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Executive compensation or executive pay is composed of the financial compensation and other non-financial awards received by an executive from their firm for their service to the organization. It is typically a mixture of salary, bonuses, shares of or call options on the company stock, benefits, and perquisites, ideally configured to take into account government regulations, tax law, the desires of the organization and the executive, and rewards for performance.
Contents
- Types
- Stock options
- Restricted stock
- Levels
- Controversy
- United States
- Australia
- Canada
- Europe
- United Kingdom
- Asia
- Regulation
- References
The three decades starting with the 1980s, saw a dramatic rise in executive pay relative to that of an average worker's wage in the United States, and to a lesser extent in a number of other countries. Observers differ as to whether this rise is a natural and beneficial result of competition for scarce business talent that can add greatly to stockholder value in large companies, or a socially harmful phenomenon brought about by social and political changes that have given executives greater control over their own pay. Recent studies have indicated that executive compensation should be better aligned with social goals (e.g. public health goals ). Executive pay is an important part of corporate governance, and is often determined by a company's board of directors.
Types
There are six basic tools of compensation or remuneration:
In a modern corporation, the CEO and other top executives are often 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" (vesting occurring on one date), and "graded vesting" (which occurs over a period of time) and which maybe "uniform" (e.g., 20% of the options vest each year for 5 years) or "non-uniform" (e.g., 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 chauffeured limousine, an executive jet, and interest-free loans for the purchase of housing.
Stock options
Executive stock option pay rose dramatically in the United States after scholarly support from University of Chicago educated Professors Michael C. Jensen and Kevin J. Murphy. Due to their publications in the Harvard Business Review 1990 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. 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 (see options pricing). Stock options also present a potential up-side gain (if the stock price goes up) for the executive, but no downside risk (if the stock price goes down, the option simply isn't exercised). Stock options therefore can incentivize excessive risk seeking behavior that can lead to catastrophic corporate failure.
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.
Levels
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. In 2007, the world's highest paid chief executive officers and chief financial officers were American. They made 400 times more than average workers—a gap 20 times bigger than it was in 1965. In 2010 the highest paid CEO was Viacom's Philippe P. Dauman at $84.5 million The U.S. has the world's highest CEO's compensation relative to manufacturing production workers. According to one 2005 estimate the U.S. ratio of CEO's to production worker pay is 39:1 compared to 31.8:1 in UK; 25.9:1 in Italy; 24.9:1 in New Zealand.
Controversy
The explosion in executive pay has become controversial, criticized by not only leftists but conservative establishmentarians such as Peter Drucker, John Bogle, Warren Buffett.
The idea that stock options and other alleged pay-for-performance are driven by economics has also been questioned. According to economist Paul Krugman,
"Today the idea that huge paychecks are part of a beneficial system in which executives are given an incentive to perform well has become something of a sick joke. A 2001 article in Fortune, "The Great CEO Pay Heist" encapsulated the cynicism: You might have expected it to go like this: The stock isn't moving, so the CEO shouldn't be rewarded. But it was actually the opposite: The stock isn't moving, so we've got to find some other basis for rewarding the CEO.` And the article quoted a somewhat repentant Michael Jensen [a theorist for stock option compensation]: `I've generally worried these guys weren't getting paid enough. But now even I'm troubled.'"
Recently, empirical evidence showed that compensation consultants only further exacerbated the controversy. A study of more than 1,000 US companies over six years finds “strong empirical evidence” that executive compensation consultants have been hired as a “justification device” for higher CEO pay.
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.
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.
Since the 1990s, CEO compensation in the US has outpaced corporate profits, economic growth and the average compensation of all workers. Between 1980 and 2004, Mutual Fund founder John Bogle estimates total CEO compensation grew 8.5%/year, compared to corporate profit growth of 2.9%/year and per capita income growth of 3.1%. By 2006 CEOs made 400 times more than average workers—a gap 20 times bigger than it was in 1965. As a general rule, the larger the corporation the larger the CEO compensation package.
The share of corporate income devoted to compensating the five highest paid executives of (each) public firms more than doubled from 4.8% in 1993-1995 to 10.3% in 2001-2003. The pay for the five top-earning executives at each of the largest 1500 American companies for the ten years from 1994 to 2004 is estimated at approximately $500 billion in 2005 dollars.
As of late March 2012 USA Today's tally showed the median CEO pay of the S&P 500 for 2011 was $9.6 million.
Lower level executives also have fared well. About 40% of the top 0.1% income earners in the United States are executives, managers, or supervisors (and this doesn't include the finance industry) — far out of proportion to less than 5% of the working population that management occupations make up.
A study by University of Florida researchers found that highly paid CEOs improve company profitability as opposed to executives making less for similar jobs. However, a review of the experimental and quasi-experimental research relevant to executive compensation, by Philippe Jacquart and J. Scott Armstrong, found opposing results. In particular, the authors conclude that "the notion that higher pay leads to the selection of better executives is undermined by the prevalence of poor recruiting methods. Moreover, higher pay fails to promote better performance. Instead, it undermines the intrinsic motivation of executives, inhibits their learning, leads them to ignore other stakeholders, and discourages them from considering the long-term effects of their decisions on stakeholders" Another 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. Australia's corporate watchdog, the Australian Securities and Investments Commission has called on companies to improve the disclosure of their remuneration arrangements for directors and executives.
Canada
A 2012 report by the Canadian Centre for Policy Alternatives demonstrated that the top 100 Canadian CEOs were paid an average of C$8.4 million in 2010, a 27% increase over 2009, this compared to C$44,366 earned by the average Canadian that year, 1.1% more than in 2009. The top three earners were automotive supplier Magna International Inc. founder Frank Stronach at C$61.8 million, co-CEO Donald Walker at C$16.7 million and former co-CEO Siegfried Wolf at C$16.5 million.
Europe
In 2008, Jean-Claude Juncker, president of the European Commission's “Eurogroup” of finance ministers, called excessive pay a “social scourge” and demanded action.
United Kingdom
Although executive compensation in the UK is said to be "dwarfed" by that of corporate America, it has caused public upset. In response to criticism of high levels of executive pay, the Compass organisation set up the High Pay Commission. Its 2011 report described the pay of executives as "corrosive".
In December 2011/January 2012 two of the country’s biggest investors, Fidelity Worldwide Investment, and the Association of British Insurers, called for greater shareholder control over executive pay packages. Dominic Rossi of Fidelity Worldwide Investment stated, “Inappropriate levels of executive reward have destroyed public trust and led to a situation where all directors are perceived to be overpaid. The simple truth is that remuneration schemes have become too complex and, in some cases, too generous and out of line with the interests of investors.” Two sources of public anger were Barclays, where senior executives were promised million-pound pay packages despite a 30% drop in share price; and Royal Bank of Scotland where the head of investment banking was set to earn a "large sum" after thousands of employees were made redundant.
Asia
Since the early 2000s, companies in Asia are following the U.S. model in compensating top executives, with bigger paychecks plus bonuses and stock options. However, with a great diversity in stages of development in listing rules, disclosure requirements and quality of talent, the level and structure of executive pay is still very different across Asia countries. Disclosures on top executive pay is less transparent compared to that in the United Kingdom. Singapore and Hong Kong stock exchange rules are the most comprehensive, closely followed by Japan's, which has stepped up its requirements since 2010.
Regulation
There are a number of strategies that could be employed as a response to the growth of executive compensation.