Executive compensation
Encyclopedia
Executive pay is financial compensation
received by an officer of a firm, often as a mixture of salary, bonuses, shares of and/or call options on the company stock, etc. Over the past three decades, executive pay has risen dramatically beyond the rising levels of an average worker's wage
. Executive pay is an important part of corporate governance
, and is often determined by a company's board of directors
.
In a modern US corporation, the CEO and other top executives are paid salary plus short-term incentives or bonuses. This combination is referred to as Total Cash Compensation (TCC). Short-term incentives usually are formula-driven and have some performance criteria attached depending on the role of the executive. For example, the Sales Director's performance related bonus may be based on incremental revenue growth turnover; a CEO's could be based on incremental profitability and revenue growth. Bonuses are after-the-fact (not formula driven) and often discretionary. Executives may also be compensated with a mixture of cash and shares of the company which are almost always subject to vesting
restrictions (a long-term incentive). To be considered a long-term incentive the measurement period must be in excess of one year (3–5 years is common). The vesting term refers to the period of time before the recipient has the right to transfer shares and realize value. Vesting can be based on time, performance or both. For example a CEO might get 1 million in cash, and 1 million in company shares (and share buy options used). Vesting can occur in two ways: Cliff vesting and Graded Vesting. In case of Cliff Vesting, everything that is due to vest vests at one go i.e. 100% vesting occurs either now or a later point in time at year X. In case of graded vesting, partial vesting occurs at different times in the future. This is further sub-classified into two types: Uniform graded vesting (e.g. Same percentage i.e. 20% of the options vest each year for 5 years) and Non-uniform graded vesting (e.g. different proportion i.e. 20%, 30% and 50% of the options vest each year for the next three years).
Other components of an executive compensation package may include such perks as generous retirement plans, health insurance
, a chauffered
limousine, an executive jethttp://www.phoenixair.com/fleet_photos_executive_charter.php, interest free loans for the purchase of housing, etc.
Supporters of stock options say they align the interests of CEOs to those of shareholders, since options are valuable only if the stock price remains above the option's strike price
. Stock options are now counted as a corporate expense (non-cash), which impacts a company's income statement
and makes the distribution of options more transparent to shareholders. Critics of stock options charge that they are granted without justification as there is little reason to align the interests of CEOs with those of shareholders. Empirical evidence shows since the wide use of stock options, executive pay relative to workers has dramatically risen. Moreover, executive stock options contributed to the accounting manipulation scandals of the late 1990s and abuses such as the options backdating of such grants. Finally, researchers have shown that relationships between executive stock options and stock buybacks, implying that executives use corporate resources to inflate stock prices before they exercise their options.
Stock options also incentivize executives to engage in risk-seeking behavior.
This is because the value of a call option
increases with increased volatility
.
(cf. options pricing). Stock options therefore - even when used legitimately - can
incentivize excessive risk seeking behavior that can lead to catastrophic corporate failure.
In the Financial crisis of 2007-2009 in the United States, pressure mounted to use more stock options than cash in executive pay. However, since many then-proportionally larger 2008 bonuses were awarded in February, 2009, near the March, 2009, bottom of the stock market, many of the bonuses in the banking industry turned out to have doubled or more in paper value by late in 2009. The bonuses were under particular scrutiny, including by the United States Treasury’s new special master of pay, Kenneth R. Feinberg, because many of the firms had been rescued by government Troubled Asset Relief Program (TARP) and other funds.
, which is stock given to an executive that cannot be sold until certain conditions are met and has the same value as the market price of the stock at the time of grant. As the size of stock option grants have been reduced, the number of companies granting restricted stock either with stock options or instead of, has increased. Restricted stock has its detractors, too, as it has value even when the stock price falls. As an alternative to straight time vested restricted stock, companies have been adding performance type features to their grants. These grants, which could be called performance shares, do not vest or are not granted until these conditions are met. These performance conditions could be earnings per share or internal financial targets.
to an individual at a high individual rate. If part of that income can be converted to long-term capital gain
, for example by granting stock options instead of cash to an executive, a more advantageous tax treatment may be obtained by the executive.
CEO compensation was in cash pay and bonuses, and the other half in vested restricted stock, and gains from exercised stock options according to Forbes magazine. Forbes magazine counted the 500 CEOs compensation to $3.3 billion during 2003 (which makes $6.6 million a piece), a figure that includes gains from stock call options used (the options may have been rewarded many years before the option to buy is used).
that rewards them substantially if the company gets taken over or they lose their jobs for other reasons. This can create perverse incentive
s.
One example is that overly attractive Golden Parachutes may incentivize executives to facilitate the sale of their company at a price that is not in their shareholders' best interests.
It is fairly easy for a top executive to reduce the price of his/her company's stock - due to information asymmetry
. The executive can accelerate accounting of expected expenses, delay accounting of expected revenue, engage in off balance sheet transactions to make the company's profitability appear temporarily poorer, or simply promote and report severely conservative (e.g. pessimistic) estimates of future earnings. Such seemingly adverse earnings news will be likely to (at least temporarily) reduce share price. (This is again due to information asymmetries since it is more common for top executives to do everything they can to window dress their company's earnings forecasts).
A reduced share price makes a company an easier takeover target. When the company gets bought out (or taken private) - at a dramatically lower price - the takeover
artist gains a windfall from the former top executive's actions to surreptitiously reduce share price. This can represent 10s of billions of dollars (questionably) transferred from previous shareholders to the takeover artist. The former top executive is then rewarded with a golden handshake
for presiding over the firesale that can sometimes be in the hundreds of millions of dollars for one or two years of work. (This is nevertheless an excellent bargain for the takeover artist, who will tend to benefit from developing a reputation
of being very generous to parting top executives).
Similar issues occur when a publicly held asset or non-profit organization undergoes privatization
. Top executives often reap tremendous monetary benefits when a government owned, mutual or non-profit entity is sold to private hands. Just as in the example above, they can facilitate this process by making the entity appear to be in financial crisis - this reduces the sale price (to the profit of the purchaser), and makes non-profits and governments more likely to sell. Ironically, it can also contribute to a public
perception that private entities are more efficiently run reinforcing the political will to sell of public assets.
Again, due to asymmetric information, policy makers and the general public see a government owned firm that was a financial 'disaster' - miraculously turned around by the private sector (and typically resold) within a few years.
documents the problem of excessive CEO compensation, showing that the return on investment from these pay packages is very poor compared to other outlays of corporate resources.
Defenders of high executive pay say that the global war for talent and the rise of private equity
firms can explain much of the increase in executive pay. For example, while in conservative Japan a senior executive has few alternatives to his current employer, in the United States it is acceptable and even admirable for a senior executive to jump to a competitor, to a private equity firm, or to a private equity portfolio company
. Portfolio company executives take a pay cut but are routinely granted stock options for ownership of ten percent of the portfolio company, contingent on a successful tenure. Rather than signaling a conspiracy, defenders argue, the increase in executive pay is a mere byproduct of supply and demand for executive talent. However, U.S. executives make substantially more than their European and Asian counterparts.
Shareholders, often members of the Council of Institutional Investors or the Interfaith Center on Corporate Responsibility
have often filed shareholder resolution
s in protest. 21 such resolutions were filed in 2003. About a dozen were voted on in 2007, with two coming very close to passing (at Verizon, a recount is currently in progress). The U.S. Congress is currently debating mandating shareholder approval of executive pay packages at publicly traded U.S. companies.
The U.S. stood first in the world in 2005 with a ratio of 39:1 CEO's compensation to pay of manufacturing production workers. Britain second with 31.8:1; Italy third with 25.9:1, New Zealand fourth with 24.9:1.
In 2005, the issue of executive compensation at American companies has been harshly criticized by columnist and Pulitzer Prize
winner Gretchen Morgenson
in her Market Watch column for the Sunday "Money & Business" section of the New York Times newspaper.
A February 2009 report, published by the Institute for Policy Studies
notes the impact excessive executive compensation has on taxpayers:
Unions have been very vocal in their opposition to high executive compensation. The AFL-CIO
sponsors a website called Executive Paywatch http://www.aflcio.org/corporatewatch/paywatch/ which allows users to compare their salaries to the CEOs of the companies where they work.
In 2007, CEOs in the S&P 500, averaged $10.5 million annually, 344 times the pay of typical American workers. This was a drop in ratio from 2000, when they averaged 525 times the average pay.
To work around the restrictions and the political outrage concerning executive pay practices, banks in particular turned to using life insurance policies to fund bonuses, deferred pay and pensions owed to its executives. Under this scenario, a bank insures thousands of its employees under the life insurance policy, naming itself as the beneficiary of the policy. Bank undertake this practice often without the knowledge or consent of the employee and sometimes with the employee misunderstanding the scope of the coverage or the ability to maintain employee coverage after leaving the company. In recent times, a number of families became outraged by the practice and complained that banks should not profit from the death of the deceased employees. In one case, a family of a former employee filed a lawsuit against the bank after the family questioned the practices of the bank in its coverage of the employee. The insurance company accidentally sent the widow of the deceased employee a check for a $1.6 million that was payable to the bank after the former employee died in 2008. In that case, bank allegedly told the employee in 2001 that the employee was eligible for a $150,000 supplemental life insurance benefit if the employee signed a consent form to allow the bank to add the employee to the bank's life insurance policy. The bank fired the employee four months after the employee consented to the arrangement. After that employee's death, the family collect no benefits from the employee life insurance policies provided by the bank, since the bank had canceled the employee's benefit after the firing. The family claimed that the former employee was "cognitively disabled" because of brain surgery and medical treatments at the time of signing the consent form to understand fully the scope of insurance coverage under the bank's master insurance benefit plan.
The practice of financing executive compensation using corporate-owned life insurance
policies remain controversial. On the one hand, observers in the insurance industry note that "businesses enjoy tax-deferred growth of the inside buildup of the [life insurance] policy’s cash value, tax-free withdrawals and loans, and income tax-free death benefits to [corporate] beneficiaries." On the other hand, critics frowned upon the use of "janitor's insurance" to collect tax-free death benefits from insurance policies covering retirees and current and former non-key employees that companies rely on as informal pension funds for company executives. To thwart the abuse and reduce the attractiveness of corporate-owned life insurance policies, changes in tax treatment of corporate-owned insurance life insurance policies are under consideration for non-key personnel. These changes would repeal "the exception from the pro rata interest expense disallowance rule for [life insurance] contracts covering employees, officers or directors, other than 20% owners of a business that is the owner or beneficiary of the contracts."
A study by University of Florida
researchers found that highly paid CEOs improve company profitability as opposed to executives making less for similar jobs.
On the other hand, a study by Professors Lynne M. Andersson and Thomas S. Batemann published in the Journal of Organizational Behavior found that highly paid executives are more likely to behave cynically and therefore show tendencies of unethical performance.
Anecdotal evidence for the General Electric corporation suggest that after examples of excess early last century and the Great Depression, following World War II executive pay remained fairly constant at GE for almost three decades. This may have been in part due to high income taxes on the wealthy. To get around this, companies like General Electric began to offer stock options in the late 1950s. The United States government eventually pared down the income taxes on the wealthy – from 91% in the 1950s, to 28% in the 1980s. Thus the level of pay for GE’s top three managers increased at a slow rate of about two percent per year from the 1940s to the 1960s but this period of little growth was followed by a rapid acceleration in top management pay. Mostly encouraged by the increasing use of stock
options since the 1980s and of restricted stock since the 1990s. From the 1970s to the
present, the compensation of the three highest-paid officers at GE has grew at the
significantly higher annual rate of eight percent yearly.
The years 1993 -2003 saw executive pay increase sharply with the aggregate compensation to the top five executives of each of the S&P 1500 firms compensation doubling as a percentage of the aggregate earnings of those firms - from 5 per cent in 1993–5 to about 10 per cent in 2001–3.
The Financial Crisis has had a relatively small net effect on executive pay. According to the independent research firm Equilar
, median S&P 500 CEO compensation fell significantly for the first time since 2002. From 2007 to 2008, median total compensation declined by 7.5 percent. A sharp decline in bonus payouts contributed most to declines in total pay, with median annual bonus payouts for
S&P 500 CEOs dropping to $1.2 million in 2008, down 24.5 percent from the 2007 median of $1.6 million. Additionally, 20.6 percent of CEOs received no bonus payout at all for 2008.
On the other hand, equity compensation changed little from 2007 to 2008, despite the market turmoil. The median value of option
awards and stock awards rose by 3.5 percent and 1.4 percent, respectively. Options maintained its place as the most
prevalent equity award vehicle, with 72.2 percent of CEOs receiving option awards. In 2008, nearly two-thirds of total CEO
compensation was delivered in the form of stock or options.
Salary
A salary is a form of periodic payment from an employer to an employee, which may be specified in an employment contract. It is contrasted with piece wages, where each job, hour or other unit is paid separately, rather than on a periodic basis....
received by an officer of a firm, often as a mixture of salary, bonuses, shares of and/or call options on the company stock, etc. Over the past three decades, executive pay has risen dramatically beyond the rising levels of an average worker's wage
Average worker's wage
An average worker's wage is the mean salary of a group of workers. This measure is often monitored and used by Government or other organisations as a benchmark for the wage level of individual workers in an industry, area or country....
. Executive pay is an important part of corporate governance
Corporate governance
Corporate governance is a number of processes, customs, policies, laws, and institutions which have impact on the way a company is controlled...
, and is often determined by a company's board of directors
Board of directors
A board of directors is a body of elected or appointed members who jointly oversee the activities of a company or organization. Other names include board of governors, board of managers, board of regents, board of trustees, and board of visitors...
.
Types of compensation
There are six basic tools of compensation or remuneration.- salary
- bonuses, which provide short-term incentives
- long-term incentive plans (LTIP)
- employee benefitEmployee benefitEmployee benefits and benefits in kind are various non-wage compensations provided to employees in addition to their normal wages or salaries...
s - paid expenses (perquisites)
- insurance (Golden parachuteGolden parachuteA golden parachute is an agreement between a company and an employee specifying that the employee will receive certain significant benefits if employment is terminated. Sometimes, certain conditions, typically a change in company ownership, must be met, but often the cause of termination is...
)
In a modern US corporation, the CEO and other top executives are paid salary plus short-term incentives or bonuses. This combination is referred to as Total Cash Compensation (TCC). Short-term incentives usually are formula-driven and have some performance criteria attached depending on the role of the executive. For example, the Sales Director's performance related bonus may be based on incremental revenue growth turnover; a CEO's could be based on incremental profitability and revenue growth. Bonuses are after-the-fact (not formula driven) and often discretionary. Executives may also be compensated with a mixture of cash and shares of the company which are almost always subject to vesting
Vesting
In law, vesting is to give an immediately secured right of present or future enjoyment. One has a vested right to an asset that cannot be taken away by any third party, even though one may not yet possess the asset. When the right, interest or title to the present or future possession of a legal...
restrictions (a long-term incentive). To be considered a long-term incentive the measurement period must be in excess of one year (3–5 years is common). The vesting term refers to the period of time before the recipient has the right to transfer shares and realize value. Vesting can be based on time, performance or both. For example a CEO might get 1 million in cash, and 1 million in company shares (and share buy options used). Vesting can occur in two ways: Cliff vesting and Graded Vesting. In case of Cliff Vesting, everything that is due to vest vests at one go i.e. 100% vesting occurs either now or a later point in time at year X. In case of graded vesting, partial vesting occurs at different times in the future. This is further sub-classified into two types: Uniform graded vesting (e.g. Same percentage i.e. 20% of the options vest each year for 5 years) and Non-uniform graded vesting (e.g. different proportion i.e. 20%, 30% and 50% of the options vest each year for the next three years).
Other components of an executive compensation package may include such perks as generous retirement plans, health insurance
Health insurance
Health insurance is insurance against the risk of incurring medical expenses among individuals. By estimating the overall risk of health care expenses among a targeted group, an insurer can develop a routine finance structure, such as a monthly premium or payroll tax, to ensure that money is...
, a chauffered
Chauffeur
A chauffeur is a person employed to drive a passenger motor vehicle, especially a luxury vehicle such as a large sedan or limousine.Originally such drivers were always personal servants of the vehicle owner, but now in many cases specialist chauffeur service companies, or individual drivers provide...
limousine, an executive jethttp://www.phoenixair.com/fleet_photos_executive_charter.php, interest free loans for the purchase of housing, etc.
Stock options
Executive stock option pay arose out of scholarly support from University of Chicago educated Professors Michael C. Jensen and Kevin J. Murphy. Due to this and support from Wall Street and institutional investors, Congress passed a law making it cost effective to pay executives in equity.Supporters of stock options say they align the interests of CEOs to those of shareholders, since options are valuable only if the stock price remains above the option's strike price
Strike price
In options, the strike price is a key variable in a derivatives contract between two parties. Where the contract requires delivery of the underlying instrument, the trade will be at the strike price, regardless of the spot price of the underlying instrument at that time.Formally, the strike...
. Stock options are now counted as a corporate expense (non-cash), which impacts a company's income statement
Income statement
Income statement is a company's financial statement that indicates how the revenue Income statement (also referred to as profit and loss statement (P&L), statement of financial performance, earnings statement, operating statement or statement of operations) is a company's financial statement that...
and makes the distribution of options more transparent to shareholders. Critics of stock options charge that they are granted without justification as there is little reason to align the interests of CEOs with those of shareholders. Empirical evidence shows since the wide use of stock options, executive pay relative to workers has dramatically risen. Moreover, executive stock options contributed to the accounting manipulation scandals of the late 1990s and abuses such as the options backdating of such grants. Finally, researchers have shown that relationships between executive stock options and stock buybacks, implying that executives use corporate resources to inflate stock prices before they exercise their options.
Stock options also incentivize executives to engage in risk-seeking behavior.
This is because the value of a call option
Call option
A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...
increases with increased volatility
Volatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
.
(cf. options pricing). Stock options therefore - even when used legitimately - can
incentivize excessive risk seeking behavior that can lead to catastrophic corporate failure.
In the Financial crisis of 2007-2009 in the United States, pressure mounted to use more stock options than cash in executive pay. However, since many then-proportionally larger 2008 bonuses were awarded in February, 2009, near the March, 2009, bottom of the stock market, many of the bonuses in the banking industry turned out to have doubled or more in paper value by late in 2009. The bonuses were under particular scrutiny, including by the United States Treasury’s new special master of pay, Kenneth R. Feinberg, because many of the firms had been rescued by government Troubled Asset Relief Program (TARP) and other funds.
Restricted stock
Executives are also compensated with restricted stockRestricted stock
Restricted stock, also known as letter stock or restricted securities, refers to stock of a company that is not fully transferable until certain conditions have been met. Upon satisfaction of those conditions, the stock becomes transferable by the person holding the award.One type of restricted...
, which is stock given to an executive that cannot be sold until certain conditions are met and has the same value as the market price of the stock at the time of grant. As the size of stock option grants have been reduced, the number of companies granting restricted stock either with stock options or instead of, has increased. Restricted stock has its detractors, too, as it has value even when the stock price falls. As an alternative to straight time vested restricted stock, companies have been adding performance type features to their grants. These grants, which could be called performance shares, do not vest or are not granted until these conditions are met. These performance conditions could be earnings per share or internal financial targets.
Tax issues
Cash compensation is taxableIncome tax
An income tax is a tax levied on the income of individuals or businesses . Various income tax systems exist, with varying degrees of tax incidence. Income taxation can be progressive, proportional, or regressive. When the tax is levied on the income of companies, it is often called a corporate...
to an individual at a high individual rate. If part of that income can be converted to long-term capital gain
Capital gain
A capital gain is a profit that results from investments into a capital asset, such as stocks, bonds or real estate, which exceeds the purchase price. It is the difference between a higher selling price and a lower purchase price, resulting in a financial gain for the investor...
, for example by granting stock options instead of cash to an executive, a more advantageous tax treatment may be obtained by the executive.
Levels of compensation
The levels of compensation in all countries has been rising dramatically over the past decades. Not only is it rising in absolute terms, but also in relative terms.Fortune 500 compensation
During 2003, about half of Fortune 500Fortune 500
The Fortune 500 is an annual list compiled and published by Fortune magazine that ranks the top 500 U.S. closely held and public corporations as ranked by their gross revenue after adjustments made by Fortune to exclude the impact of excise taxes companies collect. The list includes publicly and...
CEO compensation was in cash pay and bonuses, and the other half in vested restricted stock, and gains from exercised stock options according to Forbes magazine. Forbes magazine counted the 500 CEOs compensation to $3.3 billion during 2003 (which makes $6.6 million a piece), a figure that includes gains from stock call options used (the options may have been rewarded many years before the option to buy is used).
Forbes categories of compensation
The categories that Forbes use are (1) salary (cash), (2) bonus (cash), (3) other (market value of restricted stock received), and (4) stock gains from option exercise (the gains being the difference between the price paid for the stock when the option was exercised and that days market price of the stock). If you see someone "making" $100 million or $200 million during the year, chances are 90% of that is coming from options (earned during many years) being exercised.Typical compensation
The typical salary in the top of the list is $1 million - $3 million. The typical top cash bonus is $10 million - $15 million. The highest stock bonus is $20 million. The highest option exercise have been in the range of $100 million - $200 million.Compensation protection
Senior executives may enjoy considerable income protection unavailable to many other employees. Often executives may receive a Golden ParachuteGolden parachute
A golden parachute is an agreement between a company and an employee specifying that the employee will receive certain significant benefits if employment is terminated. Sometimes, certain conditions, typically a change in company ownership, must be met, but often the cause of termination is...
that rewards them substantially if the company gets taken over or they lose their jobs for other reasons. This can create perverse incentive
Perverse incentive
A perverse incentive is an incentive that has an unintended and undesirable result which is contrary to the interests of the incentive makers. Perverse incentives are a type of unintended consequences.- Examples :...
s.
One example is that overly attractive Golden Parachutes may incentivize executives to facilitate the sale of their company at a price that is not in their shareholders' best interests.
It is fairly easy for a top executive to reduce the price of his/her company's stock - due to information asymmetry
Information asymmetry
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...
. The executive can accelerate accounting of expected expenses, delay accounting of expected revenue, engage in off balance sheet transactions to make the company's profitability appear temporarily poorer, or simply promote and report severely conservative (e.g. pessimistic) estimates of future earnings. Such seemingly adverse earnings news will be likely to (at least temporarily) reduce share price. (This is again due to information asymmetries since it is more common for top executives to do everything they can to window dress their company's earnings forecasts).
A reduced share price makes a company an easier takeover target. When the company gets bought out (or taken private) - at a dramatically lower price - the takeover
Takeover
In business, a takeover is the purchase of one company by another . In the UK, the term refers to the acquisition of a public company whose shares are listed on a stock exchange, in contrast to the acquisition of a private company.- Friendly takeovers :Before a bidder makes an offer for another...
artist gains a windfall from the former top executive's actions to surreptitiously reduce share price. This can represent 10s of billions of dollars (questionably) transferred from previous shareholders to the takeover artist. The former top executive is then rewarded with a golden handshake
Golden handshake
A golden handshake is a clause in an executive employment contract that provides the executive with a significant severance package in the case that the executive loses his or her job through firing, restructuring, or even scheduled retirement...
for presiding over the firesale that can sometimes be in the hundreds of millions of dollars for one or two years of work. (This is nevertheless an excellent bargain for the takeover artist, who will tend to benefit from developing a reputation
Reputation
Reputation of a social entity is an opinion about that entity, typically a result of social evaluation on a set of criteria...
of being very generous to parting top executives).
Similar issues occur when a publicly held asset or non-profit organization undergoes privatization
Privatization
Privatization is the incidence or process of transferring ownership of a business, enterprise, agency or public service from the public sector to the private sector or to private non-profit organizations...
. Top executives often reap tremendous monetary benefits when a government owned, mutual or non-profit entity is sold to private hands. Just as in the example above, they can facilitate this process by making the entity appear to be in financial crisis - this reduces the sale price (to the profit of the purchaser), and makes non-profits and governments more likely to sell. Ironically, it can also contribute to a public
perception that private entities are more efficiently run reinforcing the political will to sell of public assets.
Again, due to asymmetric information, policy makers and the general public see a government owned firm that was a financial 'disaster' - miraculously turned around by the private sector (and typically resold) within a few years.
Regulation
There are a number of strategies that could be employed as a response to the growth of executive compensation.- In the United States, shareholders must approve all equity compensation plans. Shareholders can simply vote against the issuance of any equity plans. This would eliminate huge windfalls that can be due to a rising stock market or years of retained earnings.
- Independent non-executive directorNon-executive directorA non-executive director or outside director is a member of the board of directors of a company who does not form part of the executive management team. He or she is not an employee of the company or affiliated with it in any other way...
setting of compensation is widely practised. Remuneration is the archetype of self dealing. An independent remuneration committee is an attempt to have pay packages set at arms' length from the directors who are getting paid.
- Disclosure of salaries is the first step, so that company stakeholders can know and decide whether or not they think remuneration is fair. In the UK, the Directors' Remuneration Report Regulations 2002 introduced a requirement into the old Companies Act 1985Companies Act 1985The Companies Act 1985 is an Act of the Parliament of the United Kingdom of Great Britain and Northern Ireland, enacted in 1985, which enabled companies to be formed by registration, and set out the responsibilities of companies, their directors and secretaries.The Act was a consolidation of...
, the requirement to release all details of pay in the annual accounts. This is now codified in the Companies Act 2006Companies Act 2006The Companies Act 2006 is an Act of the Parliament of the United Kingdom which forms the primary source of UK company law. It had the distinction of being the longest in British Parliamentary history: with 1,300 sections and covering nearly 700 pages, and containing 16 schedules but it has since...
. Similar requirements exist in most countries, including the U.S., Germany, and Canada.
- A say on paySay on paySay on pay is a term used for a rule in corporate law whereby a firm's shareholders have the right to vote on the remuneration of executives.Often described in corporate governance or management theory as an agency problem, a corporation's directors are likely to overpay themselves because,...
- a non-binding vote of the general meeting to approve director pay packages, is practised in a growing number of countries. Some commentators have advocated a mandatory binding vote for large amounts (e.g. over $5 million). The aim is that the vote will be a highly influential signal to a board to not raise salaries beyond reasonable levels. The general meeting means shareholders in most countries. In most European countries though, with two-tier board structures, a supervisory board will represent employees and shareholders alike. It is this supervisory board which votes on executive compensation.
- Progressive taxation is a more general strategy that affects executive compensation, as well as other highly paid people. There has been a recent trend to cutting the highest bracket tax payers, a notable example being the tax cuts in the U.S. For example, the Baltic States have a flat taxFlat taxA flat tax is a tax system with a constant marginal tax rate. Typically the term flat tax is applied in the context of an individual or corporate income that will be taxed at one marginal rate...
system for incomes. Executive compensation could be checked by taxing more heavily the highest earners, for instance by taking a greater percentage of income over $200,000.
- Maximum wageMaximum wageA maximum wage, also often called a wage ceiling, is a legal limit on how much income an individual can earn. This is a related economic concept that is complementary to the minimum wage used currently by some states to enforce minimum earnings...
is an idea which has been enacted in early 2009 in the United States, where they capped executive pay at $500,000 per year for companies receiving extraordinary financial assistance from the U.S. taxpayers. The argument is to place a cap on the amount that any person may legally make, in the same way as there is a floor of a minimum wageMinimum wageA minimum wage is the lowest hourly, daily or monthly remuneration that employers may legally pay to workers. Equivalently, it is the lowest wage at which workers may sell their labour. Although minimum wage laws are in effect in a great many jurisdictions, there are differences of opinion about...
so that people can not earn too little.
- DebtDebtA debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
Like Compensation - It has been widely accepted that the risk taking motivation of executives depends on its position in equity based compensation and risky debt. Adding debt like instrument as part of an executive compensation may reduce the risk taking motivation of executives. Therefore, as of 2011, there are several proposals to enforce financial institutions to use debt like compensation. - Indexing Operating Performance is a way to make bonus targets business cycle independent. Indexed bonus targets move with the business cycle and are therefore fairer and valid for a longer period of time.
Criticism
Many newspaper stories show people expressing concern that CEOs are paid too much for the services they provide. In Searching for a Corporate Savior: The Irrational Quest for Charismatic CEOs, Harvard Business School professor Rakesh KhuranaRakesh Khurana
Rakesh Khurana is the Marvin Bower Professor of Leadership Development in organizational behavior at Harvard Business School. He is also the co-Master of Cabot House at Harvard University. Rakesh received his degrees in organizational behavior from Harvard's Ph.D. program in 1998, A.M from Harvard...
documents the problem of excessive CEO compensation, showing that the return on investment from these pay packages is very poor compared to other outlays of corporate resources.
Defenders of high executive pay say that the global war for talent and the rise of private equity
Private equity
Private equity, in finance, is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange....
firms can explain much of the increase in executive pay. For example, while in conservative Japan a senior executive has few alternatives to his current employer, in the United States it is acceptable and even admirable for a senior executive to jump to a competitor, to a private equity firm, or to a private equity portfolio company
Portfolio company
A portfolio company is a company or entity in which a venture capital firm, buyout firm, holding company, or other investment fund invests. All of the companies currently backed by a private equity firm can be spoken of as the firm’s portfolio....
. Portfolio company executives take a pay cut but are routinely granted stock options for ownership of ten percent of the portfolio company, contingent on a successful tenure. Rather than signaling a conspiracy, defenders argue, the increase in executive pay is a mere byproduct of supply and demand for executive talent. However, U.S. executives make substantially more than their European and Asian counterparts.
Shareholders, often members of the Council of Institutional Investors or the Interfaith Center on Corporate Responsibility
Interfaith Center on Corporate Responsibility
The Interfaith Center on Corporate Responsibility is a coalition of 275 faith-based institutional investors. Founded in 1973, the organization advocates for corporate social responsibility and files shareholder resolutions and engages in dialogue with corporate management on issues such as global...
have often filed shareholder resolution
Shareholder resolution
With respect to public companies in the United States, Shareholder resolutions are proposals submitted by shareholders for a vote at the company's annual meeting. Typically, resolutions are opposed by the corporation's management, hence the insistence for a vote...
s in protest. 21 such resolutions were filed in 2003. About a dozen were voted on in 2007, with two coming very close to passing (at Verizon, a recount is currently in progress). The U.S. Congress is currently debating mandating shareholder approval of executive pay packages at publicly traded U.S. companies.
The U.S. stood first in the world in 2005 with a ratio of 39:1 CEO's compensation to pay of manufacturing production workers. Britain second with 31.8:1; Italy third with 25.9:1, New Zealand fourth with 24.9:1.
United States
The U.S. Securities and Exchange Commission (SEC) has asked publicly traded companies to disclose more information explaining how their executives' compensation amounts are determined. The SEC has also posted compensation amounts on its website to make it easier for investors to compare compensation amounts paid by different companies. It is interesting to juxtapose SEC regulations related to executive compensation with Congressional efforts to address such compensation.In 2005, the issue of executive compensation at American companies has been harshly criticized by columnist and Pulitzer Prize
Pulitzer Prize
The Pulitzer Prize is a U.S. award for achievements in newspaper and online journalism, literature and musical composition. It was established by American publisher Joseph Pulitzer and is administered by Columbia University in New York City...
winner Gretchen Morgenson
Gretchen Morgenson
Gretchen C. Morgenson is a Pulitzer Prize-winning journalist who writes the Market Watch column for the Sunday "Money & Business" section of the New York Times.-Life:...
in her Market Watch column for the Sunday "Money & Business" section of the New York Times newspaper.
A February 2009 report, published by the Institute for Policy Studies
Institute for Policy Studies
Institute for Policy Studies is a left-wing think tank based in Washington, D.C..It has been directed by John Cavanagh since 1998- History :...
notes the impact excessive executive compensation has on taxpayers:
U.S. taxpayers subsidize excessive executive compensation — by more than $20 billion per year — via a variety of tax and accounting loopholes. For example, there are no meaningful limits on how much companies can deduct from their taxes for the expense of executive compensation. The more they pay their CEO, the more they can deduct. A proposed reform to cap tax deductibility at no more than 25 times the pay of the lowest-paid worker could generate more than $5 billion in extra federal revenues per year. Although a proposal such as this one would tighten controls on pay to executives, this study does take into consideration (or at least does not address) the tax obligations of the individual (CEO) that receives this compensation. Every dollar that is deducted from the firm's income is subject to the personal tax of the individual receiving such pay.
Unions have been very vocal in their opposition to high executive compensation. The AFL-CIO
AFL-CIO
The American Federation of Labor and Congress of Industrial Organizations, commonly AFL–CIO, is a national trade union center, the largest federation of unions in the United States, made up of 56 national and international unions, together representing more than 11 million workers...
sponsors a website called Executive Paywatch http://www.aflcio.org/corporatewatch/paywatch/ which allows users to compare their salaries to the CEOs of the companies where they work.
In 2007, CEOs in the S&P 500, averaged $10.5 million annually, 344 times the pay of typical American workers. This was a drop in ratio from 2000, when they averaged 525 times the average pay.
To work around the restrictions and the political outrage concerning executive pay practices, banks in particular turned to using life insurance policies to fund bonuses, deferred pay and pensions owed to its executives. Under this scenario, a bank insures thousands of its employees under the life insurance policy, naming itself as the beneficiary of the policy. Bank undertake this practice often without the knowledge or consent of the employee and sometimes with the employee misunderstanding the scope of the coverage or the ability to maintain employee coverage after leaving the company. In recent times, a number of families became outraged by the practice and complained that banks should not profit from the death of the deceased employees. In one case, a family of a former employee filed a lawsuit against the bank after the family questioned the practices of the bank in its coverage of the employee. The insurance company accidentally sent the widow of the deceased employee a check for a $1.6 million that was payable to the bank after the former employee died in 2008. In that case, bank allegedly told the employee in 2001 that the employee was eligible for a $150,000 supplemental life insurance benefit if the employee signed a consent form to allow the bank to add the employee to the bank's life insurance policy. The bank fired the employee four months after the employee consented to the arrangement. After that employee's death, the family collect no benefits from the employee life insurance policies provided by the bank, since the bank had canceled the employee's benefit after the firing. The family claimed that the former employee was "cognitively disabled" because of brain surgery and medical treatments at the time of signing the consent form to understand fully the scope of insurance coverage under the bank's master insurance benefit plan.
The practice of financing executive compensation using corporate-owned life insurance
Corporate-owned life insurance
Corporate-owned life insurance , also known as dead peasant life insurance or janitors insurance, is life insurance on employees' lives that is owned by the employer, with benefits payable to the employer...
policies remain controversial. On the one hand, observers in the insurance industry note that "businesses enjoy tax-deferred growth of the inside buildup of the [life insurance] policy’s cash value, tax-free withdrawals and loans, and income tax-free death benefits to [corporate] beneficiaries." On the other hand, critics frowned upon the use of "janitor's insurance" to collect tax-free death benefits from insurance policies covering retirees and current and former non-key employees that companies rely on as informal pension funds for company executives. To thwart the abuse and reduce the attractiveness of corporate-owned life insurance policies, changes in tax treatment of corporate-owned insurance life insurance policies are under consideration for non-key personnel. These changes would repeal "the exception from the pro rata interest expense disallowance rule for [life insurance] contracts covering employees, officers or directors, other than 20% owners of a business that is the owner or beneficiary of the contracts."
A study by University of Florida
University of Florida
The University of Florida is an American public land-grant, sea-grant, and space-grant research university located on a campus in Gainesville, Florida. The university traces its historical origins to 1853, and has operated continuously on its present Gainesville campus since September 1906...
researchers found that highly paid CEOs improve company profitability as opposed to executives making less for similar jobs.
On the other hand, a study by Professors Lynne M. Andersson and Thomas S. Batemann published in the Journal of Organizational Behavior found that highly paid executives are more likely to behave cynically and therefore show tendencies of unethical performance.
Australia
In Australia, shareholders can vote against the pay rises of board members, but the vote is non-binding. Instead the shareholders can sack some or all of the board members.Trends in executive compensation
There are some examples of exceptionally high chief executive officer pay in the early twentieth century. When the United States government took control of the railroad industry during the 1910s, they discovered enormous salaries for the railroad bosses. After the Securities and Exchanges Commission was set up in the 1930s, it was concerned enough about excessive executive compensation that it began requiring yearly reporting of company earnings to help reign in abuse. These examples show that exceptionally high CEO pay is not a new phenomenon, just perhaps not as common as today.Anecdotal evidence for the General Electric corporation suggest that after examples of excess early last century and the Great Depression, following World War II executive pay remained fairly constant at GE for almost three decades. This may have been in part due to high income taxes on the wealthy. To get around this, companies like General Electric began to offer stock options in the late 1950s. The United States government eventually pared down the income taxes on the wealthy – from 91% in the 1950s, to 28% in the 1980s. Thus the level of pay for GE’s top three managers increased at a slow rate of about two percent per year from the 1940s to the 1960s but this period of little growth was followed by a rapid acceleration in top management pay. Mostly encouraged by the increasing use of stock
options since the 1980s and of restricted stock since the 1990s. From the 1970s to the
present, the compensation of the three highest-paid officers at GE has grew at the
significantly higher annual rate of eight percent yearly.
The years 1993 -2003 saw executive pay increase sharply with the aggregate compensation to the top five executives of each of the S&P 1500 firms compensation doubling as a percentage of the aggregate earnings of those firms - from 5 per cent in 1993–5 to about 10 per cent in 2001–3.
The Financial Crisis has had a relatively small net effect on executive pay. According to the independent research firm Equilar
Equilar
Equilar is a California-based company that provides information about total executive compensation packages of the top officers at publicly traded companies....
, median S&P 500 CEO compensation fell significantly for the first time since 2002. From 2007 to 2008, median total compensation declined by 7.5 percent. A sharp decline in bonus payouts contributed most to declines in total pay, with median annual bonus payouts for
S&P 500 CEOs dropping to $1.2 million in 2008, down 24.5 percent from the 2007 median of $1.6 million. Additionally, 20.6 percent of CEOs received no bonus payout at all for 2008.
On the other hand, equity compensation changed little from 2007 to 2008, despite the market turmoil. The median value of option
awards and stock awards rose by 3.5 percent and 1.4 percent, respectively. Options maintained its place as the most
prevalent equity award vehicle, with 72.2 percent of CEOs receiving option awards. In 2008, nearly two-thirds of total CEO
compensation was delivered in the form of stock or options.
See also
- Agency costAgency costAn agency cost is an economic concept that relates to the cost incurred by an entity associated with problems such as divergent management-shareholder objectives and information asymmetry...
- Bonus-MalusBonus-MalusThe term bonus-malus is used for a number of business arrangements which alternately reward or penalize .It is used, for example, in the call center and insurance industries.- Call centers :...
- Corporate-owned life insuranceCorporate-owned life insuranceCorporate-owned life insurance , also known as dead peasant life insurance or janitors insurance, is life insurance on employees' lives that is owned by the employer, with benefits payable to the employer...
- Golden handshakeGolden handshakeA golden handshake is a clause in an executive employment contract that provides the executive with a significant severance package in the case that the executive loses his or her job through firing, restructuring, or even scheduled retirement...
- Golden parachuteGolden parachuteA golden parachute is an agreement between a company and an employee specifying that the employee will receive certain significant benefits if employment is terminated. Sometimes, certain conditions, typically a change in company ownership, must be met, but often the cause of termination is...
- Options backdatingOptions backdatingOptions backdating is the practice of issuing options contracts on a later date than that which the options have listed. While options backdating is not, in and of itself, an illegal practice, intentional backdating that coincides with low underlying stock prices and accounting reports that claim...
- RemunerationRemunerationRemuneration is the total compensation that an employee receives in exchange for the service they perform for their employer. Typically, this consists of monetary rewards, also referred to as wage or salary...