): Whereas in the US study executive remuneration has a significant impact on dividend policy, the latter study which is based on a unique dataset that includes information on the dividend protection of equity-based compensation contracts finds that the Finnish companies that have adopted an option program show no tendency to avoid dividends.

But why is it a problem that executive compensation is linked to a firm’s payout decision? In general, executive compensation (and equity-based pay in particular) is meant to function as a corporate governance mechanism that incentivizes management to pursue actions beneficial to shareholders. According to the managerial power idea, however, the popularity of stock options as a payout device may be linked to its effectiveness in extracting wealth from the firm (while trying to avoid ‘shareholder outrage’ (Bebchuk et al., 2002)). Managers may hence adopt a payout decision that maximizes the value of their compensation but may not necessarily be optimal or preferred by shareholders.

In our paper, Executive Remuneration and the Payout Decision, which was recently made publicly available on SSRN, we examine the impact of the different components of CEO remuneration on both the level of corporate payout and the payout channel choice. We draw on a long-term sample of virtually all listed firms in the UK, for which we have actual share repurchase information and detailed information on the various components of pay. We account for taxation, market and stock sentiment, major blockholder concentration, and other control variables. In order to study the payout decision at various levels, we employ quantile regressions.

Our main findings can be summarized as follows. First, firms that pay their CEOs with stock options pay lower dividends and their total payout is lower. Second, when a CEO is granted sizable stock options and restricted shares, the firm is more likely to opt for share repurchases or share repurchases combined with dividends rather than only dividends as a payout channel. Third, we find that this payout channel choice holds particularly true for firms that decided to increase their level of total payout.

We argue that these observations are not incongruent with managerial self-dealing (in the sense of Bebchuk et al., 2002), as in the absence of dividend protection (which is the case for the majority of UK-listed firms) the payout of dividends reduces the value of the CEO’s equity-based pay, whereas share repurchases drive up its value. Consequently, the payment of dividends is costly to a CEO holding stock options (and restricted stock) and hence leads to a lower dividend payout. In other words, we conclude that executive officers influence corporate decisions to maximize their personal wealth, while some specific categories of shareholders could prefer a different dividend payout (e.g. for tax reasons).

We contend that the option component of CEO pay does not alleviate the agency problem between CEO and shareholders, as it leads to a decrease in total payout and a partial restitution of dividends by share repurchases that are beneficial to the CEO (and not necessarily to all equity holders).

The full paper is available for download here.