Employee Compensation
Executive Compensation: An agency problem:
The globalized world of today has seen many scandals derived from the compensation schemes that are granted to top-level executives from their respective organizations. The compensation policies put in place in organizations are a result of a fundamental agency problem, the problem being that of the principal and the agent relationship. The issue arises due to the principal who hires the agent to perform day-to-day management tasks and oversee operations; the principal cannot directly monitor the performance of the agent and how well the agent’s efforts translate into that of the company’s performance. However, the principal still has to compensate the agent on a yearly basis regardless of management effort. The separation of ownership and control is the root cause of the agency problem.
The owners of a firm cannot directly monitor management efforts, and the agent’s performance is not directly related to that of the company’s performance in a semi-strong market form. The question then becomes how are top tier managers compensated when in reality their performance cannot be measured in a timely and an accurate manner.
Thus the executive compensation as stated in the text is an “agency contract between the firm and its manager that attempts to align the interest of the owners and the managers by basing the managers compensation on one or more measures of the manager’s performance.” This alignment of interest is key in ensuring that the manager acts in a manner that best benefits its shareholders. However, streamlining company profitability into that of manager compensation leads to opportunistic behaviour by the manager. On the other side of the coin, not paying managers enough and not streamlining managers’ compensation with profitability will lead to information asymmetry in the form of moral hazard. Moral hazard, in the aforementioned context means that managers will shirk from performing their duties, as they are
The globalized world of today has seen many scandals derived from the compensation schemes that are granted to top-level executives from their respective organizations. The compensation policies put in place in organizations are a result of a fundamental agency problem, the problem being that of the principal and the agent relationship. The issue arises due to the principal who hires the agent to perform day-to-day management tasks and oversee operations; the principal cannot directly monitor the performance of the agent and how well the agent’s efforts translate into that of the company’s performance. However, the principal still has to compensate the agent on a yearly basis regardless of management effort. The separation of ownership and control is the root cause of the agency problem.
The owners of a firm cannot directly monitor management efforts, and the agent’s performance is not directly related to that of the company’s performance in a semi-strong market form. The question then becomes how are top tier managers compensated when in reality their performance cannot be measured in a timely and an accurate manner.
Thus the executive compensation as stated in the text is an “agency contract between the firm and its manager that attempts to align the interest of the owners and the managers by basing the managers compensation on one or more measures of the manager’s performance.” This alignment of interest is key in ensuring that the manager acts in a manner that best benefits its shareholders. However, streamlining company profitability into that of manager compensation leads to opportunistic behaviour by the manager. On the other side of the coin, not paying managers enough and not streamlining managers’ compensation with profitability will lead to information asymmetry in the form of moral hazard. Moral hazard, in the aforementioned context means that managers will shirk from performing their duties, as they are