Chapter 19: Executive Compensation

Overview: This chapter analyzes how executive pay is determined. It examines base salary, short-term incentives (bonuses), long-term incentives (stock options), deferred compensation, benefits and perquisites. In addition, this chapter spells out the process of setting executive compensation, as well as discussing the problem of excesses in executive pay.

Corresponding courses

12 IRS Reasonable Executive Compensation

21 Compensation for Business Leaders

22 Black-Scholes Valuations

42 Accumulated Earnings and Deferred Compensation

INTRODUCTION

Unquestionably, the most contentious topic in Compensation Administration is Executive Compensation. Total compensation for executives has risen rapidly for a long period of time, certainly much more rapidly than for any other employees in the organization. For instance, in 2001 the ratio of CEO-to-worker pay hit a peak of 525-to-1 while in 1982, the average CEO made only 42 times more.1 At the end of this chapter we will discuss these rampant increases in executive compensation more fully. As pointed out in the previous chapter, managers and particularly executives represent the most common group to be identified as requiring special compensation program. Executives are the leaders at the top of the organizational hierarchy (the top 1-2% of the organization's work force). They are responsible for developing goals and strategies to keep the organization effective. Private owners, through the Board of Directors, often view executives as the trustees of their resources. Within this group are position titles beginning with:

  • Top
  • Chief
  • President
  • Vice President (except in financial institutions) and Director

Ordinarily, the organization's executives are responsible for the total operation of the organization (the Chief Officers and Executive VPs) or a major segment of the organization (such as an operating division with a set of products) or a major organizational function such as finance.

Top executives often have an external role in:

  • developing relationships
  • gathering and analyzing critical information
  • deciding where the organization is going and how to get there

Given these important roles, compensation for top management should closely align to the goals, mission and success of the organization as a whole. This executive group is of such importance and their compensation arrived at so differently from other employee groups that ERI has developed a special Executive Compensation Assessor software to analyze its pay practices.

Tax Treatment

Since executive compensation plans provide favorable tax treatment for both the executive and the organization, it is important to identify who is in this group of employees. The IRS provides two classifications: Key Employees and Highly Paid Employees.

Key Employees

The IRS definition of a key employee is:

  • one of 10 employees owning the largest percentage of the company
  • any employee owning more than 5% of the company
  • any employee who earns more than $150,000 per year and owns 1% of the company
  • the definition excludes anyone who earns less than $45,000 a year

Highly paid employees

The IRS definition of a highly paid employee is:

  • any employee who owns 5% of the company
  • employees earning $75,000 a year [this year or last year]employees who earned over $50,000 [this year or last] and are in the top 20% of all salaries paid to active employees
  • officers who earned over 150% [last year or this year] of the dollar limit for annual additions to a defined contribution plan.

Note that the salary figures indicated are changed each year to keep up with inflation.

The Executive Role

As already indicated, executives are those at the top of the organizational hierarchy, usually the top 1-5 percent of the organization's work force. They are responsible for the total operations of the organization (the CEO and executive VPs), a major segment of the organization (an-operating division with a set of products), or a major organizational function (such as finance). The results of these units are measurable, and it is usually assumed that these managers had a significant impact on these results and therefore should be rewarded on the basis of the results.

The executive's view is looking out of the organization to the environment. They are charged with developing the goals and strategies required to keep the organization effective. The owners, through the board of directors, see these people as the trustees of their resources. Thus compensation for this group is closely associated with the success of the organization as a whole.

Ordinarily, top management is responsible for the total operations of the organization (the CEO and executive VPs), a major segment of the organization (an-operating division with a set of products), or a major organizational function (such as finance). The results of these units are measurable, and it is usually assumed that these managers had a significant impact on these results and therefore should be rewarded on the basis of the results.

The Executive as Agent

In the American corporation there is ordinarily a diffusion of ownership among a large group of investors or stockholders.2 This diffuse group of owners has neither the interest nor the ability to operate the modern corporation. Instead, through a Board of Directors who is elected by the stockholders, a group of executives is hired to operate the organization. Thus ownership lies with the stockholder but control of the operations of the organization lies with this hired managerial group. The result is what has been called the separation of ownership and control.

The nature of the relationship between the stockholder and the executive is seen as an agency relationship in which the executive acts as an agent of the stockholder and is to act in such a way as to maximize the stockholders interests. The agency problem is that the executives may not act in the best interests of the stockholders but in their own best interests which are not the same as those of the stockholders. In fact, as will be examined later, the executive has considerable power over the Board of Directors who is the appointed representative of the stockholders but often end up acting in the best interests of the executives.3 As we shall see, the way to bring together these diverse interests is to develop a compensation system for executives, which is performance driven, with performance defined as stockholder's interests.

THE EXECUTIVE COMPENSATION SYSTEM

The executive compensation system has a number of components. Some of these components are the same as those for other compensation systems but are administered differently, while others are unique to executive compensation. The components of executive compensation are:

  • base pay
  • bonuses (short term incentives)
  • capital appreciation plans (long term incentives)
  • deferred compensation
  • benefits
  • perquisites

The two components that are not common in the compensation plans for most other employees are deferred compensation and perquisites. Note that variable pay has two components, short term and long term.

BASE PAY

Base pay of the Chief Executive Officer has recently represented about one third of total compensation. This is down from about two-thirds in past years. The change is certainly not due to a lowering of executive base pay, but to the increase in the variable pay of the executive. For executives below the CEO level the percentage of base pay to total compensation is higher. Though the percentage tends to vary with organization level; the higher the level, the lower the percentage of total pay represented by base pay.

Setting base pay for executives is a classic example of the use of market pricing. External competitiveness is the major goal. There is little internal comparison to be made as the group is small and the comparisons apparently not important. Benchmarking is the major method for determining executive base pay. Through surveys the Compensation Committee determines the competitive position that the organization wishes to attain. There are many executive compensation surveys; ERI's Listing of Executive Compensation Surveys provides a listing of such surveys. A good example of executive surveys is ERI's Executive Compensation Assessor. ERI does benchmarking for executive positions in two ways:

  1. The first level of analysis is at a macro level, much like any wage survey. ERI's database includes U.S. SEC proxy data and 10-K reports, providing a group of comparisons in the thousands. The Executive Compensation Assessor Survey data reports competitive salaries and bonuses for more than 400 top management position titles as found within multiple industries. Salary, bonus and total cash compensation is reported by average compensation and with percentiles. This data may be adjusted for geographic area, industry, organization size, pay strategy and compensation valuation or planning date.
  2. The second level of analysis is the comparison with specific organizations that are matched for industry, geography as well as organization size, and that are chosen for these characteristics by the ERI program. This data can provide information on specific organizations or provide aggregated averages. In addition, information can be obtained on specific organizations chosen by the organization's Compensation Committee as being organizations that they wish to compete with.

Note that the comparisons here are between organizations, not executives. The focus is on how "our" organization compares with other organizations. This puts a premium on organizational size since this creates the largest variation in base pay, although industry can also carry a good deal of weight. The characteristics of the individual executive, such as their current performance or experience, can be taken into account by using different percentile ranking than the wage level determination.

A major problem that occurs in setting executive base pay is the ratchet effect: the commonly observed phenomenon that some processes cannot go backwards once certain things have occurred. In our scenario, this involves pay. Any salary figure below the average is perceived as "below market" and all executives are seen as better than average. Thus each organization raises their executives above the market for the year. The next year the average market rate has risen substantially to reflect all these "above average" executives.4

Despite the fact that base pay is a declining percentage of total executive compensation it is perceived as very important by executives. This can be exemplified in contract negotiations with executives. Some of this can be explained by the fact that it is a fixed, rather than variable, component of the compensation package and executives, like most people, have a certain amount of risk aversion. Probably most important, base pay is the basis for many other parts of the executive's compensation package, particularly retirement benefits.

SHORT TERM INCENTIVES

Executive incentives come in two varieties; short-term or long-term. Short term incentives, discussed here first, are almost universally annual bonus plans. Executive bonuses are based upon the base pay of the executive and how well he/she meets short term [one year] goals. This section discusses this form of compensation.

The use of annual bonuses is just about universal for executives.5 These plans are paid annually and are based upon the current year's performance. Under section 162(m) of the Internal Revenue Code, the deductibility of compensation paid to an executive is limited unless it is tied to specific, measurable performance in which bonuses are based upon preset, objective performance goals. These plans can be examined in terms of three basic components; performance measures, performance standards and the pay-performance relationship.

Performance Measures

The executive who receives a bonus receives it because some measure of performance was met during the past time period, typically a year. Measures may be financial or non-financial and may be singular but are more likely multiple in nature.

The most common form of managerial bonus is financial - organizational profits. But there are a number of other possible organizational measures, such as sales, productivity, or cost savings of one sort or another. Individual job-related standards may relate to job outcomes or to the performance of particular activities beyond minimum expectations.

Bonus standards may be either single or multiple. Profit sharing is a single standard. Organizations may choose to focus managers on a number of variables that they feel are important measures of success. These may include combining organizational and job measures. Each variable must be weighted when multiple criteria are used. The problems with multiple plans are that they are more complex and therefore not as understandable. The executive may have a hard time knowing what he or she they will receive, since the factors may overlap or cancel each other out. Although profits may be the most popular organizational measure there are a number of other ones.

  1. Earnings per Share: the organization's net income divided by the average number of shares of common stock outstanding
  2. Return on Equity: the organization's net income divided by the average of shareholders' equity (common and preferred stock plus retained earnings)
  3. Return on Capital: the organization's net income divided by its average capital (shareholders' equity plus outstanding loans)
  4. Return on Assets: the net income of the organization divided by the net assets of the organization
Figure 19-1. Four Common Financial-Performance Criteria

To learn how to calculate these measures, see DLC Course 29: Quantitative Methods Used in Executive Compensation.

Performance Standards

The performance standard describes how the measure is determined. There are a number of ways that are utilized:

  • The Budget. This standard uses as its measure the organization's business plan or budget goals. The point is to meet or beat the budget forecast.
  • Prior Year. This standard requires the executive to do better this year than last year.
  • Peer Group. This is an external standard. The executive's performance is compared to performance of other organizations on their performance measures.
  • Timeless Standards. These are fixed standards that do not change over time, such as a 10% increase in sales.
  • Cost of Capital. This standard is based upon the organization's cost of capital, such as value added measures.
  • Discretionary. This standard is one developed subjectively by the Board of Directors usually after the fact upon reviewing the year's performance. The arbitrary nature of this procedure and the lack of knowledge by the executive on the effect of his or her actions ahead of time decreases the motivational value of this type of standard.6

Pay-Performance Relationship

Most managerial short-term bonuses are established on the basis of a formula that operates at given levels of profit or other measures, such as those described above. The most common of these is called an 80/120 plan. In this plan no bonus is paid unless the performance measures are met to at least an 80 percent level. Further, no additional bonus would be granted if performance exceeded 120 percent. Thus, there is a cap on the amount of bonus that can be awarded. The amount of the bonus would be a range tied to the percentage of the performance standard achieved by the executive.

Where there are a number of performance measures there may be a sum of targets approach. This requires the separate performance measures to be combined in some fashion, usually additive. In fact what happens is that each performance standard has some threshold level that needs to be achieved for any reward to be granted. The amount of reward may vary between performance standards depending upon their importance. The executive's bonus would be a weighted combination of the various rewards. But it may also be more complex. In one alternative, poor performance on one measure can be made up for with superior performance on another, or it may be that there is no bonus at all unless a satisfactory level has been achieved on all measures.7

Evaluation of Bonuses. Bonuses generally pass the test for having a line of sight. The executive can clearly see the relationship between performance and reward as long as the bonus has clear cut performance standards, i.e. is not discretionary. In addition, their actions can affect the outcome. There are, however, some considerations to take into account with annual bonuses. The most obvious is that they are short sighted and therefore lead to behavior that maximizes today's performance to the possible detriment of the future. In addition, since the basis for the measures is mostly accounting data, the focus is backward looking when the executives focus should be upon the future.

The performance measures are often influenced by the executive. Both the choice of the measure to use and the standard can be involved in a political process to the advantage of the executive. Performance standards that are based upon improvement from year to year are particularly subject to games of how much to improve this year when a large improvement will create a high hurdle in succeeding years.

LONG TERM INCENTIVES

In contrast to short-term incentives, which are ordinarily paid in cash, long-term incentives are usually deferred and are based upon stock. There is a dual purpose for long-term incentives. The first is to focus the executive on the long-term success of the organization and the second is to align the executive's goals with those of the stockholders. In today's competitive business climate, when American business is being criticized for its focus on short-term profits and executives seem to be out for the most they can get, these longer-term incentives take on added importance.

Long term incentives have become more popular in recent years because of the tax advantages that can be achieved through this form of incentive as well as the concern with the performance of American businesses. The problem, however, can be that the tax laws change over time, and plans that are attractive and useful today may no longer qualify under tomorrow's tax laws. The 2002 passage of the Sarbanes-Oxley law is again changing the manner and form of long term incentives for executives. So although there are a number of ways in which these programs operate, which are covered in this section, there is no guarantee that they will stay useful with future changes in the tax laws.

Stock Option Plans

Basically, under a stock-option plan, the manager is offered stock to buy the organization's stock at a set price. He or she may purchase that stock at any time within a period specified by the plan. If the value of the stock rises, the manager gains a considerable amount. Exercising the option does take money, however, and this is often a problem for the manager. Taxation is another problem. Finally, the executive may not always be able to take advantage of increases in the price of the stock, since he or she may not use insider information when selling the stock. Simply stated, an employee stock option plan is one in which the executive has a right to purchase a specified number of shares of the organization’s stock at some future date at a specific price. Done correctly, this is a bonus for good performance.8

Why not just provide the employee with a cash bonus?

  • With the Stock Option Plan there is no immediate cash outlay by the organization. This allows for cash to be used for non-wage factors in the organization.
  • The option, given the delayed time dimension, focuses the executive on the long term. This is a major problem with bonuses that are based upon the current year's performance.
  • The eventual value of the option varies with the stock price, thereby aligning the executive's reward with the stockholders major interests.
  • Stock options, due to their delayed time dimension, provide a type of "golden handcuff" that keeps executive with the organization.

Dimensions of Employee Stock Options. A stock option grant to an employee contains a number of important variables. They are:

  • A Strike Price. This variable is the price at which the employee can purchase the shares from the organization. Regardless of what the market value is at any time this is what the shares can be purchased for. A more generic term for this is the option price or exercise price. This price is ordinarily the market price on the date of issue of the stock option grant. If it is not, there are negative tax consequences.
  • The Number of Shares. Each option grant has a maximum number of shares that can be purchased at the strike price. This number should be in relationship to the performance of the executive. A major criticism of executive stock options is the large number of shares that are granted each year.
  • The Vesting Schedule. In employee stock options there is a date at which the executive may start exercising the option. It need not be done on that date, it may be done later, nor do all of the options need to be exercised at one time. Unlike regular stock options that all come due at one time, a vesting schedule is ordinarily the way in which employee stock options come due. A common schedule is called a cliff vesting schedule in which 25% of the granted shares come due each year for four years. Thus it would be four years before all the shares granted could be exercised.
  • Expiration Date. While not all shares need to be exercised immediately, there is an expiration date by which they must be exercised. Typically, this is ten years from the date on which the stock option was granted.
  • Legalese. The option grant is a legal document. As such it contains a whole series of "What happens if….." questions and answers.

Types of Employee Stock Options. There are two types of employee stock options:

  • Incentive Stock Options [ISO's]
  • Nonqualified Stock Options [NQSO's]

In the basics of the operation of a stock option these two plans do not differ. The difference between these two is the set of Internal Revenue Code restrictions that are applied. Some of these differences are:

  • Who may receive the options? For an ISO: only employees. For a NQSO others such as Directors may qualify.
  • ISO's have a ten-year mandatory expiration date.
  • ISO's have a strict set of rules that have to be stated in the organization's ISO documents.
  • Most important! Each is taxed differently.

Exercising Options. Stock options may not be exercised until the vesting date. At that point there are three options:

  • Do nothing. The timing may not be right to exercise them at this time: the price may be expected to rise, the employee may not have the resources to exercise the option, or may choose not to because of tax considerations.
  • Do a cashless exercise. The employee can contact the broker or plan administrator to first purchase the stock at the strike price and then immediately sell the stock on the market. The employee then receives the monetary gain.
  • Pay for the stock. The employee could request the stock and pay for it. Why would one do this? Timing of the sale and/or tax considerations would sometimes make this a viable alternative.

What is the Value of an Option? The value of employee stock options can vary from zero to an enormous amount of money. Almost 2/3 of the astronomical compensation reported for top executives comes from exercising stock options. So what are some of the situations that affect the value of a stock option?

  • Being Underwater. If the current market price is lower than the strike price than the options are said to be underwater. The value of the option is zero and there is no reason to exercise the option. At least with an employee stock option it is not necessary to exercise it on the exact date it becomes vested. In many companies when it appears that the market price of the stock will not rise enough to get the stock option above water, the company cancels the current stock options and re-issues them with a lower strike price. This practice has come under attack and is discussed in more detail at the end of this section.
  • Being Above Water. This is the most desirable situation. This is where it makes sense to exercise the options. The value of the options is the current market rate less the strike price and whatever brokerage fees apply.
  • Lack of a Market. Start-ups and privately owned companies often offer stock options. But unless the company engages in an Initial Public Offering [IPO] the options have little value as there is no market for the stock, leaving the employee with nowhere to sell the shares. Usually these stock options are issued in anticipation of an IPO and the strike price is set quite low. A successful IPO can make for very valuable stock options. In some cases, the stock options can be exercised even without the company going public- the employee has put out money to exercise the option and has the stock, but cannot sell it as there is no market.
  • Not yet Vested. This is the most difficult situation in which to set a value to a stock option. One approach is to say that any stock option has no value before the vesting date since one does not know whether the market value will ever exceed the strike price. Another approach is to use the current market value but that is an uncertain measure at best because again, the value at the date of vesting may have little to do with current market value. This approach is called an intrinsic approach to valuation. To get beyond guessing more complicated and mathematical techniques are required. The Black-Scholes model is the best known of these techniques. At present all stock options must be valued and this value reflected in the organization's accounting statements. (See DLC course 22).

Non Qualified Stock Options (NQSOs) are now the norm (and many large corporations utilize NQSOs throughout their organization). The difference between employee, management, and executive treatment with stock options today is found in the number of shares granted. To find out more about how these plans work, see ERI DLC Course 20: The Basics of Employee Stock Option Plans.

Stock Appreciation Rights (SARs)

These types of plans work like stock options, but the executive does not have to buy the stock. As with a stock option, the executive is granted an option at a stated price. The executive then may call in that option at any time during an established period. But rather than having to purchase the stock, the executive receives from the organization the difference between the current market value of the stock and the stated option value of the stock. This saves the executive from having to come up with the cash necessary to purchase the stock. However, many plans restrict the amount of possible gain to 50 to 60 percent of growth in the stock's value. The gain is taxed as ordinary income to the executive when received, but there is no tax obligation when the rights are offered. This incentive plan provides a cash incentive over a longer period but no ownership advantages.9

Restricted Stock Plans

In this type of plan the executive is granted a certain number of shares of stock as a bonus but may not sell those shares until certain conditions have been met. These conditions usually involve holding the stock for a period of time and remaining employed with the organization during that period. Another condition may be meeting some performance objectives on the job. The organization has the right to reacquire the shares (usually for the lower of the amount, if any, paid by employees for their shares or the fair market value of the shares at the time they are reacquired) if certain financial targets are not met or the employee does not remain employed by the company for a certain period of time. In the latter case, the company's right to reacquire the stock typically declines over time. As far as taxes are concerned, the lifting of the restrictions creates an ordinary income liability for the difference between the current value and employee cost. The executive may choose, at the time of the award, to be taxed on the current value of the stock, but any appreciation would be taxed at time of sale. As stock options have come under attack this type of stock plan has become more popular.

Phantom Stock Plans

In some circumstances it is impossible or undesirable to allow executives to have stock. This may be because the organization is closely held and does not want ownership dilution. Phantom stock plans can work well in these circumstances. In these plans the executive is awarded units that represent shares of stock. These units typically mature at some time, ordinarily four to six years. At maturity the executive is paid the then-current value of the stock or the difference between the original value and current value. Obviously, the executive does not have to invest in the stock in this case. Again, the award is treated as ordinary income when received. Determining the current value of the stock can be a problem. Where the stock is not widely traded there is no real market value. Sometimes a number of other financial measures are used as surrogates for the stock value and the rise in them is assumed to create a higher value in the stock. Other times, organizations will use the services of an appraiser to make annual valuations (much like that required by an Employee Stock Ownership Plan: ESOP).10

Performance Share Plans

In this type of plan the executive is granted performance units that represent shares of common stock. He or she earns these shares through the performance of the organization. For instance, an executive might be granted 100 units. If the organization's earnings per share averaged 10 percent growth over 5 years, the executive would receive 25 percent of the shares. If the earnings per share averaged 15 percent growth over five years, the executive would receive up to 100 percent of the shares. Typically the payoff in this type of program is 50 percent stock and 50 percent cash based upon the current value of the stock. The executive is taxed on both the cash and the value of the stock as ordinary income.

In all these plans there are three common themes. One is to reward the executive for organizational success. The second is to establish performance goals for the executive that reflects this success. The third is to try to maximize the value of the reward to the executive by taking advantage of the tax laws. The first two are relatively stable goals, but the third is constantly changing. The value of and interest in different long-term executive incentives will continue to vary with changes in the tax laws.

Taxes

As described, the "non stock" option (which look like stock options but do not include stock) are simply forms of annual or long-term cash incentives. Value is derived from performance in future years and when paid, these sums are taxed exactly like any other form of compensation. This is not the case with stock options (which use stock) in that large compensation amounts can be built up over time, but because the employee decides not to exercise (for example, until the last day of the 10th year), these amounts accrue and are accounted for in a manner that spreads out their compensation affect over the years. This then leads to a problem; if expenses are to be recognized in present years for this compensation plan, how does one know the appreciation that might exist (when one doesn’t know what the price of the stock will be in some distant year)?

Today most publicly traded companies use the Black-Scholes Formula to calculate this amount (although it appears that no two companies use the formula in exactly the same way). This formula was developed by Scholes and Merton and it earned them a Nobel Prize in 1997.

The Black-Scholes formula factors include: volatility of the stock, a risk free interest rate (annualized), the exercise price of the option and the present price of the stock, along with the time to maturity. For those interested in working through this formula as it applies to the value of an option, we refer you to the ERI DLC Course 22: Black-Scholes Valuations.

Underwater Stock Options

When there are rapidly changing economic conditions, particularly downturns, executive compensation practices do not always have the effects that were planned. Of note has been the downturn in the stock market. When this occurs the value of the stock option turns negative-called being underwater. This has made the attractiveness of stock options decline and the rewards that executives expected evaporate. The response has been for boards to engage in re-pricing or reissuing stock options.

Re-Pricing Options. All stock options have an exercise price; one at which the executive can purchase the stock when the option vests. The idea is that the value of the stock has risen so that when the executive receives the shares at the exercise price they can be sold at a price exceeding this exercise price. But if the stock is underwater, it is currently below the exercise price and the option is worthless since there is no profit in purchasing a stock that could be purchased on the market at a lower price.

So what can the board do? Simple: re-price the options with a lower exercise price. This can usually be done by simply sending a letter to the executive stating that the options have been re-priced at a lower level. There is little or no problem with regard to taxes or the SEC with doing this although both view this as a cancellation and re-issue.

Reissuing Stock Options. Reissuing is very similar. In this case the board simply cancels the previous options and issues new stock options with a lower exercise price. This alternative has some more flexibility for the committee as it can also vary the number of stock options granted at that time.

Should the organization do either of these? The positive argument is that it helps retain the executive. Promising large returns that don't come true creates dissatisfaction and can lead to the executive seeking other employment. In addition, the argument could be made that the downturn that caused the stock decline was not controllable by the executive and he/she should therefore not be held accountable. On the negative side, these actions can be viewed as a de-motivator. Here is a program based upon performance measures considered important to the organization and certainly to stockholders that is being manipulated to create a reward for lower performance. If downturns are not the executive’s fault, are upturns more their doing? After all, the stockholders have taken a hit on the value of their investment, so shouldn’t the executives share the pain?

These are the considerations that the organization must work through in deciding if they will re-price options and by how much. The hard part is trying to separate the effects of the low stock value from economic circumstances and how much of the blame to place on the performance of the executive during this time period.

Reload Stock Options [RSO]

Reload stock options are a way in which the organization can maintain the ownership level of executives who have option grants outstanding. A reload is a feature of stock options that allows an executive to exercise a valuable stock option before the end of its term, when using already-owned shares. This is done by stipulating that a new grant option will be made to the executive at the time the executive exercises the original option award. These awards have the following design criteria:

  • The number of RSO's is equal to the number of shares used to purchase the options
  • The exercise price of the RSO's is the current stock price at the time of the reload
  • The term of the reloaded options is the same as that of the original award.

Reloads work like this. An executive has 1,000 shares, 500 in already owned shares and 500 in options. She decides to exercise a 300 share option grant and pay for it with 200 shares of her already purchased shares. Without the reload she would now have 800 shares, 600 purchased and 200 options. With the reload she still has 1,000 shares, 600 purchased and 400 options. The advantages to her would be:

  • It provides her with dividend and voting rights on the profit shares.
  • It dampens (but does not eliminate) the effect of a subsequent decline in stock price on option value.
  • It allows for further appreciation on the option profit shares to be taxed as a capital gain rather than as ordinary income.
  • It results in an increase in actual share ownership.

As stated before, the major advantage to the organization is in continuing the executive's holding stock in the corporation. The downside is mostly administrative since the SEC and FASB consider the reload to be a new stock option grant.

DEFERRED COMPENSATION

At their simplest, deferred compensation plans are promises to pay future retirement benefits (often with death benefits) and to supplement qualified retirement plan benefits levels. This type of deferred compensation plans are benefits for a limited number of employees-the executives. As such, under the rules of ERISA these plans are considered non-qualified.

Nonqualified Plans

Congress has passed numerous laws that restrict the benefits that can be provided to highly compensated employees in a qualified retirement plan. These include a $200,000 compensation cap, a $30,000 maximum contribution to a Defined Contribution Plan, a Defined Benefit maximum benefit of $98,064, and the broad coverage requirements of Sec. 410(b). In order to provide these employees with an adequate level of benefits, organizations must look to other strategies. As a result, an increasing number of organizations are adopting nonqualified deferred compensation plans as a way to provide an appropriate level of retirement income to their executives.

So in contrast to a qualified plan, a non-qualified plan's major purpose is to provide supplemental or additional benefits to the company's executives and/or highly paid employees. There are no restrictions on the magnitude of benefits that may be offered in a nonqualified plan. Further, there are no reporting requirements. Recently, however, a series of requirements have been put in place under Section 409A of the internal Revenue Code. This section includes not only plans discussed in this section but also in the previous section of long term incentives plus severance plans that are still to be discussed. Most of the changes have to do with when deferrals may take place and adds a penalty tax for deferrals that do not meet the requirements.

The disadvantage of a nonqualified plan for the organization is the tax deduction can only be made when the executive receives the benefit. This may be many years from now. The disadvantage to the executive is that the benefit is insecure. The plan is an unsecured promise on the organization's part: in a worse case scenario, that of company bankruptcy, the executive's claim would be that of any other creditor.

In designing a Nonqualified Deferral Plan [NQDP] there are three things that must be considered in the design to avoid current income taxation for the employee:

  • Constructive Receipt
  • Economic Benefit
  • Risk of Forfeiture

Constructive Receipt. Under the constructive receipt doctrine, an amount may become currently taxable before it is actually received. The tax code states that taxpayers must include payments as income when they are actually or constructively received. The amount will be taxable if:

  • it is currently credited to the employee's account.
  • set aside for the employee.
  • otherwise made available to the employee.

Once income is unconditionally subject to the taxpayer's demand, that income must be reported even if the employee chooses not to currently accept the income. In other words, once an employee has the right to receive compensation, even if they choose not to receive it, it will be subject to current taxation.

Thus, corporate payments to an executive will be currently taxable as soon as the money is made available to the executive, if there are no restrictions on the right to be paid. Three key criteria must be met to avoid constructive receipt with respect to an NQDP:

  • The election to defer must be made before the compensation is earned
  • There must be a substantial limitation or restriction over the receipt
  • The plan must remain unfunded (see below)

Income will not be constructively received if the employee's control over the receipt is subject to a substantial limitation or restriction. A common substantial limitation is the passage of time, i.e., the employee cannot receive the money until retirement, termination, disability, death - an event beyond the employee's control.

To successfully avoid constructive receipt in an NQDP, the plan must remain unfunded. A plan is unfunded when there are no formal assets set aside in trust to pay plan benefits. Any informal assets associated with the plan must be subject to the corporation's general creditors. If the plan is unfunded, constructive receipt will be avoided, even if the employee is 100% vested in his benefits (i.e., the benefits are non-forfeitable except for the employer's refusal or inability to pay). The employee, in essence, has an unsecured promise of the employer to pay the benefits, and is put in the position of a general creditor.

The IRS has issued a number of Revenue procedures which specifically deal with guidelines to avoid constructive receipt - Rev. Proc. 71-19 and Rev. Proc. 92-65. Basically, the IRS requires that the participant cannot take benefit distributions except under plan provisions, and the plan must remain as merely a promise of payment by the corporation. The IRS has stated that they will not issue favorable rulings on plans that do not satisfy the guidelines contained in these two Revenue Procedures.11

Economic Benefit. The Economic Benefit Doctrine requires that any benefit granted to an individual that has economic or financial value be included as compensation for income tax purposes in the year the benefit is granted. In essence, if something of value is granted to an employee that has a real and measurable value in terms of money, then the current value is taxable to the employee. This would be true even if the employee does not have a current right to receive the property in question. The key to avoiding the imposition of the Economic Benefit Doctrine is the existence of a substantial risk of forfeiture.

This however, does not prevent an employer from purchasing mutual funds, life insurance, etc. as a reserve fund to cover their liability, as long as the fund remains a general asset of the corporation.12

Risk of Forfeiture. Both of the above design considerations emphasized that there needs to be a substantial risk of forfeiture in designing an NQPD. The best way to ensure that this criterion is met is to keep the plan unfunded. If there are assets in the plan these assets need to be subject to the company's general creditors in case of bankruptcy.

Types of Plans

Nonqualified Deferred Pay Plans come in a wide assortment. Some are individual contracts designed for a specific executive and some are more generally an employer pay plan. Individual contracts can be established to meet the combined needs of the individual and the corporation. This section examines most of the more common employer plans.

Excess Benefit Plan. These are plans that are in addition to the organization’s regular retirement plan. Where the company wishes to reward highly paid executives with benefits greater than allowed under ERISA, an excess benefit plan is added to the regular retirement plan. These plans may be either funded or unfunded. An excess benefit plan that is unfunded is exempt from all ERISA requirements. A funded excess benefit plan is subject to ERISA's reporting and disclosure provisions, its administrative provisions and its fiduciary standards.

Top-Hat Plans. This type of plan is more accurately called a Supplemental Executive Retirement Plan [SERP]. It is an Excess Benefit Plan for top executives only.

A top-hat plan may be either unfunded or funded by the organization. From the executive's standpoint, an unfunded plan means that the executive assumes the risk that the organization may refuse to pay benefits owed under the plan due to a merger, acquisition, insolvency, or other reason. The executive pays tax on the organization's unfunded top-hat plan contributions when the benefits are actually distributed or made available. If the plan is funded, however, the organization's contributions are includible in the executive's income in the year that the contributions are made.

Similarly, an organization may generally not deduct contributions to a top-hat plan until the benefits are actually distributed or made available to the executive, which varies depending on whether the plan is funded or unfunded. With a funded plan, the organization is also subject to ERISA's participation, vesting, funding, fiduciary responsibility, and plan termination insurance rules.13

Deferred Bonuses. The simplest form of deferral is postponing the receipt of one year's bonus and having it paid over several annual installments, frequently over five years. An unfunded plan may, at the participant's option to defer receipt of the entire bonus amount, defer the tax consequences of the bonus payment, even though it serves no other purpose. This type of plan may be most useful where the person is retiring and will have lower income in future years to be taxed.

Vested Trusts. A vested trust is an unfunded Nonqualified Deferred Compensation Trust in which the executive is not paid any benefits from organization contributions until vesting occurs. Vesting usually is scheduled to occur in conjunction with a specific event, such as termination, takeover, or reaching a certain age.

The executive is generally not taxed on the benefits held in trust until vesting occurs, assuming that the executive's rights are nontransferable and subject to a substantial risk of forfeiture (a fact which should be clearly stated in the trust's vesting provisions).

The organization, as the grantor of the trust, is currently taxed on all vested trust income. The ultimate payment of benefits by the organization, therefore, is includible in the executive's gross income and the organization may generally take a corresponding deduction at that time.

Rabbi Trusts. Perhaps the most talked about method of deferring compensation for executives is the use of a rabbi trust (so named because it was first used to provide deferred compensation for a rabbi). In a rabbi trust assets are transferred to an irrevocable trust to be held for the benefit of the executive, similar to a vested trust. The trust is designed to provide some assurance to the beneficiary that future benefit obligations will be satisfied.

The IRS will find a valid rabbi trust exists if the following three conditions are met:

  • the trust's assets must be available to all the general creditors of the organization if the organization files for bankruptcy
  • there are no insolvency triggers that hasten payments to executives when the organization's net worth falls below a certain point, thereby bypassing creditors before insolvency is declared
  • there is a procedure to provide notice to the trustee of the bankruptcy of the organization or financial hardship of the organization

Because a rabbi trust is subject to the claims of the organization's general creditors, the organization is considered the owner of the trust and the executive is not subject to tax on the deferred amounts until payments are actually received. When payments are actually received and the executive is taxed, the organization may take a corresponding deduction.

Rabbi trusts can be funded by the organization on a periodic or ongoing basis, or they can be unfunded until some event occurs. The latter trust, known as a springing trust, is typically funded at the time of an actual or impending change of control. Investments that can be placed within a rabbi trust can include taxable assets, tax-sheltered assets such as insurance vehicles or municipal bonds, and company stock.

Assets within a rabbi trust are reported in consolidation as part of the sponsoring company’s financial statements. Organizations may not deduct for tax purposes, their contributions to a rabbi trust, and income on trust assets is taxed to the organization. Payments from a rabbi trust to an executive/participant are deductible when made.14

Secular Trusts. The term "secular" for this type of trust is to distinguish it from a Rabbi Trust. Secular trusts are also a type of nonqualified deferred trust that is funded to compensate executives and particularly key executives. A major distinction between secular and rabbi trusts is that an organization’s bankruptcy creditors cannot reach the money held in a secular trust.

As a result, an organization's contributions to a secular trust and the trust's earnings are generally considered taxable income to the executive or key executive. However, the executive can still benefit from contributions to the trust to help pay the increased tax liability.

The organization is also allowed a current tax deduction for its contributions when they are taxed to the executive, or when the contributions become vested. Once taxed, these later distributions to the executive (from already taxed contributions) are tax-free.

Double taxation is a problem in secular trusts. Undistributed earnings of a secular trust are currently taxable to the executive-beneficiary. The secular trust pays income tax on its undistributed income and the executive-beneficiaries also pay income tax on the increased vested account balances that are attributable to the secular trust's undistributed income. Therefore, this should be factored into any arrangement made between an organization and executive when a secular trust is involved. Most organizations gross up (increase the amount of) vested secular trust benefits to cover the tax due on trust contributions.

Purpose of Deferred Compensation?

Exactly what deferred compensation is intended to do is not always clear. For the most part these are retirement plans that are in excess of what the organization offers its employees. In this way deferred compensation can be classified as a benefit and is a membership reward. On the other hand the amounts placed into deferred compensation plans are generally based upon the discretionary view of the Board of directors as to the performance of the executive. This would make these plans a watered down performance reward.

BENEFITS

As indicated, the above discussion of deferred compensation is really a discussion of executive benefits since much of it has to do with their retirement. Clearly executives receive much better retirement benefits than other organizational employees. The same is true of other benefits. Often executives have more extensive medical plans focused on prevention and including items that are excluded from most medical plans.

Insurance is another area in which executives have additional benefits. Life insurance is more than term insurance and is often some form of split-dollar life insurance. In addition, many executives are granted disability and long term care coverage.

Severance Pay

One benefit that executives definitely get that few other employees have is severance pay. This benefit provides pay and benefits to an executive after being terminated, or alternatively a lump sum amount. As the turnover of executives has increased severance pay has become a major bargaining item in executive recruiting. The reasons for severance may include performance or a change of ownership, particularly a merger or acquisition. In this latter circumstance, the severance pay is called a golden parachute. Severance pay may extend pay and benefits for a period of time, usually one to five years. Alternatively, many severance arrangements calculate the amount as a multiple of the executive’s base pay, sometimes including bonuses.

As indicated, offering severance pay makes recruitment easier, since it limits the risk for executives of unforeseen future events (such as a hostile takeover). It is also attractive to organizations since it helps define the employment relationship of the executive and forestalls legal action in the case of termination.15

Perquisites

This is a set of special benefits available to executives which are designed to satisfy the special needs of this group. There are a number of perquisites. The first category is internal. These perquisites consist of items that are part of the work setting of the executive, such as special offices and furniture that exemplifies their status. A second category, external perquisites, has to do with conducting business outside the organization, and may include a car, entertainment expenses, and club memberships. The last category is personal perquisites. This category consists of a wide variety of items, such as free medical examinations, low-cost loans, and financial or legal counseling. The last group is distinguished from the first two in that it is usually taxable to the employee.

ADMINISTRATION OF EXECUTIVE COMPENSATION

The administration of executive compensation differs from other compensation programs in the organization in one major regard: "Who is to set the executive's pay?" For all other groups the answer would be the executives, but having the executives establish their own pay is unsatisfactory.

Corporate Malfeasance

In most of the 1990's corporate executives were seen as heroes. But as the economic boon evaporated in 2000, another factor came to the fore to further tarnish the reputation of corporate executives. This started with Enron and spread to other companies such as Global Crossing, WorldCom, Tyco and others as these companies were shown to have manipulated their accounting data to show better performance than was true, compounding the issue when some used company assets for their own personal gain. These disclosures, which in some cases have led to bankruptcies and/or prison terms, have led to a demand for change and oversight if not outright control.

Legal Response. Congress responded to these revelations about corporation operations by passing the Sarbanes-Oxley Act in 2002. This act requires companies to establish an independent audit committee. It forbids company loans to company executives [many of them were not expected to be repaid.]. It calls on top executives to certify company accounts. And it extends protection for whistleblowers: no company may "discharge, demote, suspend, threaten, harass, or in any other manner discriminate against an employee" because of any lawful provision of information about suspected fraud.

In section 404 it makes managers responsible for maintaining an adequate internal control structure and implementing procedures for financial reporting; demanding that companies' auditors attest to the management's assessment of these controls and disclose any material weaknesses. Other major provisions of the act are: criminal and civil penalties for securities violations, auditor independence, insider trading and financial statements and of particular interest to this discussion - increased disclosure regarding executive compensation. In general these provisions are intended to increase the transparency of corporate operations.16

Regulatory Response. A major regulatory body is the Federal Accounting Standards Board [FASB]. This board for years had wanted to require that stock options be expensed. They were able to require that companies disclose in the notes to their consolidated financial statements the net income it would have reported if it had expensed options using the fair value method on its income statement. During the discussions leading up to the Sarbanes-Oxley bill this topic was again raised and some companies decided to voluntarily do this as it is also a requirement of the International Accounting Standards Board. FASB continued to push for this and as of June15, 2005 all new stock options are required to be expensed. It appears this change has had a depressing effect on stock options and may lead to other forms of long term rewards.17

Shareholder Response. Stockholder groups, in particular pension funds, have become more active in examining corporate activities and have taken to putting proposals before the stockholders to be voted on in the annual meeting. These proposals cover a variety of topics. Some are proposals regarding the composition of the board [internal vs. external], election procedures of the board, performance based incentives particularly stock options, a critical look at issuing new stock and the incentives package for executives.

While the success of stockholder initiated proposals are not guaranteed, the large number that are being put forward are getting the attention of corporate executives.

The Role of the Board of Directors

The response of publicly traded companies, ESOP organizations and many privately held corporations is to utilize a special committee of the Board of Directors known as the Compensation Committee. This committee typically consists of three to five members who are not executives within the organization. That is, they are "outside" directors, as opposed to "inside directors." The reason for this is to assure stockholders, creditors, and other interested parties that the management group is not unfairly taking advantage of its place of power to strip funds from the organization. These outside board members typically meet independently of the rest of the board, often with consultants, to ascertain the level and effectiveness of the organization's compensation plans, to establish compensation plans and set compensation levels for the organization's executives.18

The Role of a Compensation Committee

The basic role of the committee is to design the compensation package for the top corporate executives. This is a very difficult task. Developing a package that is excessive costs the stockholders. This excess often has a de-motivating effect on the executives. Yet developing a package that offers too little can also be de-motivating and put the corporation in jeopardy of losing the executive. But this is not the only dilemma facing the committee. There is a need to have all aspects of the compensation plan relate as directly as possible to the desired measures of performance. While executives say they want pay for performance they also crave security, something that paying for performance puts in jeopardy. Ultimately there are two models of motivation: equity and expectancy.

Equity. In this model people want to be paid fairly. This puts an emphasis on the comparison of what the person contributes to what he/she receives. Furthermore, the executive looks at what he/she contributes in relation to what he/she perceives are the contributions and rewards of comparable peers. Equity as a criterion is most easily achieved when using surveys to determine what the "fair" amount is to pay the executive.

Expectancy. This model has three parts:

  • Valence. What this means is that the person must want the reward offered. There is little problem stating that just about everyone wants money. But what explains the huge amounts of money involved in executive pay? It is not the money itself but what it signifies to the person that makes it so important.
  • Performance-Reward. For something to be motivating, the person must see a connection between what they do, their performance, and the reward being offered. This is easy to say and rather hard to do, as has been already discussed in this course, since coming up with the measures of performance are difficult.
  • Performance-Effort. The other connection that must be made is the relationship between performance and the person’s efforts. Connecting performance and reward makes little sense unless the person sees a relationship between what they do, how their performance is measured, and how that relates to any ensuing rewards. For instance, while a top executive may see a relationship between his/her decisions and the price of the corporation’s stock a sales person would be hard pressed to see any similar correlation.

Both equity and expectancy models of motivation need to be considered in developing a comprehensive executive compensation plan. The focus on pay for performance sometimes overshadows the need for maintaining equity in a plan.

Tasks of the Compensation Committee

The Compensation Committee, in order to carry out its role, engages in a sequence of activities. These start by developing and subsequently reviewing a compensation strategy along with policies and procedures to see that the strategy is carried out. Next the committee must design the compensation package for top management and implement the plan for the next year with a report to the board. Lastly, the committee needs to periodically, during the year, review the progress of the top executives in meeting their goals as described in the plan. Diligence in the review process sets the stage for the next year's plans.

It is an important qualification of being a member of the compensation committee to be independent from the executive group. It is also important to have members who are interested in and knowledgeable about the topic, as well as having ample time, as this is a time consuming process.

Laws and Regulations

The increased focus on executive pay has led, if not to much new legislation, a renewed emphasis upon the application of the current laws and regulations. The two main areas of legal and regulatory consideration are (1) the committee member's fiduciary responsibility and (2) IRC 162 (m) that restricts the organization in how much executive pay may be deducted as a business expense.

Fiduciary Responsibilities. Corporate directors are in a fiduciary relationship with the organization, and particularly with regard to the stockholders. Under common law a fiduciary has a duty of care and loyalty to the organization. Care can be defined as being diligent, careful and paying attention to what you are doing when making decisions in committee. Loyalty has to do with putting the organization and the stockholders interests above ones own or any others, such as top management. Decisions of the committee need to meet the criteria of the Business Judgment Rule. Aspects of this rule include:

  • Committee members must be independent. This includes not having any transactions with the organization outside the directorship role.
  • Committee members will be held to a higher standard of care when dealing with executive compensation.
  • Courts may view the level of an executive compensation package to be a poor expenditure of corporate assets even if approved by a supposedly independent committee
  • Compensation plans adopted in the face of a threatened takeover or similar action may be held to the reasonable response standard.

In the legal system it is up to the plaintiff to show a dereliction of duty on the part of the committee. Thus the plaintiff would have to show a failure to:

  • Act in good faith
  • Exercise prudent judgment
  • Act in the best interests of the organization.

As indicated in the beginning of this discussion, times are changing. To quote a judge involved in much of the litigation in this area: There is now "a new set of expectations for directors…..that is changing how the courts look at these issues."19 The case that made headlines in this area was that of The Walt Disney Co. The court stated that "Where a director consciously ignores his or her duties to the corporation, thereby causing economic injury to the shareholders, the director's actions are either 'not in good faith' or 'involve intentional misconduct." The case goes on to show considerable doubt as to whether the committee had done its duty in a proper fashion or at all.

What needs to be made very clear is that not only are the rules changing, or more accurately, being more strictly observed, but that the costs to the directors and top management can be very high. If there is a finding of a lack of good faith the organization's D&O insurance cannot cover the damages issued in the judgment, leaving the directors personally liable. In the case of the executives they may be required to pay back the amounts considered excessive in the compensation package. These are not suppositions but reflections of what is happening in current court cases.

IRC 162(m). This section of the internal revenue code denies publicly held corporations any tax deduction for annual compensation of more than one million dollars to the top five highest paid executives in the corporation. This includes all cash and non-cash benefits for services except for:

  • Individual commissions
  • Performance based pay
  • Payments to qualified pension plans or other benefit plans such as medical plans

The kicker in this section is performance based pay. A performance based pay plan is excluded if it meets the following requirements:

  • There must be a pre-established objective goal [Established in writing no later than 90 days into the time period covered by the plan]. The test of whether the standard is met is:
    1. a third party having relevant knowledge could determine if the goal had been met
    2. this same party could then calculate accurately the amount to be paid the executive
  • The plan be established by a committee where at least two members are outside members and all non-outside directors recuse themselves from the performance goal process
  • The terms of the performance goal under which the compensation is to be paid are disclosed to and approved by the shareholders in a separate vote before any payment is made
  • The compensation committee certifies that the goals have been met prior to payment.

Stock options, and stock appreciation rights are considered performance based plans as long as:

  • The grant is made by the compensation committee
  • The plan has a maximum number of shares or rights that may be granted during any specified time to any executive
  • The amount of compensation received by the executive is based solely upon an increase in the value of the stock after the date of grant.

Ordinarily, restricted stock does not qualify as performance based compensation. It may qualify if the basis for the issuance is attainment of the performance related goal and in all other respects the plan meets the requirements of a performance based plan.

Employment Contracts

One of the end products of the Compensation Committee is an Executive Employment Contract. This controversial practice places executives in a different situation from other employees whose employment is considered "at-will". Executives generally have a contract that defines their relationship to the organization in some detail. An employment contract usually contains specific terms of employment including:

  • Job Description. The executive's duties and responsibilities as well as authority over finance and personnel and reporting relationships need to be defined in detail.
  • Compensation. The rewards for taking on the job, both those that are set and those that are dependent upon performance. This includes all of the above discussion of design aspects of executive compensation.

In addition there are some more parts that are specific to executive contracts and very contentious.

  • Term. How long is the contract for and what happens at the time it terminates?
  • Termination. Under what circumstances can the executive be terminated and what is he/she entitled to at that time? This latter point, severance, is a particular sore point. On one hand the executive wants maximum protection but on the other hand the public sees the executive being granted a huge severance package for not doing well.
  • Non-Compete. Most executive employment contracts have a clause that prevents the person from seeking employment with competitors for some time period and/or not revealing company confidential information.20

IS EXECUTIVE PAY EXCESSIVE?

As indicated at the beginning of this chapter executive pay in America has risen dramatically over the past twenty years and the gap between the average employee and top management has drastically widened. What appears to be happening is that the need to remain competitive (or above competitive levels) is feeding upon itself because of the ease of accessing the vast stores of information available.

One critic of executive pay illustrates how executive pay rises in all circumstances. When an Executive Compensation Consultant is hired one of the following three things happens:

  1. The CEO is truly underpaid. The consultant reports this to the Compensation Committee, and the executive's salary is increased.
  2. The CEO is not underpaid and the company is doing well. The consultant is asked to compare the executive's salary to a set of companies who are known to pay highly. The result is a recommendation to raise the executive's pay.
  3. The CEO is not underpaid and the company is not doing well. The consultant finds management lamenting that with these low wages, turnover is inevitable. The consultant then suggests a raise to prevent turnover.21

Further, critics routinely point out the growing disparity between executive and employee pay.

Year CEO salary compared
to blue-collar worker
1980

42 times
1990

85 times
2000<

531 times
2007

344 times
Figure 19-2. CEO salary compared to blue-collar worker, 1980 to 2007
Source: G. William Domhoff, Who Rules America, April 2010

Is this a problem?

We will examine this question from a number of theoretical standpoints

The Equity Model

The public looks at the high salaries of executives as a problem of equity and asks if this person is truly worth that much more than other people? The assumption is that if the rewards are this high then the contributions must be equally great.22 It is not easy to prove that the executive is in fact worth that much more than others. Some people would claim that this much difference in contribution and therefore reward, is not possible. It is difficult to describe the contribution made by the executive to those outside the organization. The visibility of the executive can be easily exploited by the press, making this figure even more public and pointing out the supposed discrepancy. As in so many things in life, perception is everything.

The Performance-Motivation Model

Each of the three major facets of the performance-motivation model provides a question regarding the size of executive salaries. As we have seen, the first part of the model is valence, or the attractiveness of the reward. Clearly the reward is attractive, but how much does it take to be attractive? Critics point out that executives in Europe and Japan do not get these large salaries but still perform very well.23 (In most of the Pacific Rim the unwritten rule is a 20 to 1 ratio.) One response is that there are more alternatives in the United States for these talented people to go out on their own and make high incomes in an entrepreneurial manner.

The performance-reward connection questions whether there is in fact such a connection in executive salaries. As discussed in this chapter, there is evidence that this connection is tenuous at best: this may be a major area in which pay reform is needed. If American organizations need to improve their performance, assuring this connection would need to be a high priority.

The performance-effort connection questions whether it is the executive or other factors that lead to the organizational results for which the executive is rewarded. At times it may be true that the executive gains from improvement in the general economy rather than from his or her own particular efforts. Of course, the reverse is also true – the executive gets blamed for poor performance that may not be his or her fault – so this should even out. Unfortunately, executives often receive raises even when their companies falter. Even executives of failed corporations receive large exit bonuses.

Kmart Former CEO Chuck Conaway filed the country's largest retail bankruptcy, after which he (and other Kmart executives) still received bonuses. While Kmart laid off 22,000 workers without severance pay, Conaway walked away with $9 million.
Webvan George Shaheen left the online grocery company a few months before it closed its doors, taking a severance package of $375,000 per year for life. (If he dies, his wife still receives the compensation.)
Mattel While Jill Barad was at the reigns of Mattel, the stock price dropped 70%, but she still walked away with over $10 million.
Figure 19-3. Executive exit bonuses
Jennifer Dixon, "Departure of Kmart Chief Raises Questions about Severance Package," Detroit Free Press, March 12, 2002.

Agency Theory

Three further theories add to the description of how and why executive pay has gotten so high. The first of these is agency theory. According to this theory, top executives are the agent for the stockholders. This assumes that the interests of the stockholders and the top executives are the same, which they are not. This creates the agency problem discussed earlier. Shareholders then attempt to overcome this divergence by aligning the interests of top management with their own by designing attractive compensation packages.

Tournament Theory

This theory views the promotion ladder in the organization as a series of tournaments. Promotion means one has won that tournament and is entitled to the rewards from winning that tournament. Each level has higher rewards for winning, but the number of tournaments (i.e. positions) diminishes as each step up the ladder is attained. The ultimate tournament is that of CEO. The rewards must be high because the probabilities are so low of winning. In this way the situation looks like the lottery.24

Social Comparison Theory

In social comparison theory, people need to evaluate themselves in comparison to others. For an executive to be seen as doing well, he/she must be rewarded comparable to, or higher than their executive peers. Compensation committees respond to this by keeping the executive's compensation comparable to that of executives at competing organizations. In fact, one of the driving forces in propelling executive pay incessantly upward is that these committees decide that their executive is "better" and therefore increase the compensation even more in a one-upmanship bid. If all committees follow the same formula, compensation is driven up rapidly.25

SUMMARY

Executives are considered a most important group of employees whose compensation plan is unique. While they represent a small percentage of the workers, they represent a major cost of compensation. It is important to develop a compensation program for this group that both obtains the most from these employees and keeps the costs within reason. The executive job is one of high stress and requires a great variety of talents and skills. Further it requires considerable judgment. Executives are highly committed to the organization, have an action orientation and a need to utilize and express their power.

Compensation programs for executives are a combination of base pay, incentive pay [short and long term], deferred compensation, benefits and perquisites. Given the importance of this group, its high visibility, and ease of movement to other organizations, it is usual to utilize a high-paying wage level strategy for this group. Individual pay determination is most typically dominated by pay-for-performance, with management by objectives used as a basis for measuring performance. All organizations have a keen interest in the rewards being earned by similar individuals in other corporations who are in similar positions.

Executive incentives are divided into short- and long-term plans. Short-term programs are typically rewards for performance in a particular year based on how well the executive did in achieving company goals. Long-term executive incentives are intended to tie the executive to the organization, both so the executive will stay with the organization and so that they will have motivation to continue to perform highly. Most of these plans are a variation of a stock option plan that grants stock or money, based on overall organizational worth, to the executive over a long time period. In addition, executives are granted deferred income plans that enhance their retirement. Executives are also granted a variety of benefits and perquisites that are not available to other employee groups

Today, top executives receive upwards of 400 times blue-collar workers' pay. This may be necessary due to an undersupply of candidates. But it is also attributed to a lack of board oversight and the desire to pay execs more than the competition. Recently, there has been a need for the Board of Directors to establish a compensation sub-committee to establish compensation plans for the organization's executives as well as establish compensation amounts and monitor the results of these plans.

Footnotes

1 http://money.cnn.com/2005/08/26/news/economy/ceo_pay/

2 Berle, A., & Means, G. The modern Corporation and Private Property, New York, Macmillan, 1932.

3 Jensen, M & Meckling, W. "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure" Journal of Financial Economics, vol. 3 1976. pp.305-360

4 Baker, G., Jensen, M. & Murphy, K. "Compensation and Incentives: Practice vs. Theory" Journal of Finance, Vol. 43 #3 1988 pp.593-616.

5 Murphy, K. "Executive Compensation" in Ashenfalter, O. & Card, D. Eds. Handbook of Labor Economics, Vol. 3B, Elsevier Science North Holland, Chapter 38 pp. 2485-2563.

6 Murphy, IBID.

7 Murphy, IBID.

8 For an extended discussion of stock options see: Delves, D. Stock Options and the New Rules of Corporate Accountability: Measuring, Managing and Rewarding Executive Performance, New York, McGraw-Hill, 2004.

9 Zong, L., "Equity Plans Under New Deferred Compensation Rules," Journal of Deferred Compensation. New York: Fall 2005. Vol. 11, Iss. 1; p. 22

10 Ryterband, D. "Focused Equity Incentives for Public Company Subsidiaries," World at Work Journal, Vol. 10 #2 Second Quarter 2001.

11 https://www.deferral.com/dts/content/legal/constructivereceipt.asp

12 https://www.deferral.com/dts/content/legal/economicbenefit.asp

13 http://thismatter.com/money/tax/nqdc-plan-types.htm

14 https://www.deferral.com/dts/content/legal/rabbitrust.asp

15 Jones, R. "Severance and Change-in-Control Policies: Now is the Time to Act" Workspan, World at Work, Vol 47 #5, May 2004.

16 http://fl1.findlaw.com/news.findlaw.com/hdocs/docs/gwbush/sarbanesoxley072302.pdf

17 http://www.fasb.org/st/summary/stsum123.shtml

18 Reda, J. Compensation Committee Handbook, New York, John Wiley, 2002.

19 Elson, C. "What's Wrong with Executive Compensation" Harvard Business Review, Vol. 81 # 1 Jan. 2003.

20 Tauber, Y. & Silverman, C. "Employment Contracts Get Employers in the Game" Workspan, World at Work, Vol.45 # 8.

21 Crystal, G. In Search of Excess: The Overcompensation of American Executives, New York, W. W. Norton, 1991.

22 D. Kraus, "Executive Pay: Ripe for Reform?" Harvard Business Review, September-October 1980, pp. 78-85.

23 Crystal, op Cit.

24 Bognanno, M. "Corporate Tournaments" Journal of Labor Economics, Vol. 19 3 2 April 2001.

25 Ezzamel, M. 7 Watson, R. "Pay Comparability Across and within UKBoards: an Empirical Analysis of the Cash Pay Awards to CEOs and Other Board Members." Journal of Management Studies, Vol.39 #2, March 2002.

Internet Based Benefits & Compensation Administration

Thomas J. Atchison
David W. Belcher
David J. Thomsen

ERI Economic Research Institute

Copyright © 2000 - 2013

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HF5549.5.C67B45 1987 658.3'2 86-25494 ISBN 0-13-154790-9

Previously published under the title of Wage and Salary Administration.

The framework for this text was originally copyrighted in 1987, 1974, 1962, and 1955 by Prentice-Hall, Inc. All rights were acquired by ERI in 2000 via reverted rights from the Belcher Scholarship Foundation and Thomas Atchison.

All rights reserved. No part of this text may be reproduced for sale, in any form or by any means, without permission in writing from ERI Economic Research Institute. Students may download and print chapters, graphs, and case studies from this text via an Internet browser for their personal use.

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