United States Auto Industry Case Study

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Chapter 10: Pay-for-Performance: Incentive Rewards: 10.8 Incentives for Executives Book Title: Managing Human Resources Printed By: Cedric Turner ([email protected]) © 2016 Cengage Learning, Cengage Learning

10.8 Incentives for Executives

10.8a The Executive Pay Package

Executive compensation plans consist of five basic components:

base salary,

short-term incentives or bonuses,

long-term incentives or stock plans,

benefits, and

perks.

Each of these elements may receive different emphasis in the executive’s compensation package depending on various organizational goals and executive needs.

Executive Base Salaries

Executive base salaries represent between 30 and 40 percent of total annual compensation. An analysis of executive salaries shows that the largest portion of executive pay is

received in long-term incentive rewards and bonuses. Regardless, executives of Fortune 500 firms routinely earn an annual base salary in excess of $500,000, with executives in very large corporations earning considerably more. The levels of competitive salaries in the job market exert perhaps the greatest influence on executive base salaries. An organization’s compensation committee—normally members of the board of directors—will order a salary survey to find out what executives earn in comparable enterprises. For example, by one estimate, 96 percent of companies in the Standard & Poor’s 500 stock index use a technique called competitive benchmarking when setting executive pay or to remain competitive for executive talent. As noted in Business Week, company boards reason that a CEO who does not earn as much as his or her peers is likely to “take a hike.” Comparisons may be based on organization size, sales volume, or industry groupings. Thus, by analyzing the data from published studies, along with self-generated salary surveys, the compensation committee can determine the equity of the compensation package outside the organization.

Executive Short-Term Incentives

Annual bonuses represent the main element of executive short-term incentives. A bonus payment may take the form of cash or stock and may be paid immediately (which is

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frequently the case), deferred for a short time, or deferred until retirement. Most organizations pay their short-term incentive bonuses in cash (in the form of a supplemental check), in keeping with their pay-for-performance strategy. By providing a reward soon after the performance and thus linking it to the effort on which it is based, they can use cash bonuses as a significant motivator. Deferred bonuses are used to provide a source of retirement benefits or to supplement a regular pension plan.

Incentive bonuses for executives should be based on the contribution the individual makes to the organization. A variety of formulas have been developed for this purpose. Incentive bonuses may be based on a percentage of a company’s total profits or a percentage of profits in excess of a specific return on stockholders’ investments. In other instances, the payments may be tied to an annual profit plan whereby the amount is determined by the extent to which an agreed-upon profit level is exceeded. Payments may also be based on performance ratings or the achievement of specific objectives established with the agreement of executives and the board of directors.

In a continuing effort to monitor the pulse of the marketplace, more organizations are tying operational yardsticks to the traditional financial gauges when computing executive pay. Called balanced scorecards, these yardsticks may measure things such as customer satisfaction, the ability to innovate, or product or service leadership. Notes David Cates, a compensation principal with Towers Perrin, a balanced scorecard “allows companies to focus on building future economic value, rather than be driven solely by short-term financial results.” Mobil Oil uses a balanced scorecard that better indicates exactly where the company is successful and where improvement is needed.

Executive Long-Term Incentives

Stock options are the primary long-term incentive offered to executives. The principal reason driving executive stock ownership is the desire of both the company and outside investors for senior managers to have a significant stake in the success of the business—to have their fortunes rise and fall with the value they create for shareholders. Stock options can also be extremely lavish for executives. Consider these examples. For 2006, Edward E. Whitacre, Jr., CEO of AT&T, received long-term compensation totaling $38.4 million; Patrick Hassey, CEO of Allegheny Technologies, received $35.3 million; and James J. Mulva, CEO of Conoco Phillips, received $30.4 million. Not surprisingly, the creativity in designing a stock option program seems almost limitless. Figure 10.5 highlights several common forms of long-term incentives.

Figure 10.5

Types of Long-Term Incentive Plans

Stock options Rights granted to executives to purchase shares of their organization’s stock at an established price for a fixed

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period of time. Stock price is usually set at market value at the time the option is granted.

Stock appreciation rights (SARs)

Cash or stock award determined by increase in stock price during any time chosen by the executive in the option period; does not require executive financing.

Stock purchase Opportunities for executives to purchase shares of their organization’s stock valued at full market or a discount price, often with the organization providing financial assistance.

Phantom stock Grant of units equal in value to the fair market value or book value of a share of stock; on a specified date the executive will be paid the appreciation in the value of the units up to that time.

Restricted stock Grant of stock or stock units at a reduced price with the condition that the stock not be transferred or sold (by risk of forfeiture) before a specified employment date.

Performance units Grants analogous to annual bonuses except that the measurement period exceeds one year. The value of the grant can be expressed as a flat dollar amount or converted to a number of “units” of equivalent aggregate value.

Performance shares

Grants of actual stock or phantom stock units. Value is contingent on both predetermined performance objectives over a specified period of time and the stock market.

© Cengage Learning

Short-term incentive bonuses are criticized for causing top executives to focus on quarterly profit goals to the detriment of long-term survival and growth objectives. Therefore, corporations such as Sears, Combustion Engineering, Borden, and Enhart have adopted compensation strategies that tie executive pay to long-term performance measures. Each of these organizations recognizes that compensation strategies must also take into account the performance of the organization as a whole. Important to stockholders are such

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performance results as growth in earnings per share, return on stockholders’ equity, and, ultimately, stock price appreciation. A variety of incentive plans, therefore, have been developed to tie rewards to these performance results, particularly over the long term. Additionally, stock options can serve to retain key executive personnel when exercising the options is linked to a specified vesting period, perhaps two to four years (this type of incentive is called “golden handcuffs”).

Stock options are under attack. Some object to the sheer magnitude of these incentive rewards. The link between pay and performance that options are championed to provide can also be undermined when compensation committees grant additional options to executives even when company stock prices fall or performance indexes decline. Peter Clapman, chief counsel for TIAA-CREF, the world’s largest pension system, notes, “It’s sort of heads you win, tails let’s flip again.” Even worse for shareholders is the dilution problem. Every option granted to executives makes the shares of other stockholders less valuable.

Executive Benefits

The benefits package offered to executives may parallel one offered to other groups of employees. Various programs for health insurance, life insurance, retirement plans, and vacations are common. However, unlike other employee groups, the benefits offered to executives are likely to be broader in coverage and free of charge. Additionally, executives may be given financial assistance in the form of trusts for estate planning, payment of mortgage interest, and legal help.

Executive Perks

Perks (or perquisites (Special nonmonetary benefits given to executives; often referred to as perks) ) are nonmonetary rewards given to executives. Perks are a means of demonstrating the executive’s importance to the organization. The status that comes with perks—both inside and outside the organization—shows a pecking order and conveys authority. Corporate executives may simply consider perks a “badge of merit.” Perks can also provide tax savings to executives because some are not taxed as income.

The dark side of perks is that they are viewed as wasteful spending and overly lavish. A recent study, however, shows that perks can facilitate company productivity by saving executive time (e.g., private planes and chauffeur service) or improve or maintain executive health (e.g., spas, health clubs, and company cabins). Therefore, the cost of perks should be weighed against the added efficiency and managerial effectiveness they generate. Highlights in HRM 5 shows the more common perks offered to executives.

Chapter 10: Pay-for-Performance: Incentive Rewards: 10.8 Incentives for Executives Book Title: Managing Human Resources Printed By: Cedric Turner ([email protected]) © 2016 Cengage Learning, Cengage Learning

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