Executive compensation

Executive compensation is the total remuneration or financial compensation a top executive receives within a corporation. This includes a basic salary, any and all bonuses, shares, options, and any other company benefit. Over the past three decades, executive compensation has risen dramatically beyond the rising levels of an average worker's wage.^[1] Executive compensation is an important part of corporate governance, and is often determined by a company's board of directors.

Contents 1 Types of compensation 1.1 Stock options 1.2 Restricted stock 1.3 Tax issues 2 Levels of compensation 2.1 Fortune 500 compensation 2.2 Forbes categories of compensation 2.3 Typical compensation 2.4 Compensation protection 3 Regulation 4 Criticism 4.1 United States 4.2 Australia 5 Trends in executive compensation 6 See also 7 Notes 8 References 9 External links

Types of compensation

There are six basic tools of compensation or remuneration.

• a base salary
• short-term incentives, or bonuses
• long-term incentive plans (LTIP)
• employee benefits
• perquisites, or perks
• compensation protection (Golden parachute)

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). Other components of an executive compensation package may include such perks as generous retirement plans, health insurance, a chauffered limousine, an executive jet[2], interest free loans for the purchase of housing, etc.

Stock options

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 excessively and that they invite management abuses such as the options backdating of such grants. Stock options also pose a conflict of interest in which a CEO can artificially raise the stock price to cash in stock options at the expense of the company's long-term health, although this is a problem for any type of incentive compensation that goes unmonitored by directors. Indeed, "reload" stock options allow executives to exercise options and then replace them in part (and sometimes in whole), essentially selling the company stock short (i.e., profiting from the stock's decline). For various reasons, including the accounting charge, concerns about dilution and negative publicity related to stock options, companies have reduced the size of grants to executives.

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.^[2]

Restricted stock

Executives are also compensated with restricted stock, 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 taxable 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.

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 500 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.^[3] Forbes magazine counted the 500 CEOs compensation to $3.3 billion during 2003 (which makes $6.6 million a piece). Notice that this figure 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.^[4] The typical top cash bonus is $10 million - $15 million.^[5] The highest stock bonus is $20 million.^[6] The highest option exercise have been in the range of $100 million - $200 million ^[7].

Compensation protection

Senior executives may enjoy considerable income protection unavailable to many other employees. Often executives may receive a Golden Parachute that rewards them substantially if the company gets taken over or they lose their jobs for other reasons. This can create perverse incentives.

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 (eg. 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 100s 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.

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 director setting of compensation is widely practised.^{[citation needed]} 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^[8] introduced a requirement into the old Companies Act 1985, the requirement to release all details of pay in the annual accounts. This is now codified in the Companies Act 2006. Similar requirements exist in most countries, including the U.S., Germany, and Canada.^{[citation needed]}

• A say on pay - 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).^[9] 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.^{[citation needed]}

• 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.^{[citation needed]} For example, the Baltic States have a flat tax system for incomes.^{[citation needed]} 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 wage 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 US 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 wage so that people can not earn too little.

• 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^[10] 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 Khurana 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.^[10]

Shareholders, often members of the Council of Institutional Investors or the Interfaith Center on Corporate Responsibility have often filed shareholder resolutions in protest. 21 such resolutions were filed in 2003. ^[11] About a dozen were voted on in 2007, with two coming very close to passing (at Verizon, a recount is currently in progress).^[12] The U.S. Congress is currently debating mandating shareholder approval of executive pay packages at publicly traded U.S. companies. ^[13]

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.^[14]

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^[15] 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. ^[16]

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:

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.^[17] 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 sponsors a website called Executive Paywatch [3] ^[18] 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.^[14]

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.^[19][20] 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.^[19] 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.^[19] 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.^[19]

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."^[21] 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.^[22] 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."^[22]

A study by University of Florida researchers found that highly paid CEOS improve company profitability as opposed to executives making less for similar jobs.^[23]

Australia

In Australia, shareholders can vote against the pay rises of board members, but the vote is non-binding.^[24] Instead the shareholders can sack some or all of the board members. ^[25]

Trends in executive compensation

There are some examples of excessive 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.^[26] 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.^[27] These examples show that excessive CEO pay is not a new phenomenon, just perhaps not as common as today.

However, while there were some examples of excess early last century, CEO pay generally increased very little on a yearly basis.^[28]. This was 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.^[29] The United States government eventually pared down the income taxes on the wealthy – from 91% in the 1950s, to 28% in the 1980s.^[30] In effect, this greatly reduced any implied salary cap on compensation.

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. ^[31]

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.^[31]

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.^[31]

Though overall pay composition changed little, more companies have slowly moved toward increasing their use of performance shares for CEOs. In 2008, fewer companies awarded a single equity vehicle as companies expanded their equity mix to include performance shares.^[31]

See also

• Agency cost
• Bonus-Malus
• Corporate-owned life insurance
• Golden handshake
• Golden parachute
• Options backdating
• Remuneration

Notes

References

• Sean O'Grady, 'Economist Stiglitz blames crunch on 'flawed' City bonuses system' (24.3.2008) The Independent

External links

• Cost-Cutting Strategies in the Downturn: 2009 Pulse Survey
• 2008 Executive Compensation, The Globe Opinion
• Forbes.com - Executive Pay (updated with 2004 pay)
• Executive Remuneration - Analytical article by Mercer/CEO Forum Group
• The Guardian, August 4, 2005, "Chief executives' pay rises to £2.5m average" in United Kingdom
• Executive Compensation: The Fallacy of Disclosure Paper by Paolo Cioppa, UC Berkeley, Boalt Hall School of Law
• The 2007-2009 Financial Crisis and Executive Compensation: An Analysis and a Proposal for a Novel Structure Paper by Yoram Landskroner and Alon Raviv
• European Executive Compensation Data Visualizer 2006 2007
• Directory of Compensation Data Providers
• Frydman, Carola; Saks, Raven E. (2007-01-18). "Historical Trends in Executive Compensation 1936-2005". http://www.vanderbilt.edu/econ/sempapers/Frydman1.pdf. 
• Bebchuk, Lucian; Grinstein, Yaniv (April 2005). "The Growth of Executive Pay". Harvard University: John M. Olin Center for Law, Economics and Business. http://www.law.harvard.edu/programs/olin_center/papers/pdf/Bebchuk_et%20al_510.pdf.