10.2 Executive Compensation

Executive compensation is a hot-button issue in corporate governance. It's all about how companies pay their top dogs and why. From base salaries to stock options, the goal is to keep execs happy while also making sure they're working hard for shareholders.

But it's not just about the money. There's a whole science behind executive pay, with theories like tournament theory and efficiency wage theory trying to explain it. Compensation committees and shareholder votes also play a big role in keeping things fair and transparent.

Executive Compensation Components

Pay Components and Their Purposes

Top images from around the web for Pay Components and Their Purposes

• 

  The determinants and effects of CEO-employee pay ratios - Journalist's Resource View original

  Is this image relevant?

• 

  CEO pay-performance sensitivity in the South African context View original

  Is this image relevant?

• 

  Securities Management | Boundless Finance View original

  Is this image relevant?

• 

  The determinants and effects of CEO-employee pay ratios - Journalist's Resource View original

  Is this image relevant?

• 

  CEO pay-performance sensitivity in the South African context View original

  Is this image relevant?

1 of 3

Top images from around the web for Pay Components and Their Purposes

• 

  The determinants and effects of CEO-employee pay ratios - Journalist's Resource View original

  Is this image relevant?

• 

  CEO pay-performance sensitivity in the South African context View original

  Is this image relevant?

• 

  Securities Management | Boundless Finance View original

  Is this image relevant?

• 

  The determinants and effects of CEO-employee pay ratios - Journalist's Resource View original

  Is this image relevant?

• 

  CEO pay-performance sensitivity in the South African context View original

  Is this image relevant?

1 of 3

• Executive compensation packages include base salary, annual bonus, stock options, restricted stock, and other long-term incentive plans (LTIPs)
  • Base salary is the fixed portion of compensation, providing a stable income
  • Bonuses and LTIPs are variable and often tied to performance metrics, incentivizing executives to meet specific targets
  • The mix of fixed and variable pay influences executive risk-taking and decision-making (higher variable pay encourages more risk-taking)
• Stock options give executives the right to purchase company stock at a predetermined price (strike price), aligning their interests with stock price appreciation
  • Options have value only if the stock price rises above the strike price, encouraging executives to focus on long-term stock performance
• Restricted stock grants provide executives with actual shares of company stock, subject to vesting conditions (time-based or performance-based vesting)
  • Restricted stock aligns executive wealth with shareholder returns, as the value of the stock grants fluctuates with the company's stock price

Non-Monetary Benefits and Employment Agreements

• Perquisites (perks) are non-monetary benefits provided to executives (company cars, private jet usage, country club memberships)
  • Perks can be a significant portion of total compensation and are often used to attract and retain top talent
  • However, excessive perks can be seen as a sign of poor corporate governance and may draw criticism from shareholders and the public
• Employment contracts outline the terms of an executive's employment, including compensation, benefits, and termination provisions
  • Contracts provide executives with job security and clarity on their compensation and benefits
  • Severance agreements specify the benefits an executive receives upon termination (cash payments, accelerated vesting of equity awards)
• Golden parachutes provide substantial benefits to executives in the event of a change in control (merger, acquisition) or termination
  • These provisions can help align executive interests with shareholders during a takeover, encouraging them to negotiate the best deal
  • However, excessive golden parachutes can also incentivize executives to pursue deals that may not be in the best interest of shareholders

Executive Pay Alignment with Shareholders

Addressing the Principal-Agent Problem

• The principal-agent problem arises when the interests of executives (agents) diverge from those of shareholders (principals), leading to potential conflicts and agency costs
  • Executives may prioritize short-term gains over long-term value creation or engage in excessive risk-taking
  • Executive compensation should be designed to minimize these conflicts and align interests, encouraging actions that benefit shareholders
• Pay-for-performance compensation ties executive pay to specific performance metrics (stock price, earnings per share, return on equity)
  • This aligns executive incentives with shareholder value creation, as executives are rewarded for meeting or exceeding performance targets
  • However, poorly designed performance metrics can lead to unintended consequences, such as short-term thinking or manipulation of results

Equity Ownership and Clawback Provisions

• Stock ownership guidelines and holding requirements encourage executives to maintain a significant equity stake in the company
  • Executives with substantial stock ownership have their personal wealth tied to the company's performance, aligning their interests with shareholders
  • Holding requirements prevent executives from selling shares immediately after vesting, promoting long-term thinking
• Clawback provisions allow the company to recoup compensation from executives in the event of financial restatements or misconduct
  • These provisions discourage short-term manipulation and promote accountability, as executives face financial consequences for improper actions
  • Clawbacks help maintain the integrity of the compensation system and protect shareholder interests

Shareholder Involvement in Executive Pay

• Shareholder "say on pay" votes provide a non-binding advisory vote on executive compensation
  • These votes allow shareholders to express their approval or disapproval of pay practices, sending a signal to the board and management
  • While non-binding, negative say on pay votes can lead to changes in compensation practices and increased shareholder engagement
• Proxy advisory firms (Institutional Shareholder Services, Glass Lewis) provide recommendations to institutional investors on how to vote on executive pay
  • These firms analyze compensation practices and assess their alignment with shareholder interests
  • Their recommendations can influence the outcome of say on pay votes and pressure companies to reform their pay practices

Executive Compensation and Firm Performance

Empirical Evidence and Theories

• Empirical studies have yielded mixed results on the relationship between executive pay and firm performance
  • Some studies find a positive correlation, suggesting that higher pay is associated with better performance
  • Others find weak or no significant relationship, indicating that factors other than compensation may drive firm performance
• The pay-performance sensitivity measures the change in executive wealth for a given change in firm value
  • Higher sensitivity suggests a stronger alignment between pay and performance, as executive wealth is more closely tied to company success
  • However, measuring pay-performance sensitivity can be challenging due to the complexity of compensation packages and the time horizon of incentives

Tournament Theory and Managerial Power

• Tournament theory suggests that the large pay gap between CEO and other executives creates a tournament-like competition for the top job
  • The prospect of a significant pay increase motivates executives to perform better and vie for promotion to CEO
  • However, excessive pay disparity can also lead to negative consequences (reduced cooperation, increased risk-taking, internal politics)
• Managerial power theory argues that powerful CEOs can influence their own pay, leading to compensation that is more a function of CEO power than firm performance
  • CEOs with greater tenure, control over the board, or personal relationships with directors may be able to extract higher pay
  • This can result in rent extraction and suboptimal pay practices that do not align with shareholder interests

Efficiency Wage Theory

• The efficiency wage theory suggests that paying executives above-market wages can attract and retain top talent, leading to better firm performance
  • Higher pay can help companies secure the best managerial talent, which is scarce and highly sought after
  • Retaining top executives can provide stability and continuity in leadership, supporting long-term strategy implementation
• However, this theory assumes that the labor market for executives is efficient and competitive
  • In reality, the executive labor market may be influenced by factors such as social networks, reputation, and asymmetric information
  • Paying above-market wages may not always result in better performance if the executive's skills do not match the company's needs or if other factors limit their effectiveness

Compensation Committees and Executive Pay

Committee Composition and Responsibilities

• The compensation committee is a subcommittee of the board of directors responsible for overseeing and determining executive compensation
  • The committee should be composed of independent directors to minimize conflicts of interest and ensure objective decision-making
  • Independence requirements vary by country and stock exchange, but generally exclude directors with material relationships to the company or its executives
• Compensation committees set performance goals and metrics for incentive compensation, ensuring alignment with the company's strategy and shareholder interests
  • They determine the target pay levels and mix of compensation components (salary, bonus, equity, etc.) for each executive
  • Committees also review and approve employment contracts, severance agreements, and change-in-control provisions

Compensation Consultants and Disclosure

• Compensation committees typically engage compensation consultants to provide market data, benchmarking analysis, and advice on pay practices
  • Consultants help committees understand market trends, design competitive pay packages, and assess the appropriateness of compensation levels
  • However, the use of consultants can also lead to potential conflicts of interest if the consultant provides other services (e.g., employee compensation, benefits consulting) to the company
• Compensation committees are responsible for drafting the Compensation Discussion and Analysis (CD&A) section of the company's proxy statement
  • The CD&A discloses and explains the company's executive compensation philosophy, practices, and decision-making process to shareholders
  • It provides transparency on pay levels, performance metrics, and the rationale behind compensation decisions
  • Shareholders can use the CD&A to assess the alignment of executive pay with company performance and shareholder interests