Executive Compensation: Executive Compensation: Something Old, Something Something Old, Something

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Marianna Makri Marianna Makri

& Luis R. Gomez-Mejia & Luis R. Gomez-Mejia

Hot TopicHot Topic

Executive compensation has been a Executive compensation has been a hot HR topic because of:hot HR topic because of:• High visibility High visibility • Frequently perceived unfairness Frequently perceived unfairness

(particularly in North America) (particularly in North America) • ImportanceImportance

Corporate Governance RatingCorporate Governance Rating

A good corporate governance rating A good corporate governance rating sends a signal to potential investors sends a signal to potential investors that the firm is a better investment that the firm is a better investment because presumably the board of because presumably the board of that firm is working for shareholders that firm is working for shareholders as opposed to cozying up to the CEO as opposed to cozying up to the CEO

Executive Compensation PackageExecutive Compensation Package

Can either be a motivational tool Can either be a motivational tool encouraging executives to pursue encouraging executives to pursue strategic decisions that are in the strategic decisions that are in the best interest of shareholders or it can best interest of shareholders or it can be designed to reinforce the wrong be designed to reinforce the wrong strategic choices strategic choices

The CEO Pay PackageThe CEO Pay Package

Two out of three CEOs have seen Two out of three CEOs have seen their pay go up in the last couple of their pay go up in the last couple of years years

Only a small percentage of the Only a small percentage of the differences in pay among CEOs could differences in pay among CEOs could be explained by differences in the be explained by differences in the performance of their firms performance of their firms

CEOs who were making more money CEOs who were making more money were also running larger companies were also running larger companies

What Does Pay Mean?What Does Pay Mean?

Large pay packages are flagged as a Large pay packages are flagged as a sign of weak boards that are too cozy sign of weak boards that are too cozy with management and not looking with management and not looking out for shareholders out for shareholders

Low ratings signal that the board is Low ratings signal that the board is ineffective in monitoring the CEO ineffective in monitoring the CEO which can in turn hurt the firm’s which can in turn hurt the firm’s stock price stock price

The Role of Risk in the Executive The Role of Risk in the Executive Compensation ContractCompensation Contract

Employment risk - the possibility that the Employment risk - the possibility that the executive will be terminated either due to executive will be terminated either due to unsatisfactory performance or due to unsatisfactory performance or due to change in control change in control

Compensation risk - the potential Compensation risk - the potential unpredictability in the executive’s future unpredictability in the executive’s future pay represented mainly by the proportion pay represented mainly by the proportion of stock options in the total pay package of stock options in the total pay package

The Role of Risk in the Executive The Role of Risk in the Executive Compensation Contract ContinuedCompensation Contract Continued

Business risk - the uncertainty Business risk - the uncertainty surrounding the firm’s competitive surrounding the firm’s competitive environmentenvironment

Components of the Pay PackageComponents of the Pay Package

Fixed pay – salary and benefitsFixed pay – salary and benefits• Typically smaller than variable payTypically smaller than variable pay• Firms can only write off one million Firms can only write off one million

dollars in fixed paydollars in fixed pay• Most companies top off salaries at about Most companies top off salaries at about

one million dollarsone million dollars

Components of the Pay Package Components of the Pay Package ContinuedContinued

Variable pay – bonuses and stock Variable pay – bonuses and stock optionsoptions• Draw the CEO’s attention to Draw the CEO’s attention to

performance results and can serve to performance results and can serve to align the goals of the company and its align the goals of the company and its shareholders with the personal goals of shareholders with the personal goals of the executive the executive

Recent Environmental Changes Recent Environmental Changes Affecting CEO Risk Affecting CEO Risk

Shareholder activismShareholder activism Sarbanes-Oxley Act (SOX)Sarbanes-Oxley Act (SOX) SEC disclosuresSEC disclosures

Shareholder ActivismShareholder Activism

Proxy resolutions sponsored by union Proxy resolutions sponsored by union and public pension funds, aimed at and public pension funds, aimed at cutting CEO pay, are winning cutting CEO pay, are winning extraordinary victories extraordinary victories

If shareholder activism keeps If shareholder activism keeps spreading it will ignite a good spreading it will ignite a good amount of reform amount of reform

The Sarbanes-Oxley Act (SOX)The Sarbanes-Oxley Act (SOX)

SOX holds the new generation of SOX holds the new generation of CEOs personally accountable for their CEOs personally accountable for their companies' financial statements companies' financial statements

Some worry that SOX forces CEOs to Some worry that SOX forces CEOs to place more focus on the internal place more focus on the internal control environment and the short control environment and the short term as opposed to focusing on the term as opposed to focusing on the long term long term

SEC DisclosuresSEC Disclosures

The SEC voted on an expansion in The SEC voted on an expansion in disclosure requirements for disclosure requirements for executive pay including:executive pay including:• The dollar value of every benefit that The dollar value of every benefit that

executives derived from their executives derived from their employment employment

• Companies should report the extent to Companies should report the extent to which executives sell shares given to which executives sell shares given to them as variable pay them as variable pay

SEC Disclosures ContinuedSEC Disclosures Continued

Additional SEC disclosures include:Additional SEC disclosures include:• Companies should disclose not just the Companies should disclose not just the

amounts paid but also the criteria based amounts paid but also the criteria based upon which those bonuses were upon which those bonuses were awarded awarded

• Companies should annually disclose the Companies should annually disclose the dollar value of the package that each dollar value of the package that each executive will receive upon exit in the executive will receive upon exit in the case of a change in control, termination case of a change in control, termination or retirement or retirement

Managing Executive RiskManaging Executive Risk

Stock optionsStock options Pay for performancePay for performance Change-in-control provisionsChange-in-control provisions

Stock OptionsStock Options

Stock options are the right to Stock options are the right to purchase stock at a predetermined purchase stock at a predetermined priceprice

Restricted stock is a right granted to Restricted stock is a right granted to purchase during a specified period, purchase during a specified period, at the market price on the date of at the market price on the date of the option, a specified number of the option, a specified number of shares shares

Stock Options ContinuedStock Options Continued

Restricted stock is replacing stock Restricted stock is replacing stock options in executive benefits options in executive benefits packages due to changes in packages due to changes in accounting standardsaccounting standards

Restricted stock is not as tied to Restricted stock is not as tied to organizational performance as stock organizational performance as stock optionsoptions

Pay for PerformancePay for Performance

Tying executive compensation to Tying executive compensation to specific performance guidelines can specific performance guidelines can be counterproductivebe counterproductive

CEO performance should be tied to CEO performance should be tied to broader metrics that go well beyond broader metrics that go well beyond financial measures such as financial measures such as leadership and innovationleadership and innovation

Pay for Performance ContinuedPay for Performance Continued

SOX provisions increase business risk SOX provisions increase business risk for CEOs leading to risk averse for CEOs leading to risk averse business strategiesbusiness strategies

Link pay to performance very loosely Link pay to performance very loosely and motivate them with restricted and motivate them with restricted stock options stock options

Change in Control Provisions to Change in Control Provisions to Manage Employment RiskManage Employment Risk

Golden parachute clauses have Golden parachute clauses have increased in popularityincreased in popularity

Golden parachutes are payments in Golden parachutes are payments in the form of cash, an acceleration of the form of cash, an acceleration of vesting or other benefit that occurs vesting or other benefit that occurs in connection with a change in the in connection with a change in the ownership or control of a company's ownership or control of a company's stock or assets stock or assets

Golden Parachute ProvisionsGolden Parachute Provisions

Typical golden parachute provisions Typical golden parachute provisions include:include:• a lump-sum payment equal to typically a lump-sum payment equal to typically

three times the base salary plus bonus three times the base salary plus bonus • accelerated vesting of deferred accelerated vesting of deferred

compensation and supplemental compensation and supplemental executive retirement plan (SERP) executive retirement plan (SERP) benefits benefits

Golden Parachute Provisions Golden Parachute Provisions ContinuedContinued

Additional golden parachute Additional golden parachute provisions include:provisions include:• Additional age and service credit during Additional age and service credit during

the severance period (typically three the severance period (typically three years) for purposes of pension years) for purposes of pension calculation calculation

• Accelerated vesting of equity awards Accelerated vesting of equity awards

Linking Pay to PerformanceLinking Pay to Performance

Individuals in positive contexts can Individuals in positive contexts can become risk averse while individuals become risk averse while individuals in negative contexts can become risk in negative contexts can become risk seeking seeking

An ideal level of risk needs to be An ideal level of risk needs to be determined for the executive and the determined for the executive and the extent that pay is tied to extent that pay is tied to performanceperformance

The Risk EnvironmentThe Risk Environment

Firms operating in highly Firms operating in highly competitive, high-risk environments competitive, high-risk environments need to pay more to attract and need to pay more to attract and retain high quality executives than retain high quality executives than firms operating in low risk firms operating in low risk environments environments

The Risk Environment ContinuedThe Risk Environment Continued

The proportion of variable pay needs The proportion of variable pay needs to be balanced by the potential to to be balanced by the potential to earn more money earn more money

Total pay should be highest in Total pay should be highest in settings where risk is greatest for the settings where risk is greatest for the CEO such as high technology firms or CEO such as high technology firms or family controlled firms family controlled firms

CEO Pay in High Technology FirmsCEO Pay in High Technology Firms

High technology firms need to High technology firms need to reward CEOs by using multiple reward CEOs by using multiple performance criteria including:performance criteria including:• Financial indicatorsFinancial indicators• Emphasis on innovationEmphasis on innovation• Support of basic researchSupport of basic research

CEO Pay in Family FirmsCEO Pay in Family Firms

Family firms differ from non family Family firms differ from non family firms in two major ways:firms in two major ways:• Executives who are members of the Executives who are members of the

family exhibit a greater desire to retain family exhibit a greater desire to retain control of the firm stemming from a control of the firm stemming from a strong personal attachment strong personal attachment

• Employment and compensation risk is Employment and compensation risk is highly concentrated in the firm highly concentrated in the firm

CEO Contracts in the Family CEO Contracts in the Family BusinessBusiness

Contracts should be more Contracts should be more transactional with specific transactional with specific performance provisions for family performance provisions for family CEOsCEOs

Contracts should be more relational Contracts should be more relational for CEOs outside of the family to for CEOs outside of the family to protect them from unfair judgmentprotect them from unfair judgment

ConclusionConclusion

There are a wide variety of ways to There are a wide variety of ways to design CEO contractsdesign CEO contracts

The provisions of these contracts can The provisions of these contracts can impact the firm performanceimpact the firm performance

The environment in which the firm The environment in which the firm operates should influence the CEO operates should influence the CEO contractcontract