Corporate Governance: Executive Compensation

Corporate Governance Research Paper
Trends in Executive Compensation
Oct.10, 2013

Introduction
Top managers of firms are under scrutiny from the public due to what seem to be high salaries, bonuses and stock options. There have been definite trends in regards to executive compensation, and they all tend to lead to higher compensation of executives over time. There wasn’t always transparency in regards to executive compensation, but due to government and public pressure, companies are clearer about the compensation packages that are being given to their top executives. With recent unemployment in the US and executive scandals, the public is growing more concerned with, what seem to be, exorbitant compensation packages. There could be legitimate reasons for high compensation such as performance benefits, retention of talent, and aligning the officer’s interests with the owners, while avoiding moral hazard. There are other theories that could be reasons for high pay such as agency theory and tournament theory. All of these reasons have common criticisms which will be looked at.
Issues
Starting in the 1960s there was a noticeable trend of an increase in benefits to executives. From 1965-66 the average CEOs pay for the top 489 companies rose by 5.8% from the previous year, and had steadily been increasing for the five years leading up to 1966 (Patton, Lack. 1967, p. 22). The sixties were nicknamed “the soaring sixties” because from 1960-66, according to Patton, Lack. (1967. P. 24), the average company’s sales doubled and profits rose by over 70%. Executive compensation packages then followed suit with increases. According to Patton, Lack. (1967. P.24), historical data shows that doubling the size of a company should be followed with a 20% increase in pay due to more responsibility, and that the executives were actually taking smaller amounts for themselves. The relationship here was based on sales performance and not profits, where a company’s size was being based on sales. This explains why there was an increase in compensation to executives, but not to the degree of profits. A large portion of compensation in the US and internationally was made through bonuses; managing directors reported that on average 25% of their salary was through bonuses. The major factors in the uptrend of compensation were the cost of living and company growth (Patton, Lack. 1967). This information can link compensation with company performance, which is still one of the leading factors of executive compensation.
In 1980, a corporate CEO was making 40 times what the average worker made in the US and by the year 2000, that number went to 400 times the average workers yearly earnings (Bruvik, Gibson. 2011. P. 69). It is no wonder that the public has been so angry about what is seen as the over compensation of corporate executives. There are a couple theories that are out there as to why such enormous packages are given out though. Agency theory is the first theory described. It states that the CEO is essentially an agent for the company owners and shareholders. According to Wasserman `` Per agency theory, self-interested agents take actions inconsistent with the best interests of their organization’s shareholders when doing so is possible and serves the agents’ self-interest. The more divergent the interests of agents and principals, the greater the agency costs`` (as cited in Bruvik, Gibson. 2011. P. 71). Which means that the compensation for the CEO has to be great enough to align their personal goals with that of the shareholders best interest. Although simply putting pressure on a CEO to perform and monitoring the performance is logical, there is a back side to this too. According to Hoskisson, Castleton, & Withers, the increased pressure put on a CEO leads them to demand more compensation to make up for the stress of monitoring (as cited in Bruvik, Gibson. 2011). Another theory analyzed is tournament theory, where as the mission of executives is to get to the top of the organization to claim the largest prize. It is that thought that the CEO is playing in the toughest game and deserves the reward of the biggest paycheck. Another aspect of tournament theory is that senior executive’s career ladders will be stretched out further in their goal to achieve the largest prize (Bruvik, Gibson. 2011). Finally, according to Lee, Lev, & Yen, `` Tournament theory is perhaps more easily applied to sports figures or top performers who clearly earn a prize which is way more than the second or third finalist. In golf, it has been shown that when the prizes are higher, player performance improves. Likewise when racers drive for bigger payoffs, they demonstrate positive incentive effects in terms of performance`` (as cited in Bruvik, Gibson. 2011. P. 72). These theories both relate to each other through the apparent self-interest of the individual and not the progress of the company, but it is through this self-interest that the person can be swayed to act on the best behalf of the shareholders through compensation packages.

The way compensation packages are being delivered has changed over the past 13 years, they have increased quite a bit, the amount of shares and options being offered have also increased more than salaries. There are many reasons why there is a shift towards offering more stock options. First and foremost, it links the executives directly to the shareholder because the executive will want the company to perform well for their own sake. Second, option grants have tax benefits for both the executive and the company. Third, the options do not affect profitability since they are not being paid out, while also creating incentive for the executive to perform. Fourth, they attract and retain good employees due to the forward looking nature of the forward, and the fifth reason which is related is that if there is a bull market, the stock options will look very good to employees (Lord, Saito. 2010). It can now be seen that restricted stock grants are a larger part of compensation packages than salaries. Restricted stock grants are options set in the future if certain performance goals are met. From 1994 – 2007, the average compensation for a CEO more than doubled from $1.18 million to $2.8 million in real 1994 dollars (Lord, Saito. 2010. P. 43).The salaries in 1994 accounted for 51% and in 2000 only accounted for 25%, with option grants moving from 18-32% (Lord, Saito. 2010). This can be seen as creating tax breaks, as well as long term focus on compensation packages which will maintain strong relationships with employees.

``Some studies find evidence of a small shift of compensation from salaries and bonuses toward performance-based compensation (stocks and options), which translates into a slight increase in the sensitivity of pay to performance``(Jarque. 2008. P. 267). Although the compensation of CEO`s is increasing, they are now more closely tied to the performance of the company due to the majority of their pay being in the form of stock options. A major proportion of the package consists of restricted stock grants, so now the interests of the executives are directly linked to those of the shareholder. This also helps avoid moral hazard, because any actions that the CEO makes, will a affect the company and come full circle to affect the CEO``s stock options. (Jarque. 2008). Jensen and Murphy have documented that over the least two decades there has been a sharp increase in the sensitivity of pay related to company performance, and that it has increased across firms of all sizes (Jarque. 2008). Finally, the last link to the pull away of salary compensation has to do with regulation. In 1993, a regulation was introduced that limited the tax deductions for salaries over 1 million dollars, but the law granted the exception of performance based incentives, which is why other non salary incentives have been increased.

In recent years there have also been some high profile scandals that have rocked the corporate governance world. Fraudulent business practices have leaded the way to new reforms and laws.
The Sarbanes-Oxley Act (2002) has been put in place to restore the faith in publicly held companies. It has enacted changes to compensation packages and put restrictions on personal loans that executives can take, which was widely practiced. After the act was put in place, organizations set up review boards to audit the compensation packages of their executives to ensure that the execs were not overstating earnings in order to increase their compensation (Bruvik, Gibson. 2011. P. 78). The Emergency Economic Stabilization Act also established a fund called the Trouble Asset Relief Program (TARP), which restricted bonuses, limited golden parachutes (severance packages), denied benefits to overly risky executives, and clawed back bonuses received through faulty financial statements (Bruvik, Gibson. 2011. P. 79). The trend here is to finally restrict what CEO`s are making and restore public confidence in publicly held companies.

An Effective Executive Compensation Plan
An effective executive compensation plan is one that can adequately motivate the employee to perform with the best intentions of the company. The plan should utilize a base salary and increase it with the complexity of the job function and performance. Bonuses should be awarded for achieving short term objectives, and long term incentives like options or formulas to calculate bonuses should also be in place. (Fisher. 1995). These can all be grouped into the ``say on pay`` rule, where as the shareholders vote for the best terms. If the terms are fair, it should attract talented employees and satisfy their short term and long term goals. I believe that this would be the best practice to use in Canada.
References
Bruvik, K., & Gibson, J, W. (2011). THE PAST, PRESENT AND FUTURE OF EXECUTIVE COMPENSATION. Business Studies Journal. 3(1)69-83.
Retrieved from: http://web.ebscohost.com.libezproxy.nait.ca/ehost/detail?vid=3&sid=8f7e3b1a-029d-4e51-8c7b-8f6c8b628e48%40sessionmgr112&hid=121&bdata=JnNpdGU9ZWhvc3QtbGl2ZSZzY29wZT1zaXRl#db=bth&AN=69719245
Lord, R., & Saito, Y. (2010). Trends in CEO Compensation and Equity Holdings for S&P 1500 Firms: 1994-1997. Journal of Applied Finance. 20(2)40-56.
Retrieved from: http://web.ebscohost.com.libezproxy.nait.ca/ehost/detail?vid=3&sid=9c872b2a-f502-4749-b6ca-6fe87df4e31d%40sessionmgr115&hid=121&bdata=JnNpdGU9ZWhvc3QtbGl2ZSZzY29wZT1zaXRl#db=bth&AN=55520134
Jarque, A. (2008). CEO Compensation: Trends, Market Changes, and Regulation. Economic Quarterly. 94(3)265-300. Retrieved from: http://web.ebscohost.com.libezproxy.nait.ca/ehost/detail?vid=3&sid=f011634d-5fba-4f03-b524-d752cb3954b9%40sessionmgr112&hid=121&bdata=JnNpdGU9ZWhvc3QtbGl2ZSZzY29wZT1zaXRl#db=bth&AN=35893963
Patton, A., & Lack, J. (1967). Executive Compensation: Trends Here and Abroad. McKinsey Quarterly. 4(2)22-28. Retrieved from:http://web.ebscohost.com.libezproxy.nait.ca/ehost/detail?vid=3&sid=8f7e3b1a-029d-4e51-8c7b-8f6c8b628e48%40sessionmgr112&hid=121&bdata=JnNpdGU9ZWhvc3QtbGl2ZSZzY29wZT1zaXRl#db=bth&AN=7098148
Fisher, J. (1995). How Effective Executive compensation Plans Work. CMA Magazine. 69(5)36-39. Retrieved from: http://search.proquest.com.libezproxy.nait.ca/cbcacomplete/docview/197820197/1410917C8DA45738502/1?accountid=12654

References: Bruvik, K., & Gibson, J, W. (2011). THE PAST, PRESENT AND FUTURE OF EXECUTIVE COMPENSATION. Business Studies Journal. 3(1)69-83. Retrieved from: http://web.ebscohost.com.libezproxy.nait.ca/ehost/detail?vid=3&sid=8f7e3b1a-029d-4e51-8c7b-8f6c8b628e48%40sessionmgr112&hid=121&bdata=JnNpdGU9ZWhvc3QtbGl2ZSZzY29wZT1zaXRl#db=bth&AN=69719245 Lord, R., & Saito, Y. (2010). Trends in CEO Compensation and Equity Holdings for S&P 1500 Firms: 1994-1997. Journal of Applied Finance. 20(2)40-56. Retrieved from: http://web.ebscohost.com.libezproxy.nait.ca/ehost/detail?vid=3&sid=9c872b2a-f502-4749-b6ca-6fe87df4e31d%40sessionmgr115&hid=121&bdata=JnNpdGU9ZWhvc3QtbGl2ZSZzY29wZT1zaXRl#db=bth&AN=55520134 Jarque, A. (2008). CEO Compensation: Trends, Market Changes, and Regulation. Economic Quarterly. 94(3)265-300. Retrieved from: http://web.ebscohost.com.libezproxy.nait.ca/ehost/detail?vid=3&sid=f011634d-5fba-4f03-b524-d752cb3954b9%40sessionmgr112&hid=121&bdata=JnNpdGU9ZWhvc3QtbGl2ZSZzY29wZT1zaXRl#db=bth&AN=35893963 Patton, A., & Lack, J. (1967). Executive Compensation: Trends Here and Abroad. McKinsey Quarterly. 4(2)22-28. Retrieved from:http://web.ebscohost.com.libezproxy.nait.ca/ehost/detail?vid=3&sid=8f7e3b1a-029d-4e51-8c7b-8f6c8b628e48%40sessionmgr112&hid=121&bdata=JnNpdGU9ZWhvc3QtbGl2ZSZzY29wZT1zaXRl#db=bth&AN=7098148 Fisher, J. (1995). How Effective Executive compensation Plans Work. CMA Magazine. 69(5)36-39. Retrieved from: http://search.proquest.com.libezproxy.nait.ca/cbcacomplete/docview/197820197/1410917C8DA45738502/1?accountid=12654