Accounting Theory Assignment Executive Compensation [pic] Introduction Executive compensation together with corporate governance systems has received an increasing amount of attention- from the press, corporations, financial academics and also the government. An executive compensation plan is a major application of the agency theory study and, thus, an agency contract between the shareholders and CEO’s of the business, which attempt to align the interests of the owners and the managers by basing the CEO’s or executive’s compensation on some performance measure of the managers expended effort in operating the organization.
Over the last decade scandals such as the Enron and WorldCom have raised many issues and discussion as what went wrong? How did CEO’s walk out with so much money” and are executives overpaid and greedy? Executive compensation plans are present in our daily work lives since they set “parameters” for compensation for executive remuneration. Most plans usually encompass net income and share prices; some plans only include net income. The most common forms of compensation are bonus, shares, salary, and stock options.
This papers focus is on the effects of performance measures in motivating manager interests. The incentive plan involves a mix of incentive, risk and decision horizon considerations. Executive compensation plans are important to accountants. Because they introduce a second major role of financial report: the role to motivate and monitor manager effort. If net income is informative and reflective of manager effort it improves the operation of the managerial labour markets and motivates productivity. Our main focus are addressed below:
Theory of executive compensation -Discuss compensation committees -Net income -Persistent earnings -Share price -Sensitivity to earnings and share price Incentive Contracts -Are they necessary? -Discuss no and yes for necessary -How do incentive plans align interests of manager with shareholders? -Provide example of incentive contract Role of Risk in Compensation -How do we control risk? -Describe types of risk -Describe effects of too much risk -Describe effects of too little risk Politics of Executive Compensation Attracts political controversy -Are executives overpaid relative to firm performance? -Regulation of increased disclosure of executive compensation Compensation Committees Compensation committees are a corporate governance device whose intention is to design a compensation program that attracts, retains and motivates managers and senior executives. It also designs a plan that delivers an efficient combination of sensitivity to earnings and share price, the precision of measuring earnings and share price, the decision horizon imeframe that the manager is responsible for and the risk regarding compensation to the company and the manger. The composition of the compensation committee needs to be made up of individuals who are not affiliated with the company in order to be objective in it’s planning of the compensation. An example of a compensation committee is included in the Bank of Montreal’s Report on Executive Compensation as outlined below: “A majority of the members of the Committee are resident Canadians who are not affiliated with the Bank for purposes of the Bank Act (Canada).
Each member of the committee is not an officer or employee of the Bank or an affiliate of the Bank; and is “independent” within the meaning of applicable Canadian securities laws and New York Stock Exchange rules. ” Once the committee has been established, then the task of creating an effective compensation plan begins. Compensation plans are generally based on either net income or share price, but a truly effective compensation plan is devised using both net income and share price.
If net income of the company has high precision of information and a great deal of sensitivity to manager effort, then a greater amount of compensation can be based on net income and less on share price. The sensitivity of a compensation plan to net income can be achieved by moving to a current value accounting system, thereby reducing recognition lag. This will result in more payoffs from the manager’s effort in the current period. However current value accounting reduces the precision of the information, which means there is less importance for net income in compensation.
On the other hand, share price is more sensitive that net income sooner to certain events such as acquisitions and mergers or R&D. This sensitivity makes share price a better device for calculating compensation. Share price however is not as precise as net income since it can be affected by events such as changes in the economy’s interest rates or terrorist attacks that has nothing to do with manager effort. An alternative approach to increasing sensitivity in net income is to ensure full disclosure, especially concerning unusual and non-recurring items.
Full disclosure makes it more difficult for managers to shirk by choice of accounting policies and enables the committee to evaluate manager effort and ability as well as earnings persistence. Persistent earnings are a more sensitive measure of current manager effort then price-irrelevant earnings, which may arise independently of effort. Compensation committees tend to value persistent earnings when they are setting manager compensation.
The compensation committee can adjust the relative proportions of the net-income based and share price based compensation for manager effort as well as to ensure that the compensation package is meeting the objectives that the committee intended it to. If the committee wanted to base compensation on short-run manager effort, then it would move the compensation to be based more on net income. Conversely if it wanted to base compensation on long-run manager effort, then it would move the compensation to be based more on share price.
Basing the compensation plan more on share price tends to align the interests of the manager more with those of the shareholders. It is still not a foolproof solution though. As we have seen in cases such as Enron, share price does not always reflect the true value of the business. I believe this is why a good compensation plan should be based on information from both net income and share price. Another important factor for the compensation committee would be to review on a regular basis the compensation plan to ensure that it is still meeting all of the goals and targets that it was designed to.
It should also be reviewed with the compensation that was awarded to ensure that the amounts paid are in line with the intended compensation package. See below for an excerpt from the Bank of Montreal Report on Executive Compensation regarding their Annual Compensation Review Process. Incentive contracts To begin the discussion about incentives the first question that would occur in most of your minds is, are they necessary? Naturally, “human beings need incentives to encourage them to seek and attain goals”. (Dr. A. L. Dartnell, CGA, online lecturer) Incentives for people can cover a wide range of objectives.
A popular notion is presumed by many of us is that promotion and recognition in a firm should be sufficient to encourage mangers not to shirk – and often this is not achieved. A direct measure to reward particular effort expended to reach a goal would be a pay-off. A pay-off is considered a good method to have the manager onside and doing his or her very best. When first introduced to agency model our reaction was that managers don’t need to be motivated by performance measure. One would expect mangers to want to work hard; otherwise, they will not go ahead in the organization and will lose earning power by destroying their reputation.
This is a similar reaction shared by Fama an influential finance academic who assumes in his studies that managerial labour markets work well an the forces of reputation on the managerial labour market are enough to motivate the mangers to work hard. However, if the predictions of the agency model are taken seriously, such reactions needed to be countered. Both analytical and empirical studies (namely Wolfson) suggest that while organization and reputation considerations help to control moral hazard, they do not do so completely – an incentive contract is necessary.
As students the effort you expend depends on your individual ability to pass the course. With particular reference to CGA courses, most of us would most probably not work as hard if the course required only completing assignments to pass the course. No one questions your motivation, and, presumably, a good knowledge of the course material will help you do well in the accounting world. Consequently, you would put some effort into learning the module material but not as much as if you were under the pressure and risk of a final examination.
Since your efforts in studying the course material cannot be directly observed, a moral hazard problem is present. It seems that the incentive device of an examination is still needed. Designers of compensation plans tend to agree. According to research done by Watson Wyatt, most shareholders and regulatory bodies are under immense pressure to align executive compensation with the shareholder interests. This is because CEO’s who earned above- median increases in their cash compensation (this is the bonus plus the base salary) for 2004 delivered a return of 19. 4% -which – more than twice their counterparts who earned below-median increases.
His study also concludes that pay-for-performance philosophy is taking hold. In a recent article published by Management Issues “Executive incentives failing to boost performance” the paper discuss that British incentive plans are so complex that CEO’s fail to perform better. . With this view being conceived most organizations are usually making constant changes to their compensation plans to make shareholders and executives happy. Traditionally, when CEO’s perform well they are rewarded for their performance. However, studies have shown that this also gives rise to anomalies “where performance is anything less than stellar”.
Most compensation plans are not successful at aligning shareholders and executives interests over a sustained period. (Tom Gosling, executive at PWC). Some plans can very complex meaning that executives undervalue them and therefore the incentive to perform better is not effective. . A better alignment of reward would be to delivering more of an executive’s total pay in company shares and stock ownership. Although companies are trying to achieve better pay for performance, remuneration committees are busier than ever and motivating and retaining executive employees “it seems difficult to get it right”.
Currently, most large organizations are now reducing their usage of ESOs and replacing them with other compensation components, such as higher short-term incentive bonuses and the introduction of a 2- year stock based performance award. Presumably, this reduction is due in part to the abuses of ESOs, e. g. , CEOs tendency to manipulate share price upwards so that their ESOs become “deep-in-the-money” and also the “pump-and dump” behavior, which have raised serious questions about ESOs’ incentive value.
Most firms are shortening the decision horizon; however, this creates the possibility of short-term opportunistic manager behaviour such as deferral of maintenance, under investment in R & D etc. The article below explains if there is a magic formula to work out a good compensation plan: “With all the talk lately about the exorbitant salaries of CEOs, there was a good news story that hit the airwaves last week. CEO of Japan Air Lines, Haruka Nishimatsu was reported to receive $90,000 annual salary. Yes, that’s right, not $9 million, not even $900,000, but $90,000.
And there are no bonuses or share options attached. In fact Nishimatsu gets paid less than his pilots – and JAL is one of the worlds top 10 airlines. He doesn’t even get an executive perks and also lines up in the staff canteen with his fellow workers for lunch each day and even catches the bus to work. JAL was going through tough times in 2007 when Nishimatsu was appointed CEO. There were job cuts and early retirement. As he commented “The employees who took early retirement are the same age as me. I thought I should share the pain with them. So I changed my salary. ” Now that’s really “walking the talk”.
In comparison to most CEO’s of US Companies averaged $10. 8 million in total compensation in 2006, more than 364 times the pay of the average US worker. There have been a lot of discussions by governments globally to take measures to limit the pay to CEO’s and senior executives. Although nothing has happened yet, this seems to spark another financial crisis meltdown in the future. Then is there a magic formula? No one seems to have come up with the most perfect formulae to deal with this, since; there is an incorrect management philosophy that you must “pay people to perform”.
When CEO’s get incentives or rewards it’ only natural they will focus almost exclusively on short term, bottom line results. A popular doyen in management philosophy and practice once suggested to his students “CEO salaries should be a maximum of 20 times the salary of lowest paid worker”. A good pay scheme would preferably have the following four components: 1. Base salary. Needs to be in line with industry standards, appropriate to the role and to be seen as “fair and equitable” both within and external to the organization. 2. Share of company profits.
Needs to be calculated on net profit prior to distribution to shareholders. This should be the second highest component of the salary package for CEOs and senior executives. Once again, it would be limited to 20 times the share of profit received by the lowest paid worker (Yes, that’s right, everyone should share in the profits). Shareholders through their reps, the Board, would approve profit share. 3. Team performance rewards. Based on a pre-determined set of criteria and relative to the top team’s performance. This should be the third ranked level of salary package component.
Limited to 20 times the bonus reward for the lowest paid organizational team performance. Up to a maximum of 20% of average individual profit share (as in point 2). 4. Individual performance reward. Based on the achievement of pre-set goals. This should be the least component of salary package. Limited to 20% of base salary. What gets rewarded gets done. This approach to remuneration, rewards; teamwork, a sense of community, a drive for performance, and above all a sense of “we are in this together” – all stakeholders working for the betterment (and rewards) of the organization.
Peter Drucker was right. The magic number is 20! Based on the above article we conducted a thorough research into the Bank of Montreal’s Executive Compensation package. The below plan is somewhat consistent with the predictions of the agency models. It contains several different incentives; based on net income, share price, and individual contribution such as creativity and initiative. BANK OF MONTREAL COMPENSATION PLAN (EXCERPT SUMMARY) Executive Compensation review for implementation in 2008 • This was carried out by the Committee and the President and CEO of the ank • Purpose of the review was to enhance effectiveness and efficiency of the banks compensation program to drive top –quartile performance • Focused on the linkage between levels of pay and levels of performance achieved as measured against target to achieved • It sought to enhance the recruitment, retention and motivation of executive talent through competitive pay opportunities while ensuring alignment of compensation practices with bank strategies for maximizing shareholder value Elements of Executive Compensation: 1. Base salary: • Determined at the market rate Paid in the form of cash annual in cash 2. Short-term incentives: (STIP): about 235 participants A. Cash • -Paid to all executives based on Bank results for one year; • Individual awards are focused to reflect performance against predetermined business and individual objectives; B. Deferred stock units: • Paid to senior executives and selected offices in BMO; • Until executive terminates employment with the bank • Stock units are awarded in lieu of cash payments and payouts are based on the final value of an equivalent number of bank’s shares. For Senior Executives the level of incentive pool funding included relative performance where Total Bank earnings per share and revenue growth are assessed to the other 5 major banks 3. Performance and or restricted share units issued under the mid-term incentive plans • Paid mostly to most executives and selected officers in BMO • For a performance period of 3 years • Attainment of performance on productivity vs. planned performance • Individual awards are based on individual contribution and sustained performance 4. Stock options issued as long term incentives About 190 participants • Performance period is up to 10 years; The complexity and sophistication of the BMO plan is consistent with Holmstrom’s prediction that real compensation plans will include several different incentives. Therefore, are incentive contracts necessary? “Yes”, they are because in the presence of moral hazard incentive contracts are necessary to align shareholders and manager’s interests. When compensation is based on performance measures, the manager is motivated to work hard. This aligns manager and shareholder interests.
Secondly, compensation based on share price motivates a longer manager decision horizon than compensation based on net income. Lastly, the relative proportions of these performance measures control the length of the manager’s decision horizon. An executive compensation plan is an incentive contract between the firm and the mangers that tries to align the interests of owners and mangers. Most executive compensation’s are done basing the manger’s compensation on one or more performance measures, that is, measures that predict the payoff from the manager’s effort in operating the firm.
Compensation plans have come along way and despite all the financial scandals from Enron to the present day mortgage meltdowns and the CEO’s walking away excessive compensation packages; the Regulators, Standard Setter and corporate governances are “still trying to get it right. ” Role of Risk in Compensation Equity-linked compensation has been widely adopted by corporations during the last two decades. This phenomenon characterizes the acceptance and application of agency theory in most business settings.
The theory is concerned with resolving the problem arising from moral hazard and adverse selection in agency relationships and which explicates the modern framework of managerial labour contract. The spirit of executive employment contract is to motivate manager to ‘act’ and ‘think’ like owners through the profit and risk sharing process and hence equity vehicles such as stock option, stock appreciation right, restricted stock units and preferences shares are used significantly in corporations where control and ownership is in separation.
The trend is consistent with agency theory that fixed salaries comprise a declining percentage of total compensation. Equity-linked compensation is granted to manager as an optimal incentive arrangement to properly align manager and shareholder’s interests. Value of these equity-based compensations usually equals to a few times of executive’s annual base salaries. Ultimately, the implication is to link ‘pay to performance’ and which are often measured by firm’s net income and share price. It is undeniable that the level of CEO pay is an outcome of fairly efficient labour market.
However, are these equity vehicles really efficient in attracting and motivating the talent directors who have direct influence over the corporate performance and share price? The success of executive compensation design must be built on the appropriate level of risk and the underlying incentive. In contrast, unable to compromise the risk preferences between shareholders and managers may result in higher compensation costs, higher executive turnover and excessive use of earnings management. Type and impact of risk
Nevertheless risk mitigates the agency problems between the two parties, when risk is beyond manager’s control, the effort incentives declines. Lisa Meulbroek, a professor at Claremont McKenna College said, “rowing (… ) does not affect the boat’s progress very much relative to the effect of (a) hurricane”. Thus, to attain a desired relationship between risk and reward, potential risk must be assessed relative to the size, growth and strategic needs of the companies. Manager is a rational, risk-averse individual who is only willing to undertake a given level of risk for a desired return.
However, manager’s perception of risk differs from shareholders. It is because managers cannot fully diversify their investment risks through balancing portfolios across different industry sectors and companies; as their worth and human capitals are solely tied to their own firms. In addition, manager’s ability to exercise the stock option usually is restricted by years of services, performance thresholds and retention limitations. Stock option may even become worthless to the director during bad times. On the other hand, hedging the stock option often is prohibited to create incentive or ruled specifically by SEC filing.
Consequently, risk-adverse managers are exposed to the firm specific risks. It is not difficult to understand why directors discount the value of the stock options. Hall and Murphy (2000) used an “expected utility” approach to estimate the value stock option. An executive with some risk aversion and 50% of his wealth placed in company stock, a 10-year option granted at the money is worth only 63. 5% of its Black-Scholes value. Meulbroek (2000) also found that a manager of typical NYSE-listed Company values stock options at an average of 70% and for industries that are rapidly growth and entrepreneurial based, its value even drops to 53%.
For instance, internet-based firms may be better off in selling shares externally and reward managers with cash compensation to achieve incentives. When it costs the firm higher than what is valued by the executive, the effect of stock ownerships in aligning the interests of two parties is debatable. Therefore, the trade off between risk and incentive must be further analyzed from the cost and benefit perspective and constantly reviewed by the compensation committee.
Peter Chingos, author of “Responsible Executive Compensation for a New Era of Accountability stated that “Tying their incentive compensation to these factors turns their rewards into a form of lottery where chance dominates actions in determining outcomes”. Another issue arising when pay is substantially driven by net income and share price measure, it enormously inherits executives ought to meet the expectation of share market and investors in order to sustain their positions and remunerations. Indeed, oor performance may be caused by overall, undiversified, systematic risks like financial crisis, change in interest rates, environment, regulatory and technology. Despite managers have no influence on these factors as well as the general, market and industry volatility, managers are sometimes involuntarily blamed, penalized and potentially be held accounted for such economic consequences. In fact, share price is a noisy measurement of performance. Executives in firms with more volatile stock prices will receive less performance-based compensation.
In Aggarwal and Samwick’s analytical research, they used the variation in stock return volatility across firms to test its implication to pay-performance sensitivity of a manager’s compensation. Their findings support the principal-agency model is that compensation contract incorporate the benefits of risk sharing and “… that executives in companies with the lowest variance have pay-performance sensitivities that are an order of magnitude greater than those of executives in companies with the highest variance. Journal of Political Economy (February1999), vol. 107 (1), p. 103 The grant price, exercisable condition and vesting period of various equity mechanisms may be different but their characteristics are tailored for the same purpose – to create loyalty and long term work incentives. Executive normally need to hold the equity stock for a period of time before trading. In reality, some executives may not even have the financial merits to purchase these stocks. Also, the wealth of the executive increases under the condition that stock price appreciates over time.
When executive’s personal wealth is predominately connected to the volatile share price and noisy performance measure and if there is no assurance for downside risk, manager struggles to maintain the financial position and tends to avoid risky projects, focuses on short selling or manipulate earnings to meet financial targets. As a result, conflict arising from this adverse selection jeopardizes shareholders’ return. On the other hand, it is rational to control upside risk, otherwise, shareholder will suffer more losses than the manager.
As managers may feel that they have everything to gain but nothing to lose so it is absolutely worthy to undertake aggressive strategy in order to boost up earnings. This situation is identical to the classic illustration of moral hazard – fire insurance. If the insured individual does not have to pay deductible and additional premium in the future, he will have no incentive of preventing fire damage. Another example is the accounting sandals of Enron, WorldCom, and Tyco that brought executive compensation to the headlines during the past few years.
These companies had similar falling patterns: initially, the greed drove these CEOs to manipulate earnings excessively to fool investors, then their share prices skyrocketed, CEOs gained million/billion of dollars from trading their own companies’ shares, eventually companies filed bankruptcy, CEOs were found guilty of illegal accounting treatments and sentenced to jail. Peter Pearson, Chairman of the Blackstone Group said that stock options temptation contributed to these opportunistic accounting policies. How to control risk
Risk analysis is important in understanding the portfolios of shareholder and managers in order to determine how the underlying incentive influences manager in firm operations. The increasing demand of disclosure by SEC is beneficial to the public as when the compensation becomes more transparent, company is able to utilize this information to perform risk analysis and comparison with peer groups. Such analyses are valuable in creating award package that better fit the incentive purpose and corporate goals. To maintain a manageable pay-for-performance environment is complex and challenging.
Manager must bear risk to enhance incentive; however, their personal risks generated must be protected by a bogey in the compensation plan. For example, the structure of the compensation plan should include fixed salaries, annual bonus, short-term incentive, decision horizon and long-term compensation. The proportion of each component must be carefully weighted according to manager’s risk tolerance. Simultaneously, upside limit must also be set to prevent excessive risk taking. To develop executive pay program with a bias toward creating stock ownership is also essential.
The award process must be governed and reviewed periodically. The committee should compare whether the executive has actually purchased the stock according to the established guideline. Moreover, the firm may adopt other proxies to measure performance other than net income and share price, such as choosing peer group for executive pay and performance comparison, comparing incentive plan metrics with benchmark group of competitors, reviewing others absolute metrics includes ROE in percent, ROI in percent, EPS in dollars) Politics of Executives Compensation
The executive compensation controversy generated important political responses affecting the disclosure, accounting and taxation of top-level executive compensation. While the amounts of senior executive compensation are large, they may not be as large as they seem, due to manager risk aversion and restrictions on disposal of shares and options received as part of the compensation package. The effect of risk aversion on the value of stock-based compensation to the manager was studied by Hall and Murphy (2002), ranging up to a 55% reduction for a highly risk averse individual
Much public criticism of excessive CEO pay focused on comparison of the pay levels of CEOs with pay levels for lower-level workers. “The perception among reporters and other critics that the corner suite is sinecure with huge rewards and little accountability bears no resemblance to present reality. Fully half of the Fortune 1000 companies have replaced their man at the top since 2000. ” [Off with their Heads,” editorial, Wall Street Journal, August 1,2006]. “Each year shocking news of CEO pay greed is made public. Investors are concerned not just about their growing size of executive compensation packages, but the fact that CEO pay levels show little apparent relationship to corporate profit, stock prices or executive performance. How do they do it? For years, executives have relied on their shareholders to be passive absentee owners. CEO’s have rigged their own compensation packages by parking their boards with conflicted or negligent directors. (AFL- CIO’s web site:) Political ramifications of executive compensation • Executive compensation attracts political controversy due to the large amounts of compensation that are often involved. Some argue that executives as a group are overpaid, pointing to low sensitivity of executive compensation to firm performance, especially when performance is poor. • Others argue that executives are not overpaid, pointing out that the amount of compensation received is very small relative to the shareholder values created. Also, managers cannot diversify away their compensation risk. • Regulators have reacted to this controversy by requiring increased disclosure of executive compensation; on the grounds that the managerial labor market and the shareholders of individual firms can act if pay becomes excessive.
Are Executives Overpaid relative to firm Performance? CEOs compensation is far unrelated to their performance. Many potential causes of overpayment are • CEOs with too much power • Inattentive boards of directors • Conflicts of interest by compensation consultants • Use of stock options–the list goes on. Is It Justified- HOW MUCH IS TOO MUCH? John Mariotti, president and founder of The Enterprise Group asks “CEO Pay: How Much is Too Much? ” and answers the question himself. Citing Derek Bok, he points out that as business becomes more complex, the demand for top executives increases and thus they command greater and greater pay.
He also noted that such huge awards do little to motivate these outstanding performers, who are generally more motivated by challenge. Mike Hughlett, Staff Writer for Pioneer Planet, thinks the reason why CEO pay soars so high is that the compensation committee, usually comprised of other chief executives, generally sets CEO’s pay. Some observers have claimed that there is huge gulf between the paychecks of executives and the average workers and some believe that such comparisons are meaningless. Executives shoulder much more responsibility and usually come with degrees from the country’s top universities.
Putting arbitrary caps on executive pay is like putting a ceiling on rock bands’ earnings. Studies show the average CEO was paid $10 million to $15 million in 2005. This includes their salary, bonus, stock option gains, stock grants, and various executive benefits and perquisites. Some data sources indicate the average American worker was paid about $40,000 in 2005 There are various myths and realties as to executives pay only rises. The reality is such that Executives pay rises and fall in tandem with stock prices and the financial performance of the company.
For example, Allan Reyonds an Economists, stated, “ The income of the top 100-500 CEO’s rose unexpectedly with the stock market boom of 1997-2000 then fell by an estimated 48-53& in 2003 “. Such ups and downs of CEOs’ pay can’t be explained by the theory that mangers dominate their boards. Stock price down, but CEOs pay up “Pay for performance? Forget it. These days, CEOs are assured of getting rich — however the company does. ” In light of recent events in the financial markets, which have cast a shadow over expensive executive-compensation packages, particularly at companies that have performed poorly?
Two examples given by the authors are Home Depot and Merrill Lynch. Although Home Depot’s stock was struggling, its chief executive had an executive pay package valued at more than $190 million. When he left Home Depot in 2007, CEO Robert Nardelli received a severance package worth $210 million. Merrill Lynch CEO John Thain was the highest paid chief executive in 2007. Even as the brokerage firm’s slide was well underway, he took home total compensation of $83. 8 million. Billions of dollars have been paid to thousands of executives who have destroyed companies and ruined workers’ lives.
I have seen executives join a company shortly before a takeover and get millions in “change in control” payments. Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers and Bear Stearns are giving out $39 billion in bonuses for 2007 despite posting huge losses in the past year, Bloomberg News reported. CEOs aren’t overpaid Some argue that CEOs are not overpaid, when rock stars make big money, we can look at the ticket and album sales and understand where it comes from. However, when a CEO makes a rock star income, we figure he must be scamming the shareholders.
In other words, CEOs take advantage of their influence over boards to get what they want, regardless of performance. The possibility that executive compensation is largely driven by supply and demand for scarce executive talent is rarely mentioned. But it happens to be the truth. Of course, no candidate has their capabilities flashing on his forehead; that’s part of what makes the board’s job so difficult, and why CEOs don’t get paid more than they do–boards discount pay for uncertainty. Nevertheless, a top candidate, presumably someone with a strong reputation and plenty of opportunities, has significant bargaining power.
Nearly every reform attempting to rein in CEO pay has been based on some version of the managerial power thesis. These attempts have proved ineffective or backfired in exactly the way one would expect if executive compensation were driven by a reasonably well-functioning market for talent. For those of us who work with boards, the managerial power idea is impossible to reconcile with our experience that the vast majority of today’s directors are very conscientious, anxious to exercise their independence, and, if anything, wary about overpaying the chief.
All of this is not to say that the system works perfectly. Managerial influence is real, and occasionally overbearing. There are some weak boards out there. A few CEOs are visibly overpaid. But to continue to recommend and implement reforms based on a theory that directors are lazy, incompetent or corrupt–or that competition for talent is an afterthought in setting pay–only invites policies that impose costs on companies for which there may be no offsetting benefits, and which may create distortions that actually undermine shareholder value. Regulating Executives Compensations
A well-designed compensation program should not need to be modified if performance is not where it is expected to be, because under a well-designed compensation program, poor performance should lead to a relatively reduced payout. The role of monitoring manager performance and enabling efficient compensation contracts is as important to society as the role of communicating useful information to investors. Excessive executive compensation has come under increased scrutiny as countries have resorted to bailout plans to stabilize their domestic banking sectors. Many of these plans incorporate some restrictions on executive pay.
Companies should now review their compensation practices and procedures for executives. In particular, boards of directors and compensation committees should examine closely existing arrangements for incentive forms of compensation, caps on total compensation, and levels of severance and change of control benefits. Transparency Talent managers have a responsibility to executive boards and compensation committees to ensure the level of pay provided to executive teams is based on tangible performance. All pay decisions must be defensible, requiring a high level of comparative analysis in the compensation-design process.
Talent managers’ executive-compensation programs must illustrate how to drive shareholder value, increase share price and be competitive and reasonable. The new proxy-disclosure rules ask compensation committees to detail the connection between executive pay and performance in a compensation discussion and analysis that explains how they make decisions, the process or rationale for those pay decisions and how they link back to actual company performance in a given year. “HR professionals need to think more carefully about the design of these programs,” he said. There’s much more transparency spelling out costs — particularly on change and control and in termination events — understanding from a shareholder perspective more clearly the amount of wealth creation coming from equity and other things. As I design, I need to make sure there is enough stretch to force the executive to perform well, whether it be increased revenue, profitability or things along those lines. ” A company’s performance levels; total shareholder return, or growth in revenue; and profitability, or operating income, all must compare favorably with its overall level of executive payment.
If a poor-performing company still is giving out top-level payment — that compensation committee didn’t do its job. “We’re starting to see more companies say, ‘You’re only going to get your bonus if you meet a financial or business milestone that is going to increase the overall value of the company. ‘ What was criticized over the past couple of years around executive pay — no linked performance, excessive use of options and equity when there was not a lot of value coming from it — those things are being changed,” he said. Benchmarking pay
There is even a demand that the fat cats who had collected disproportionate pay cheque and other perks and benefits in various names from the companies they headed should be forced to return whatever is determined to be in excess of what is computed as their legitimate compensation by applying fair and equitable criteria. Some of the criteria being mentioned are: The equity base, the average return over a given period, the volume of transactions, reasonable ratio between the highest and the lowest paid employee, present and likely future investments and return on them and the prevailing trends in the industry in other industrial countries.
Disclosure Disclosure facilitates better monitoring of executives compensation. Public disclosures effectively ensures the executives contracts in publicly held corporations and not a private matter between employers and employees, but are rather influenced by media, labor unions, investors, creditors and by political forces operating outside and inside company. Disclosure and publicity of pay allows us to identify the egregious situations and apply pressure to fix them, but only when the data seem accurate to reasonable people.
In Canada and the USA the securities commissions recognize the importance of full disclosure of compensation. If the managerial labour market is to work properly to hold mangers to their reservation utility levels, an obvious minimal requirement is that the market knows how much compensation the manager is receiving. These disclosures have recently been expanded. For example the new guidelines for disclosure of pension costs for senior executives issued by Canadian Securities Administrators. Government Regulation/Limiting Tax Deduction
There have been proposals for limiting tax deductions for excessive compensation, requiring shareholder review and/or approval of compensation arrangements, and placing further limits on severance benefits. Recent experience of fraud and misconduct in a number of companies in the US and elsewhere has made it amply clear that self-regulation has not worked and will not work. Therefore, government keeping a wary eye on the enforcement of whatever pattern is arrived at becomes unavoidable. Vexed question Whatever the criteria, the matter of bringing the top executives down to earth, even if it be with a thud, brooks no delay.
The idea of what has come to be known as ‘claw-backs’, meant to recover from former bosses their ill-gotten bonanzas is most alluring and one would like to be personally present and watch their faces as they cough up what they had so brazenly appropriated for themselves without any sense of social responsibility. A salutary outcome of the global financial crisis is the coming into the open of the outrage universally felt over the sky-rocketing amounts in salaries, bonuses and severance compensation misappropriated by the top executives of firms, with the CEOs setting an awfully bad example.
Indeed, some sort of a rule had come to be established that the worse managed a firm, the more serious the malfeasance, the more ruinous the consequences for investors, the more astronomical will be the payments to the top brass. No wonder the state of affairs has earned the apt description of “heads-I-win, tails-you-lose with any answerability, accountability, and guarantee of performance. Salaries and bonuses of CEOs should be based on their success at improving their companies and bringing value to their shareholders References: Aggarwal, Rajesh K, and Andrew A.
Samwick. “The Other Side of the Trade off: The Impact of Risk on Executive Compensation. ” Journal of Political Economy (February1999), vol. 107 (1): 65–105 Brian J. Hall and Kevin J. Murphy, “Optimal Exercise Executive Option”, American Economic Review, May2000, Vol. 90 Issue 2, p209-214 Brian J. Hall and Kevin J. Murphy, “The Trouble with Stock Options”, Journal of Economic Perspectives—Volume 17, Number 3— Summer 2003—Pages 49–70 CGA Accounting Theory and Contemporary Issues, Lesson Notes Module 8: Conflict between contracting parties, 2007 Printing. ttp://www. cga-education. org/2007-08/at1/modsums/modsum08. htm CGA website Audio lectures and hand notes Module 8 Conflict between contracting parties, page 1 to 4 of 16. http://www2. bmo. com/bmo/files/annual%20reports/3/1/ExecCompReport. pdf Charlie Rose – “WorldCom update / Business and Ethics”, 2007 video http://noolmusic. com/google_videos/charlie_rose___worldcom_update_business_and_ethics. php Chingos, Peter T. , “Responsible Executive Compensation for a New Era of Accountability”, John Wiley & Sons, Inc. , Sep 2007, p. 180
Jenter, Dirk, “Executive Compensation, Incentives, and Risk”, MIT Sloan School of Management Working Paper 4466-02. April 2002, page 8 Kay, Ira, “Myths and Realties of Executive Pay”, Cambridge University Press, 2007, P. 154-159 Meulbroek, Lisa K. “The Efficiency of Equity-Linked Compensation: Understanding the Full Cost of Awarding Executive Stock Options,” Financial Management, Vol. 30(2). Summer 2001 Murphy, Kevin J. “Executive Compensation. ” in Handbook of Labor Economics, Ed. O. Ashenfelter and D. Card (NorthHolland: Elsevier: 1999), vol. , chap. 28, pp. 2485–2563. Nemeth, Martin, “Explorations in Executive Compensation – Executive Compensation Risk Modeling” http://www. riskmetrics. com/sites/default/files/RMGExplorationsPayRiskModeling20080520. pdf [Off with their Heads,” editorial, Wall Street Journal, August 1,2006]. William R. Scott, Financial Accounting Theory, Fourth Edition (Scarborough, Ontario: Prentice Hall Canada Inc. , 2007) ———————– Annual Compensation Review Process Each year the Committee reviews the levels of compensation for all xecutives, and in particular for Senior Executives, which includes the Named Executive Officers whose compensation is detailed beginning on page 33. This benchmarking process assesses both “actual” compensation delivered to executives through base salary, short-, mid- and long-term incentive awards, and the policy or “target” levels for these programs. The objective is to ensure that the total compensation position of the Bank’s executives compares appropriately with relevant comparator markets. The impact of the benefits, perquisites and pension programs is also considered.
At the beginning of each year the Committee established business performance targets for funding the executive short- and mid-term incentive plans. These targets are set at a level consistent with the Bank’s business targets, with the objectives of driving desired business results and providing a competitive level of pay relative to the results achieved. Threshold and maximum performance levels are also set, to ensure appropriate limits are placed on minimum and maximum payout amounts and that an appropriate relationship exists between pay and performance.
On at least a quarterly basis, the Committee reviews the year-to-date forecast business results and the incentive pool funding that would result. To provide the Committee with the full context in determining annual incentive pool funding for short- and mid-term incentive plans, consideration is given to the achievement of the business performance goals that were established at the beginning of the year. Judgment is then applied to increase or decrease the formula-derived level of pool funding in order to determine the appropriate level of incentive compensation pool funding.
In determining annual compensation decisions, a total compensation tally sheet for each Senior Executive is reviewed by the Committee. These tally sheets attribute a dollar value to each component of compensation, including: salary; short-term cash incentives; vested, unvested and previously paid equity awards; benefits; perquisites; pension including annual increases to liabilities, accumulated liabilities and projected payouts at retirement; and potential change in control severance payments.
The Committee reviews and recommends to the Board for approval the compensation of the President and Chief Executive Officer. The Committee reviews and approves the compensation of the other Senior Executives after considering the annual performance assessments and recommendations of the President and Chief Executive Officer. In addition, the Committee reviews and approves the aggregate annual awards of salary; short-, mid- and long-term incentive plans for executives, other than Senior Executives.
The President and chief Executive Officer is responsible for reviewing and approving all recommendations for the executives, other than Senior Executives, within the Committee approved aggregate award amounts. Any modifications to compensation design features being considered are first validated through a stress-testing process. An analysis is conducted to demonstrate to the Committee that the revised design should provide an appropriate result in future years.
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