Dicuss Question 7

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Topic

Narration

Slide 1

Introduction

Welcome to Total Rewards.

In this lesson, we will discuss An Introduction to Executive Compensation.

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Slide 2

Objectives

Upon completion of this lesson, you will be able to:

Analyze an organization’s strategy and integrate pay-for-performance plans and total rewards into a compensation strategy that will motivate desired behavior and improve job performance.

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Slide 3

Supporting Topics

Specifically, we will discuss the following topics in this lecture:

Owner manager conflict.

Components of executive compensation.

And minimizing costs to the corporation.

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Slide 4

Owner Manager Conflict

In the modern corporation, the ownership and management functions are separate. This can arise because there are individuals with pre-existing businesses who either do not desire and/or have the skills to manage a business or there are individuals with good ideas/products that may not have the funds necessary to bring those products to market and/or sustain themselves through the start up period and seek outside investors.

The separation of ownership and management functions can lead to conflict. For example, while owners are concerned with the maximization of the value of their stake in the corporation, the executive is concerned with the maximization of their well-being, which involves a trade-off between maximizing their wealth and their effort.

Academics refer to the cost arising from the separation of the ownership from the management as agency costs. If these costs can be reduced, the gains can be shared between the owners and executives. Owners and executives have the incentive to minimize these costs.

The mechanisms for controlling the incentive conflicts arising from the separation of the ownership and control of the corporation include, but are not limited to:

Monitoring by large shareholders and the Board of Directors;

Equity ownership by executives;

The market for corporate control;

The managerial labor market; and

Compensation contracts that provide incentives to increase shareholder value.

Monitoring by the Board of Directors has its limitations. For example given that most directors have limited investment in the operations on whose board they sit, directors’ incentives may not be aligned with those of shareholders. The existence of a large shareholder, feedback and individual or an institution, can mitigate this problem as a large shareholder has both the incentives and the financial resources to monitor management.

Ownership by executives mitigates the incentive conflicts by aligning the interests of executives with those of the shareholders. It does so by making the executives shareholders in the corporation. When the executive wealth constraint is combined with risk aversion, it may not be in the best interests of other shareholders for an executive to have a large amount of his or her wealth tied up in the corporation's stock. The market for corporate control provides executives with incentives to increase shareholder value. The reason is that if executives manage the corporation in a suboptimal way, the value of the corporation's shares will be low, and if a group of individuals or another corporation believes it could manage the corporation more efficiently, it has the incentive to purchase the corporation to obtain the increase in value from the improved management.

The managerial labor market mitigates the incentive conflicts by providing executives with the incentive to perform well, thereby increasing their market value or their value to the potential employees. The compensation package can also be used to align the interests of the owners and executives. It does so by rewarding executives for taking actions that increase shareholder value. Compensation is often tied to measures that are positively correlated with managerial effort, for example accounting income, share price, or market share.

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Slide 5

Other Theories

Now we will discuss other theories that exist to explain the composition and importance of the executive compensation package.

Class hegemony theory argues that executives share a common bond, and that through boards composed primarily of CEOs, executives are able to pursue their own goals and interests.

Efficiency wage theory suggests that executives are paid a premium to provide them with the incentive to exert effort to avoid being fired. This premium leads them to put forth effort, because of the consequences of being fired. In theory, this effort increases executive productivity and reduces turnover.

The figurehead theory believes the CEO is both a symbol and a representative of the corporation, representing the corporation at ceremonial events and political functions, and managing interactions with owners, employees, government, and the general public.

Under the human capital theory, the value of the executive, and his or her compensation is based upon his or her accumulated knowledge and skills.

Managerialism theory argues that the separation of ownership and control in modern corporation gives top managers almost absolute power to use the firm to pursue their personal objectives. They could then use this power to increase the level, and reduce the risk, of their compensation.

The marginal productivity theory purports that the executive should receive as compensation his or her value to the corporation.

The prospect theory focuses on executive’s loss aversion. That is, in certain circumstances to avoid losses or missing goals and/or targets, the executive is actually willing to take risks. In contrast, the executive is unwilling to take risk once he or she has achieved his litter performance goals, as the benefits of increasing performance is more than offset by the possibility of falling below target.

Under the social comparison theory, board members use their own pay as a reference point for setting pay of executives.

And the lastly, under tournament theory, executive compensation is set to provide incentives, not to the executives themselves called but rather to their subordinates.

These are simply alternative theories related to executive compensation.

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Slide 6

External Influences

A number of items external to the corporation and the executive influence both the amount and the composition of the executive compensation package. For example, different components of the compensation package of different financial reporting treatments.

Given the desire of executives to report a higher level of income, a differential accounting treatment may have caused them to design compensation packages that included more stock options, and other compensation, that would otherwise be optimal.

Section one hundred and sixty two m, of the Internal Revenue Code limits the deductibility of compensation to the CEO and the next four highest-paid executives to one million dollars per individual, with an exception allowed if compensation is performance-based. Whereas salary can never be performance-based, bonus plans can be modified to meet the exception, and, in most cases stock option plans are performance-based by that definition. Thus the tax code provides incentives for corporations subject to this constraint to shift compensation from salary to bonus and stock option plans.

Finally, the political environment surrounding executive compensation has potential to influence the level and composition of the compensation package because of the potential political costs that may be imposed upon the executive and the corporation. Political costs are the costs imposed on the executive and the corporation by the government's ability to tax and regulate. An example would be section one hundred and sixty two m of the Internal Revenue Code, which limits tax deductions, and hence, increases the after-tax cost of executive compensation.

Political costs include the costs imposed by the executive and the corporation by interested parties which include, but are not limited to, politicians, regulators, unions, suppliers, and customers. In theory, the pressure and costs imposed by these parties can reduce the level of executive compensation, and or cause a shift from the components of compensation that are not based upon corporate performance toward components of the compensation that are based on corporate performance.

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Slide 7

Sources of Data

Data on executive compensation are contained in proxy statements sent to shareholders when filed with the SEC. The SEC then makes the statements publicly available both in their offices and online. The SEC requires and governs disclosure of compensation for the CEO, CFO, and the next three highest paid executives, and potentially two additional individuals for whom disclosure would have been required except for the fact that the individual was not serving as an executive officer of the registry at the end of the last completed fiscal year.

The SEC requires disclosure of the following information in a summary table for the most recent three-year period: salary, bonus, stock awards, option awards, non equity plan incentive compensation, change in pension value and nonqualified deferred compensation earnings, and all other compensation.

In addition to the summary compensation table, the SEC requires a series of additional tables focusing on equity compensation. The first table requires disclosure of grants of land based awards, in particular the estimated future payouts, including threshold, target, and maximum payouts for plans when the payouts depend on future outcomes and the number of fixed sharing option awards. The second table will disclose the status amount, and value of share awards outstanding at year end, while the third table discloses options exercised and shares vested, including the value recognized for each.

The revised regulations require a table where the firm needs to disclose the present value of each of the named executives accumulated benefits. The firm also needs to revise tables detailing nonqualified deferred compensation, including executive contributions, firm contributions, earnings and withdrawals during the last fiscal year, and the accumulated balance at the end of the year.

And finally, in addition to the tables discussed previously, the new disclosure regulations require substantial amount of qualitative disclosure about compensation arrangements, for example, employee contracts. A central location, is the compensation discussion and analysis, where the compensation committee of the Board of Directors discuss the corporation's compensation policies applicable to executive officers, and specific relationships of corporate performance to executive compensation, and the criteria on which the CEO’s pay was based.

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Slide 8

Components of Executive Compensation

The major and most common components of executive compensation include: salary, bonus, stock options, stock grants, other stock-based forms of compensation, pensions, benefits and perquisites, severance payments and charge in-control clauses. Let's now define each one of these components.

Salary is the fixed contractual amount of compensation that does not explicitly theory with performance. However, it can be affected by performance, as good performance can lead to higher salary in future periods.

Bonus is a form of compensation that may be conditioned upon the individual, group, or corporate performance. For most executives, bonus is both based upon group performance and determined as part of a plan covering a larger group of employees. Bonuses can be based upon short-term or long-term measures.

Stock options allow the holder to purchase one or more shares of stock at a fixed exercise price over a fixed period of time.

Stock grants occur when corporations could shares to the employees. They differ from stock options in the day of note exercise price. Where is a stock option only has five of the corporation share price is above the exercise price, a stock grant has value as long as the share price is above zero. Consequently, a stock grant is always worth more than an option grant for the same number of shares.

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Slide 9

Components of Executive Compensation, continued

Stock appreciation rights, sometimes called SARS, are the right to receive the increase in the value of a specified number of shares of common stock over a defined period of time. With a stock appreciation right, the corporation simply pays the executive, in cash or common stock, the excess of the current market price of the shares over the aggregate exercise price. Thus, the executive is able to realize the benefits of a stock option without having to purchase the stock.

Phantom stock are units that act like, stock, but that do not constitute claims for ownership of the corporation. They entitle the executive to receive the increase in common stock price and any dividends declared on common stock. They are often used in privately held corporations, or public legal corporations, where the owners do not want to dilute existing ownership.

Equity units entitle the holder to purchase common stock at its book value, and then resell the stock to the corporation as its book value at a later date. The owner gets the dividend payments on the stock.

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Slide 10

Components of Executive Compensation, continued

Pensions are forms of deferred compensation, whereby after retirement from the corporation, the employer receives a payment or series of payments. These payments may be defined by the pension plan, or based on the amounts accumulate in the employee's personal retirement account.

In addition to receiving salary, bonuses, stock-based compensation, and pensions, executives receive a variety of benefits and perquisites, whose value must reported in the proxy statement. These items include:

Corporate cars;

The use of corporate airplanes and apartments;

Special dining facilities;

Country club memberships;

Health, dental, medical, life, and disability insurance; and

The ability to defer compensation at above market rates of interest.

Severance payments are fairly common and have become very controversial. Severance payments occur when an executive leaves the company under pressure or is fired without cause; consequently while they are sometimes included in the executive’s employment contract, severance payments, at most, happen once at the end of the executive's tenure with the company.

Charge-in-control clauses are also standard in the executive's compensation contract. A charge-in-control payment occurs when the company is acquired by another company and is a way to provide the executive with some insurance should he or she lose his or her job as a result of a merger.

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Slide 11

Attractive Offer

To illustrate the decisions the corporation must make in designing a compensation package, consider the corporation that wishes to hire an executive from outside the corporation. First, the corporation must make the compensation package lucrative enough to entice the target executive to take the position. That is, the value of the compensation package offered to the executive should exceed his/her next best opportunity, or opportunity cost. Changing jobs is a gamble, and executives, as risk-averse individuals, need to be compensated for taking chances. To induce them to take that chance, a substantial premium may be involved. To reduce that premium and to combat the natural risk aversion of the executive, a firm may also have to choose to include a severance provision in the contract to minimize the financial risk to the executive.

An executive may be willing to accept a lesser paying position if the corporation's headquarters is in a preferred location. Alternatively, an executive might be willing to accept less compensation to work for corporation A rather than corporation B because corporation A is viewed as more prestigious and/or has more growth potential.

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Slide 12

Proper Incentives

The corporation wants to sign a contract to encourage the CEO to act in a way consistent with the objective, presumably value maximization. To make things simple, and minimize contracting costs, the corporation could offer to pay the CEO’s salary, which would fix compensation regardless of performance. However in that situation, the CEO has little financial incentive to maximize shareholder value because he or she does not benefit from doing so. Alternatively, the corporation could offer the CEO a contract whereby his or her compensation is solely based upon corporate performance. While this would provide the CEO with incentive to maximize shareholder value, it would impose substantial risk on the CEO.

Most executive contracts include both fixed and variable components. Fixed components are included to reduce risk to the CEO and guarantee a standard of living, whereas variable components are included to provide incentives and align the interests of management and shareholders.

Fixed components might include:

Salary and benefits such as employer paid life insurance, healthcare, and pensions.

Variable components might include:

Bonuses, where the payout may be based on reported accounting numbers, market share, or customer satisfaction; and

Stock compensation, where the payout is based on stock prices.

Each has different effects on CEO incentives and has different costs to the corporation.

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Slide 13

Contract to Retain

To minimize recruiting and training costs, and to avoid the downtime associated with an open position, corporations would like to ensure that the executive being recruited stays with corporation. There are two, non-mutually exclusive tracks it can take.

The first approach would be to provide monetary incentives to stay, for example, compensation that vests over time and hence enhance is forfeited if the executive leaves before the end of the vesting period. This track which involves long-term components of compensation, such as restricted stock, stock options, and pensions, could be referred to as the golden handcuffs approach. However, if the new employer is willing to reimburse the executive for amounts forfeited when leaving the old employer, the employment contract loses its retentive effect.

The second approach is to limit the executive's alternative employment opportunities with noncompete, nondisclosure, and non-solicitation provisions. These provisions are fairly standard in executive contracts.

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Slide 14

Restrictions

Employees, in general, and high-level executives, in particular, built up a certain level of corporation and industry-specific knowledge. Preventing executives from taking positions at rival corporations makes them less likely to leave.

Further, even if the executives are willing to take a position not in competition with his or her former employer, he or she would be prohibited, through nonsolicitation provisions, from hiring any of his or her former colleagues. However, if a corporation wants an executive badly enough, it can negotiate with the executive's former employer to release executive from these restrictions.

A third approach is to use the legal system to deter potential competitors from hiring your executives.

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Slide 15

Minimizing Costs

In addition to making the package attractive enough to entice the individual under consideration, and structuring the package so that the individual has the appropriate incentives, the corporation has to take into consideration a multitude of costs. First, consider the financial costs of different forms of variable compensation. Bonuses normally require the payment of cash, whereas stock compensation only requires the issuance of previously unissued shares, a trade-off that may be important for cash-strapped corporations.

Accounting and tax treatments differ between bonuses and stock compensation, and different times of compensation. For example while bonuses are normally recognized as an expense for financial reporting purposes in the period earned, stock compensation is normally recognized as an expense over the vesting period. Under the Internal Revenue Code, bonuses are both taxable to the employee and deductible by the employer in that period paid. However, if stock option grants meet certain conditions, they are not taxable to the employee until they are exercised in certain options are not even taxable then.

While stock options are treated favorably under the Internal Revenue Code, other forms of compensation are not looked upon as favorably. In particular, subject to certain exceptions, section one hundred sixty two m of the code limits tax deductions for compensation paid to the top five executives of the corporation to one million dollars per executive per year while not limiting the amount of compensation a corporation can pay its executives, section one hundred sixty two m affects the after-tax cost to the corporation. As with other financial decisions, the corporation must take into account the after-tax cost when designing the compensation package.

Nonfinancial costs have to be considered too. One such cost would be equity. For example, it would be insulting to the outgoing CEO if the new CEO was to make more than he or she did. Not only would it be insulting, it would breed resentment and not bode well for a working relationship between the two, with the latter possibly retaining the Chairman position, or at least a position on the Board of Directors.

Similarly, a large gap between the newly hired CEO and the remainder of the executive group would add insult to injury, as not only were they passed over in favor of an outsider, that individual is also being paid much more than they are. While a contract is being designed for one person, their ramifications beyond that person that must be taken into consideration when designing executive compensation.

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Slide 16

Check Your Understanding

Slide 17

Summary

We have now reached the end of this lesson. Let’s take a look at what we have just covered:

We first discussed owner management conflict and theories that exist to explain the composition and importance of the executive compensation package. In the modern corporation, the ownership and management functions are separate and can lead to conflict. While owners are concerned with maximization of the value of their stake in the corporation, the executive is concerned with maximization of their well-being. Academics refer to the cost from the separation of ownership from management as agency costs.

We next identified the external factors that influence the composition of the executive compensation package to include differential accounting treatment, the Internal Revenue Code, and the political environment. Additionally, we discussed the various sources of data relative to executive compensation to include proxy statements and the SEC reporting guidelines.

We also identified the major and most common components of executive compensation. These include salary, bonus, stock options, stock grants, and other stock-based forms of compensation, pensions, benefits and perks, severance payments and charge-in-control clauses. Other stock-based forms of compensation include stock appreciation rights, phantom stock and equity.

Then, we discussed the importance of making an offer attractive to a potential executive by offering proper incentives that include fixed and variable components. We also learned about the different approaches to take to retain executives including golden handcuffs and limiting the executive’s alternative employment opportunities.

Finally, we talked about the restrictions that can be placed on executives, which prevent them from taking positions at rival corporations and the different ways to minimize costs to the corporation.

This concludes this lesson.