3. Executive Compensation Flashcards
Why has Executive Compensation Attracted So Much Attention?
- Executive pay is large.
- Issue of fairness.
- Concerns over whether they merit it
Equity and Efficiency
- Is it fair that executives get paid so much more than employees? This is what attracts attention.
- Senior executives have a bigger impact on firm performance than junior employees.
- Does executive pay motivate intended behaviour? Do senior executives deserve their pay? Looking at this
How can we frame the debate of executive compensation?
- Optimal contracting perspective v managerial power perspective
What are the LOs of Framing the Debate?
- Explain the role of executive compensation as a corporate governance device.
- Explain the optimal contracting v managerial power debate
What is the Optimal Contracting Perspective and why are compensation contracts are designed?
- Create financial incentives to reduce moral hazard in a principal-agent relationship.
- Compensation contracts are designed to satisfy a manager’s participation constraint and incentive compatibility constraint.
OCC: What are the exec remuneration contracts targets?
- Attract talented individuals to a post (satisfies participation constraint)
- Motivate managers to make decisions and take actions that maximise shareholder value (satisfies incentive compatibility constraint)
- Reward managers for maximising shareholder value.
OCC: State-Contingent Contracts
- Not possible
- Pay packages contain components that link rewards to outcomes
E.g. provide high-powered incentives
OCC: Stage Contingent Contract Definition
- Agreement which states actions under certain conditions will result in certain outcomes.
Framing Debate: Managerial Power Perspective
- Senior executives use their power to influence how much they are paid and pay compensation.
- Managers receive: pay for non-performance and hidden pay
- Greater managerial power results in greater excess pay e.g. rent extraction.
Executive Remuneration in Managerial Power Perspective
- In excess of that required to attract talented individuals to a post.
- In excess of that required to motivate managers.
- Is weakly related to firm value.
What is the Pay-Performance Relationship in Optimal Contracting Perspective?
- Predicts a strong pay-performance relationship e.g. reduce the agency problem managers pay is sensitive to share value.
What is the Pay-Performance Relationship in Managerial Power Perspective?
- Predicts a weak-pay performance relationship e.g. managers extract rents that have no sensitivity to share value.
What do empirical studies concerned with in pay-performance relationship?
- Determine and quantifying the pay-performance relationship.
What are the components of executive compensation packages?
- Golden hello
- Salary
- Bonus
- Executive stock option (ESO)
- Restricted Stock
- Long-Term Incentive Plan
- Golden Parachute
LOs of the Components of Exec Compensation Packages
- Explain different components of executive pay packages
- Explain how components of executive pay packages impact on incentives.
Components of Exec Comp: Golden Hello
- Lump-sum cash signing on payment.
- Used to attract talent
- Induces an individual to take a post, and shows the hiring firm’s commitment to an individual.
- Compensates an individual if they will have to give up rights to unvested stock or options.
- Not performance-related and provides no retention incentives.
Components of Exec Comp: Salary
- Fixed pay awarded over a given period.
- Executive is insured against fluctuating firm performance - attractive to risk-averse executives because they are bearing no risk.
- To induce effort managers must bear risk and be compensated for bearing risk.
Components of Exec Comp: Bonus
- Can be paid in cash or shares.
- Linked to accounting performance (sales, profits, EPS) or other metrics important to the firm (CPS, safety)
- Usually a bonus hurdle and bonus gap with pay increasing with performance between these levels (incentive zone)
- If alignment is successful, value of bonus paid should be related to performance target.
- Below bonus hurdle incentive to inflate performance, above bonus cap incentive to slacken off or defer achievement to next period.
Components of Exec Comp: Executive Stock Options (ESOs)
- Option to buy stock at some future date at a price (exercise price) close to the market price at the time granted.
- Normally a 7-year exercise window starts from 3 years after they have been granted.
- Return = (Current Market Price - Exercise Price) - Transaction Costs)
- If the share price is below exercise price, the manager does not have to bear the loss.
Components of Exec Comp: ESO Incentives
- Execs do not bear downside risk, only upside gains.
- R’ship between SO’s and share price is non-linear, it is convex - magnifying the upside returns to ESOs
- Provides risk-taking incentives to risk averse and loss averse execs.
Components of Exec Comp: Comparing Stock and Stock Option Incentives
- If exec is paid with stock, the relationship between CEO pay and stock price is linear.
- If an exec is paid with stock options the relationship between CEO pay and stock price is convex.
Components of Exec Comp: Problems with ESO
- Potential for exploitation (rent-seeking) by self-serving execs e.g. spring load.
- No penalty for underperformance.
- Pump and dump - artificially inflating price before buying and selling.
- When strike price is ‘in-the-money or ‘out-of-the-money, execs’ incentives could be distorted,
Components of Exec Comp: Long Term Incentive Plans
- Deferred payment of stock and/or cash when relative performance reached over a specified period of time.
- Award of stock may be subject to trading restrictions in the short-term,.
- After shares are awarded, manager exposed to down-side risk.
- Incentive for executives to create longer-term performance gains.
Components of Exec Comp: Problems with Long Term Incentive Plans
- Complicated and less transparent than bonuses and ESOs - potential for execs to exert managerial power over pay.
- Award linked to relative stock performance per se, so awards can be made even when the stock price is falling.
Components of Exec Comp: Restricted Stock
- Issuing stock with restrictions on trading (usually 2-3 years)
- Sometimes linked to performance targets, vest when targets met.
- Manager bears potential downside risk.
Components of Exec Comp: Severance Pay (Golden Parachutes)
- Rewards execs who have taken risky that have not paid off.
- Discourages entrenchment and encourages under-performing execs to leave
- Discourages under-performing execs from entrenching themselves and fighting a takeover.
- Perceived as a reward for failure.
Components of Exec Comp: Share of Pay Components for FTSE100 CEOs in 2021
- Base pay = 22%
- Long-Term Incentive Bonus = 38%
- Bonus = 34%
- Pension = 3%
- Benefits = 2%
Components of Exec Comp: Summary of Points
- High-powered incentives link pay to performance, execs must bear risk.
- Stock-related performance is determined by firm-specific factors in managers’ control and industry and market factors outside managers’ control.
- Relative performance filters out factors beyond executives’ control.
Relationship Between Exec Comp and Firm Behaviour LOs
- Understand how to determine and quantify the pay-performance relationship in a simple empirical model.
- Examine evidence concerning the impact of exec compensation components on performance, acquisitions, divestments.
Empirical Model Pay-Performance Relationship
- Estimate variations of the following empirical model.
- See notebook
Notations of Empirical Model for Pay-Performance Relationship
- Beta1 measures the pay-performance relationship % return
- Beta2 measures the pay-relative performance relationship % return
- Beta3 measures the pay-size relationship (elasticity)
- Control Variables can include person and firm characteristics.
- Key issues for estimating this model are measuring pay and performance.
The relationship between executive compensation and firm behaviour: Salary Performance (Evidence)
- Early evidence on executive pay:
Measured pay using salary + bonus only
Weak pay-performance relationships often reported
Strong pay-firm size relationship - Early studies found it difficult to obtain data on equity and options, impacting on sensitivity of estimates.
The relationship between executive compensation and firm behaviour: Bonus Performance (Evidence)
- Fattorusso et al 2007 find no link between bonus (short-term rewards) and shareholder return - consistent with managerial power perspective.
- Find no link between transparency measures and the odds of a bonus payout - not consistent with managerial power perspective.
The relationship between executive compensation and firm behaviour ESOs Performance (Evidence)
- Studies show ESOs result in strong pay-performance relationship
- e.g. main et al 1986 found a 10% increase in shareholder wealth led to a 7.2% increase in CEO Total pay package.
- e.g. Hanlon et al 2003 found that $1 of ESO grant is associated with the generation $3.71 of operating income over the five years after the ESO grant.
- Consistent with optimal contracting perspective.
The relationship between executive compensation and firm behaviour: LTIP Performance (Evidence)
- Buck et al 2003 find that LTIPs increase so does total compensation (managers being compensated for bearing more risk)
- LTIP reduce pay-performance sensitivity
- e.g. excluding LTIps a $1K increase in shareholder wealth is associated with 1.81p increase in CEO pay
- Including LTIPs this falls to $1.55p
- Consistent with LTIPs being part of the agency problem.
The relationship between executive compensation and firm behaviour: Acquisitions
- Sanders 2001 find that structure of pay package impacts on acquisition behaviour.
- Firms whose CEOs are compensated with ESO are more likely to engage in acquisitions and divestments.
- Firms whose CEOs own shares are less likely to engage in acquisitions and divestments.
The relationship between executive compensation and firm behaviour: Acquisitions of firms that adopt general partners
- Bebchuk et al 2014 find that firms experience a negative impact on stock returns when they are adopted.
- Associated with higher acquisition premiums
- Overall negative effect on shareholder wealth.
- Consistent with managerial power perspective.
The relationship between executive compensation and firm behaviour: Divestment
- Way of reducing the scale and scope of a firm’s activities if it has grown beyond its optimal size and scope.
- Haynes, Thompson and Wright 2007 find that CEOs are not directly awarded for voluntarily downsizing their firms via divestment.
- Find a strong pay-size relationship
- Little incentive for CEOs to voluntarily downsize.
How do we assess executive compensation as a governance device?
- Overarching framework: Optimal Contracting v Managerial Power
- Consider theoretical arguments and what arguments the evidence is consistent with.
- Impact of various pay components on behaviour.
- How performance and pay are measured matters.
- In practice, pay reflects individual and firm characteristics.
