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Strategic Compensation: A Human Resource Management Approach

Ninth Edition

Chapter 12

Compensating Executives

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Contrasting Executive Pay with Pay for Nonexecutive Employees (1 of 2)

The chief executive officer (C E O) is the seller of his or her services and

the compensation committee is the buyer of these services

An awkward situation arises when the C E O hires a compensation director or consultant. In this case, the compensation consultant who makes the recommendation to the compensation committee works for the CEO.

Contrasting Executive Pay with Pay for Nonexecutive Employees (2 of 2)

The consultant recommends to the compensation committee what the C E O compensation package should be

A conflict of interest may arise because the consultant may feel obligated to promote the financial interests of the C E O, who hired the consultant.

Applying this practice contradicts the main assumption of performance-based pay such as merit pay, which most often applies to nonexecutive employees

It is possible that C E O s could be compensated for nonperformance

Key Employees (1 of 2)

Principles of executive Compensation: Implications For Competitive Strategy

Executives are the top leaders in their companies.

It intuitively seems reasonable that executives should earn substantial compensation packages.

Their skills and experience enable them to develop and direct the implementation of competitive strategies.

Defining Executive Status

Who are executives?

The Internal Revenue Service recognizes two groups of employees and key employees

Who Are Executives? (1 of 2)

To understand the main difference, it is essential to define what we mean by executives

The Internal Revenue Service (I R S) recognizes two groups of employees who play a major role in a company’s policy decisions: key employees and highly compensated employees

Who Are Executives? (2 of 2)

Key employees those with larger salaries often receive larger benefits from their employer’s retirement plan

Highly compensated employees

Who Are Executives?

Key Employees and highly compensated employees hold positions of substantial responsibilities.

Although titles vary from company to company and in pay structures, CEO, presidents, executive vice presidents, vice president of functional are (e.g., human resource), and the directors below them usually meet the criteria of key employees.

Executive compensation Packages

Broad Comparison of Executive and Nonexecutive Compensation

Executive compensation has both core and employee benefits elements, much like compensation packages for other employees

Executive compensation packages emphasize long-term or deferred rewards over short-term rewards

Executive Compensation Components

The main components of executive compensation include:

Current or annual core compensation

Deferred core compensation: equity agreements

Deferred core compensation: separation agreements

Clawback provisions

Employee benefits: enhanced protection program benefits and perquisites

Components of Current Core Compensation

Executive current core compensation packages contain two components:

Annual base pay

Bonuses

Annual Base Pay

Is a fixed element of annual cash compensation. Companies that use formal salary structures may have specific pay grades and pay ranges for employees, including supervisory, management, professional, and executive jobs, with the exception of CEO

Annual Base Pay

C E O jobs do not fall within formal pay structures

C E Os’ work is highly complex and unpredictable

Setting C E O compensation differs from the rational processes to build market-competitive structures

Annual base represents a relatively small part of CEO’s total compensation for two reasons:

First, it typically takes years before the fruits of the CEO’s strategic initiatives are realized.

Second the IRS, limit the amount of annual salary a company may exclude as a business expense. Only up to $1 million in fixed annual salary is exempt from a company’s tax liability

Bonuses

Bonuses represent single pay-for- performance payments companies use to reward employees for achievement of specific, exceptional goals.

Four types of bonuses are common in executive compensation.

Bonus Types

Discretionary

Performance-contingent

Predetermined allocation

Target plan

Bonus Types

Discretionary: awarded on an objective basis

Boards of directors award discretionary bonuses to executives on an elective basis. They weigh four factors in determining the amount of discretionary bonus: company profits, the financial condition of the company, business condition, and prospects for the future.

For example, boards of directors may award discretionary bonuses to executives when a company’s position in the market is strong.

Bonus Types

Performance-contingent: based on the attainment of specific performance criteria.

The performance appraisal system of determining bonus awards is often the same appraisal system used for determining merit increases or general performance reviews for salary.

Bonus Types

Predetermined allocation: based on a fixed formula.

The central factor in determining the size of the total bonus pool and bonus amount is company profits.

Predetermined allocation bonus amounts are fixed, regardless of how well the executives perform.

Bonus Types

Target plan: ties bonuses to executives’ performance.

The bonus amount increases with performance.

Executives do not receive bonuses when their performance falls below minimally acceptable standards.

The target plan bonus differs from the predetermined allocation bonus in an important way: Predetermined allocation bonus amounts are fixed, regardless of how well executives perform.

Short- Term Incentives

Companies award short term incentives to executives to recognize their progress toward fulfilling competitive strategy goals.

Short term incentive compensation programs usually apply to a group of select executives within a company. The plan applies to more than one executive because the synergy that results from the efforts and expertise of top executives influences corporate performance.

The board of directors distributes short term incentive awards to each executive based on the rank and compensation level.

Short term Incentives

Current Profit Sharing Plans

Gain sharing Plans

Short term Incentives: Current Profit Sharing Plans

Profit sharing plans pay a portion of company profits to employees, separate from base pay, cost of living adjustments, or permanent merit pay increases.

Two basic kinds of profit sharing plan are used widely today.

First, current profit sharing plans award cash to employees typically on quarterly or annual basis.

Second, deferred profit sharing plans place cash awards in trust account for employees. These trusts are set aside on employees’ behalf as a source of retirement income.

Short term Incentives: Gain sharing Plans

Gain sharing describes group incentives systems that provide participating employees with incentive payment based on improved company’s performance such as increased productivity, increased customer satisfaction or better safety records.

Components of Deferred Core Compensation

Stock compensation:

Deferred compensation refers to an agreement between and employee and a company to render payments to an employee at a future date.

Deferred compensation is a hallmark (symbol)of executive compensation packages.

As an incentive, deferred compensation is supposed to create a sense of ownership, aligning the interest of the executive with those of the owners or shareholders of the company over the long term.

Deferred Compensation: Equity Agreements

Equity refers to ownership stake in a company, particularly focused on financial interests

Company stock shares are the main form of executives’ deferred compensation.

Company stock represents equity shares of equal value

A variety of important terminology to fully understand these concepts (next slide)

Stock Plans: forms of deferred (stock) compensation

Stock options

Incentive stock options

Nonstatutory stock options

Restricted stock plans and restricted stock units

Stock appreciation rights

Phantom stock

Employee stock purchase plans

Incentive Stock Options

An executive’s right to a future purchase of their company’s stock at a predetermined price, often at the stock price when the options were granted to the executive.

Executives are purchasing the stocks at discounted price.

Executives generally buy after the price has increased dramatically.

An executive receives capital gains as the difference between the stock price at the time of purchase and the lower stock price at the time an executive receives the stock option.

Nonstatutory Stock Options

Company awards stock at discounted price

No favorable tax treatment in contrast to incentive stock options.

Taxes paid on difference between the discounted price and the fair market value at the time stock was granted

Restricted Stock

Executive is awarded its company stock options or stock units at the market or a discounted price

Ownership of stock is granted at a specified future date, often multiple years (vesting period). The term restricted stock means that executives do not have any ownership control over the disposition of the stock for a predetermined period, often -10 tears.

Executive must sell stock back to the company at the same price if they leave before vested

Restricted stock grants provide executives tax incentives. They do not pay tax on any income that result from an increase in stock price until after the restriction period ends.

Restricted stock is a common type of long-term executive compensation.

Boards of directors award restricted stock to executives at considerable discounts.

Stock Appreciation Rights

Provides executives income at the end of designated period.

Similar to restricted stock options, but the executive never has to exercise stock rights to receive income

Instead, the company awards a bonus payment:

The difference in stock price between the time the company granted the stock rights at fair market value to the end of the designated period

This arrangement permits the executive to keep the stock

Phantom Stock

A phantom stock plan is a compensation arrangement whereby board of directors promise to pay a Bonus in the form of the equivalent of either the value of company shares or the increase in value over a period of time based on meeting two conditions:

Executives must be employed for many years

Executives must retire from the company upon meeting these conditions, executives receive income equal to the increase in the value of the company stock from the date the company granted the phantom stock to the conversion date.

Phantom Stock

Phantom stock plans are similar to restricted stock plans because executives must meet specific conditions before they can convert these phantom shares into real shares of company stock.

There are generally two conditions:

First, executives must remain employed for a specified period, anywhere between 5 and 20 years.

Second executives must retire from the company.

Employee Stock Purchase Plans

Executive may purchase stock after a specified time period

The executive sets aside money through payroll deduction throughout this time, which is the offering period

Deferred Compensation: Separation Agreements

Golden parachutes

Platinum parachutes

Golden Parachutes

Provide executives pay and benefit following termination due to ownership change or corporate takeover (merger or combining of two separate companies)

Advantages to executives and the company:

Limit an executive’s risk on occasion of these unforeseen events

Promote recruitment of talented executives

Virtually eliminate an executive from making decisions to save his/her job at the expense of company welfare

Platinum Parachutes

Lucrative (beneficial) awards that compensate departing executives with:

Severance (termination) pay

Continuation of company benefits

Stock options

Awarded in order to avoid legal battles or critical press reports

Clawback Provisions

Allow board of directors to take back performance-based compensation when performance goals were not achieved

These provisions becoming more common because of increasing public scrutiny (analysis) of executive compensation practices

Employee Benefits

Employee benefits represents an additional key component of executive compensation packages:

Enhanced benefits

Common perquisites

Enhanced Benefits

Supplemental life insurance: increases the value of executives’ estates bequeathed to designated beneficiaries (usually family members) upon their deaths, as well as provides executive with preferred tax treatments

Enhanced Benefits

Supplemental retirement plan: are designed to restore benefits restricted under qualified plans. Qualified plans entitle employers to tax benefits from their contributions to pension plan. This means that employers may take current tax deductions for contributions to fund future retirement income.

A qualified plan generally entitles employees to favorable tax treatment of the benefits they receive upon retirement.

Perquisites: cover a broad range of benefits, from free lunches to the free use of corporate jets

Common Perquisites (1 of 2)

Company car

Security services

Legal services

Recreational facilities

Travel perks

The Key Players in Setting Executive Compensation

Compensation consultants

Board of directors

Compensation committees

Compensation Consultants

Are often employed by large consulting firms that specializes in executive compensation.

Propose recommendations

Develop packages based on strategic analysis which entail an examination of a company’s:

External market context

Internal factors

Possible conflicts of interest

Compensation consultants were hired by the CEO to perform an objective analysis of the company’s executive pay package and to make whatever recommendations the consultant felt were appropriate.

Board of Directors

Represent shareholders’ interests by weighing the pros and cons of top executives’ decisions.

Board of diectors have approximately 15 members. These members include:

C E O s and top executives of other successful companies

Distinguished community leaders

Well regarded professionals

Give final approval of the compensation committee’s recommendation.

Are compensated well for services, often, more than $50,000 annually

Compensation Committees

Usually other board of directors’ members (outside boards members)

Major duties include:

Review consultants’ recommendations

Discuss assets and liabilities

Make final recommendations