Intermediate Sanctions

Executive Compensation Review

This course focuses specifically on executive employee compensation.

Compensation plans for executives are typically more complex than those for other groups of employees and have the following features:

• base salary
• benefits
• perquisites
• short-term incentives
• long-term incentives

We'll review each now.

Base Salary

A manager’s base pay represents 20 – 60% of the total compensation. The percentage varies with the level of the job in the organization's hierarchy. The higher the job's level, the lower the percentage of total pay represented by the base salary.

Base salaries are determined by a number of factors, including:

• Organization size. This is a major criterion in determining top management pay. It may be defined by annual revenue, assets, fiscal budget, or the number of employees.

• Organization performance. This may include such things as profit levels, earnings per share, or return on investment capital.

• Market performance. This factor aligns with shareholder interests and is based on stock price performance.

• Salary structure. Management pay is more likely to be influenced by internal organizational factors like reporting levels, budget responsibility and number of employees supervised. The organization chart becomes a guide for determining appropriate pay. The top executive's pay is a ceiling in the organization, and all other managerial positions can be measured in terms of their percentage of that person's pay.

Short-term incentives

Short-term incentives typically come in the form of annual cash bonuses and have a 12-month performance period. These incentives can be discretionary or set with pre-determined goals and objectives.

Long-term incentives

Long-term incentives are usually a form of compensation delivered with an equity instrument but can also be deferred cash plans. Equity incentives have a three to five-year performance period.

Businesses focus not only on year-over-year profitability but also on sustainability. Boards will use short-term and long-term incentives as financial levers to encourage balanced performance.

The stock option is one vehicle for long-term incentives. Stock options were originally developed to align the executive's motivations with those of the stockholder and to provide a longer-term perspective. The risk profile of stock options is higher than that of other equity instruments because:

• The stock price must increase in order for the award to have value
• When the stock price decreases, organizations tend to reprice the options
• The value is based on stock price performance.

Most tax-exempt organizations don't issue stock. So, the subject of stock options is peripheral except to the extent that in making comparisons for reasonable compensation with for-profit organizations, the value received by these executives from stock options is a part of the comparison.

Another form of long-term incentive for executives is deferred compensation.

At their simplest, deferred compensation plans promise to pay future retirement benefits (401K, pension, death benefits) and when non-qualified, to supplement qualified retirement plan benefits levels and promote retention.

In this context we will discuss non-qualified plans which typically are for executive employees. Non-qualified plans are technically "unfunded" plans and are nothing more than a company’s promise to pay benefits in some future year to managers. Managers, then, are creditors of the organization and stand in line just like other creditors, should financial problems befall the company.

Benefits

Top managers often receive add-on health and welfare benefits which are expanded versions of those offered to other employees and retirement plans are often enhanced.

Perquisites

Perquisites are a category of compensation that consists of three types of special benefits:

• Internal. These items are part of the work setting (such as special offices and furniture) and indicate the manager's status.
• External. These are business-related expenses such as cars, entertainment expenses, security, and club memberships.
• Personal. This category consists of a wide variety of items such as free medical examinations, and financial or estate planning. This group differs from internal and external perquisites in that personal perquisites are usually taxable to the employee.

This completes our brief review of executive compensation. For a closer look at this topic, see DLC Course 21: Compensation for Business Leaders.