W2: Lecture 4 Flashcards
"Executive Compensation" (25 cards)
Who determines executive compensation?
Manager compensation is determined by the (independent) compensation committee of the board of directors.
The compensation committee creates a Compensation Discussion and Analysis (CD&A); shareholders then vote on its composition.
*Compensation committees typically do not want to approve below-average compensation, –> rising compensation.
*CEO pay has surged over the last decades.
*small % (~12%) comes from salary
*varies a lot across countries.
Why such high executive compensation bonuses are being paid?
!!!While executive compensation can encourage CEOs to work hard, it can also create excessive pay.
*CEO talent in short supply?
*Maybe CEOs and directors are too closely connected?
Input and output of executive compensation
The compensation structure is most important–> pie splitting vs pie growing.
Compensation can be based on input (manager’s effort) or output (value added as a result of manager decisions).
*Input is difficult to measure. How do you quantify effort?
*Output is a function of both manager decisions and things outside a manager’s control (e.g., a global pandemic).
–>improvement: peer benchmark.
Most compensation schemes have managers bearing some of the outside risks and shareholders bearing some of the agency costs.
Building a compensation package: goals and expectations of various entities
▶ Management
▶ Compensation Committee
▶ Regulators
▶ Shareholders
▶ Media
Objectives of a compensation package
▶ Attract & Retain Talent
▶ Motivate Performance
–> align executive actions with shareholder value
–>Reward long-term value creation
–> Manage risk & risk taking
▶ Fairness and recognition
▶ Minimize pay levels
Standard view of classical theories: a good compensation package solves the principal-agent problem.
What do investors & directors care most about in designing the
compensation package?
Directors’ priority is to attract the right CEO.
Shareholders’ priority is to motivate the CEO.
Neither has minimizing pay as a priority ⇒ Focus on pie-growing rather than pie-splitting.
What to consider in a compensation package? (2 main components considered)
- Pay Mix
* Fixed vs. variable
*Short vs. long-term
*Cash vs. equity - Pay Positioning
*Market competitiveness
*Traditionally targeted to median levels
*Flexibility
Five parts of compensation packages.
- Salary
–>Fixed compensation paid to an executive for services rendered. - Annual Incentives
–>Compensation earned and paid based on the achievement of performance goals over one year. - Long-Term Incentives
–> - Retirement Benefits
–> - Other Benefits and Perquisites
–>
Base Salary
One of the components of a compensation package.
*Fixed compensation paid to an executive for services rendered.
*Provides security and predictable income for the day-to-day needs of the individual.
*Usually a small percentage of the overall total compensation.
(but since target annual and long-term incentives are often expressed as a % of salary –> changes can have a big impact on overall compensation)
Annual Incentives
<One>
*Compensation earned and paid based on achievement of performance goals over 1y.
*Often % of base salary
*Motivate performance and align executives with the company’s short-term performance objectives.
(but should also support a long-term business plan)
*Important: Which performance metrics are chosen to evaluate if the aim is reached?
-->should focus and drive performance.
Goal setting:
*Most complicated, since difficult to forecast performance
*It should be realistic. (Reflective of business plan, last year results, industry avg, investor estimates etc.)
*Under increasing scrutiny from shareholders and proxy advisory firms, full disclosure is/required.
Performance targets will be examined in various ways.
Boundaries:
MIN (payout floor, usually 25-50% target)
TARGET (Expected/budgeted level of achievement. 100% of target pay.)
MAX (payout cap ~150-200% usually)
-->Rule of Thumb
Achieve MIN of 9/10 years.
Achieve MAX of 1/10 years.
Remaining should range between min and max, clustering around the target level.
</One>
Long-term Incentives
*Largest component of executive compensation (50-60% of pay).
*Awards earned and paid based on goals for >1y.
Stock price based or business performance based
Typically, equity-based, few use cash-based.
Objective:
▶ Align executive and shareholder interests
▶ Attract, retain, and motivate
▶ Focus participants on critical performance criteria
▶ Provide competitive pay opportunities based on performance
▶ Create wealth
Grant-vest structure:
The award is granted on a certain date, and the vesting terms are established.
Once the vesting terms are met, the employee receives ownership of the designated securities.
Types of Compensation: “Long-term Incentives”
- Traditional Stock Options
Stock options are granted to the manager with a pre-set strike price.
Historically, most popular.
Requires an exercise decision, vests over time, typically not dividend protected. - Stock Appreciation Rights
Similar to TSOs but more flexible.
May not require payment of a strike price.
Can be either time- or performance-vested, typically dividend-protected. - Restricted Stock
Most popular.
Granted and then received without cost to the employee upon the vesting date.
Dividend protected and has voting rights upon vesting.
*Performance-Vested Shares
Called Performance Stock, and can vest in variable amounts (typically 50% to 200% based on performance).
*Time-Vested Restricted Stock
Stock vests over a period, contingent on continued employment.
- Employee Stock Purchase Plan
Employees opt in, the company reserves a portion of their paycheck (“offering period”), then employees purchase stock at a specified price.
The price is either set beforehand (discounted around 15%) or by the “look-back” method: the lesser of the stock price at the beginning and end of the offering period. - Employee Stock Ownership Plan
Employees are granted shares, the rights to which accrue over time, but cannot sell the shares until they leave the company.
Stock Options: Pros and Cons
Pros:
+ Alignment with shareholders
+ Easy to communicate
+ Leverage
(Potential upside employees can gain when the company’s stock price increases)
+Fixed expense
Cons:
- Not viewed as performance-based by some
- Indirectly tied to company financial performance
- Dilution
(reduction in the ownership percentage of existing shareholders caused by the issuance of new shares)
- Expense recognized even if option expires worthless
Time-Vested Restricted Stock: Pros and Cons
Pros:
+ Strong retention value and popular with employees
+ Alignment with shareholders
+ Less dilutive
+ Easy to communicate
+ Fixed expense
Cons:
- Viewed negatively as “pay for pulse”
(As long as you are employed and have a “pulse” you get the reward.)
- Not tied explicitly to company financial performance
- No leverage
Performance-Vested Shares: Pros and Cons
Pros:
+ Strong focus on performance
+ Alignment with shareholders; popular with advisory firms
+ Fixed expenses may be subject to reversal if performance goals are not met
+ May be less dilutive
Cons:
- Challenges in setting performance criteria
- Poor goal setting may lead to the perception that they are less valuable
- Reversal of expense is not possible for awards earned based on market conditions.
Advantages and disadvantages of Long-term Incentives
+Tying manager compensation to stock price incentivizes the manager to work hard to improve the stock price.
(-) Earnings manipulation:
This can lead managers to take an excessively short-term view of firm performance.
* Managers may withhold bad news or postpone investment projects if they could depress earnings in the short run.
* Managers may also under-report excessive earnings, saving the funds for quarters where they fall short of expectations.
Executive Pay and Governance
▶ Share ownership requirements
* Firms require executives to hold a certain number of shares (3-6 times base salary).
* Shares owned outright as well as unvested shares count toward this requirement.
* Executives may also be required to retain a percentage of shares after vesting/exercising.
▶ Clawbacks
* Payment can be taken back if, based on performance, later found to be erroneous.
▶ Additional disclosure required for CEO pay ratio, pay-for-performance benchmark, and hedging policies.
How have historical scandals shaped executive compensation practices?
- Academic Foundation
Jensen & Meckling (1976): Introduced the concept of aligning executive and shareholder interests through managerial equity ownership — a foundational theory in agency cost reduction. - Option Backdating Scandal
Executives were allowed to backdate options, setting the grant date (and strike price) retroactively to a day when the stock was cheaper, thus guaranteeing profits.
Though technically legal for a time, it was ethically dubious and led to widespread abuse.
Policy reform in 2002 ended this practice → Resulted in a 40% drop in option grants in the next three years.
3.Strike Price Loophole & Earnings
Prior to 2006, options with a strike price equal to market price were considered “worthless” on the books, so they did not affect reported earnings.
This masked the true cost of compensation.
Changed in 2006: such options now must be expensed, increasing transparency and reducing usage.
- The $1 Million Salary Rule (1990s)
To curb excessive pay, the U.S. tax code was amended: non-performance-based compensation above $1M became non-deductible.
Companies responded by loading pay packages with “performance-based” stock options, which were still tax-deductible.
Ironically, this accelerated the use of equity-based pay. - 2018 Policy Reversal
In 2018, the tax deductibility loophole for stock options was eliminated.
This marked the end of a long era where stock-based compensation dominated executive pay design.
What motivates a CEO to perform?
Most models assume that financial incentives are the only motivator.
BUT in reality:
Non-financial reasons (intrinsic motivation and personal reputation) are the strongest drivers of CEO efforts.
–>Give financial incentives only after introducing non-financial.
What to evaluate before introducing non-financial metrics for performance?
▶ Evaluate the company’s strategy and purpose.
▶ Benchmark against peers.
▶ Understand shareholder demand.
▶ Asses the company’s culture/attitudes toward ESG.
–> importance to investors, relevance to the business, and ability to measure (true) performance.
–> To whom do they apply?
These metrics may apply to just the CEO, to the board as a whole, or even employees further down in the organization.
Ways to incorporate ESG metrics
▶ Scorecard:
no specific weighting, both financial and non-financial metrics are broadly mixed.
▶ Individual components:
metrics are included as part of a discretionary individual assessment
(e.g., a “leadership” assessment).
▶ Weighted components:
metrics are given specific weightings and goals.
▶ Global modifier:
metrics adjust the entire payout up or down.
▶ Stand-alone plan:
metrics are included as a separate compensation plan (redundant?).
Common non-financial metrics used.
*Customer Satisfaction
*Safety
*Quality
*D&I
*Environmental goals
<these>
</these>
What is the appropriate time horizon for ESG performance targets?
Many metrics are measured in the short-term (1-3 years), but may not align with long-term goals (10+ years).
Should the sustainability metrics be disclosed if they are included in the compensation plan?
Sustainability measures are not required disclosure, but they become so once they are included in compensation plans.
–>May disincentivize companies from including ESG metrics in compensation plans.
