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Corp. Governance and CSR > Subject 2: Executive Compensation > Flashcards

Subject 2: Executive Compensation Flashcards

1
Q

What are the main components of executive compensation?

A

Base salary, (short-term) bonuses, long-term incentives, retirement benefits, and additional perks.

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2
Q

Why has base salary become a less significant part of total executive pay?

A

Companies increasingly emphasize performance-linked incentives to better align with shareholder interests.

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3
Q

What is the purpose of executive bonuses?

A

Bonuses are short-term incentives based on achieving specific performance targets, usually linked to financial metrics.

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4
Q

How do long-term incentives like stock options align executives with shareholders?

A

They encourage executives to increase the company’s long-term value, as their wealth is tied to stock performance.

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5
Q

What risk is associated with using stock options as part of executive compensation?

A

Stock options can encourage excessive risk-taking, as executives may favor high-risk strategies for potentially high rewards.

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6
Q

What are some common performance metrics used to determine executive pay?

A

Metrics include earnings, EBIT, stock price, customer satisfaction, and product development.

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7
Q

Why are accounting-based metrics considered problematic in executive compensation?

A

They are backward-looking and susceptible to manipulation, which may not accurately reflect executive effort.

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8
Q

How does stock price serve as a performance measure in executive compensation?

A

Stock price is forward-looking and harder to manipulate, although it may not solely reflect management’s performance.

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9
Q

What is pay-for-performance?

A

A compensation model that ties executive pay to the achievement of specific performance goals.

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10
Q

What is the principal-agent problem in executive compensation?

A

It refers to the misalignment of interests between shareholders (principals) and managers (agents) due to differing incentives.

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11
Q

Define “pay-for-luck” in executive compensation.

A

When executive pay increases due to favorable external circumstances unrelated to their performance, like changes in commodity prices.

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12
Q

What is “skimming” in executive compensation?

A

It’s when CEOs influence pay processes to increase their compensation opportunistically, especially when external conditions are favorable.

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13
Q

Why might stock options lead to excessive risk-taking?

A

They reward executives for stock price increases, incentivizing high-risk strategies for potentially high returns.

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14
Q

What are restricted stocks, and how do they differ from stock options?

A

Restricted stocks are shares that cannot be traded for a set period, directly linking executive wealth to the firm’s performance.

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15
Q

How do compensation committees impact executive pay?

A

They set pay levels and structures, ideally to ensure fairness, though social ties can sometimes limit their objectivity.

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16
Q

What governance mechanisms reduce pay-for-luck?

A

Stronger governance, such as large shareholders on the board and smaller boards, reduces the likelihood of executives benefiting for luck.

17
Q

How can a CEO’s ability to “skim” pay be mitigated?

A

Effective governance and transparency in compensation processes limit the potential for CEOs to opportunistically increase their pay.

18
Q

Why is the sensitivity of executive pay to performance often low?

A

Due to weak ties between pay and shareholder wealth gains, with studies showing small increases in executive wealth relative to firm performance.

19
Q

How does CEO compensation respond to shareholder wealth changes?

A

Studies, like Jensen and Murphy (1990), show only a small increase in CEO wealth per $1,000 increase in shareholder wealth.

20
Q

What is the “incentive zone” in bonus plans?

A

A range within which performance increases can earn executives higher bonuses, while poor performance limits or eliminates bonus payouts.

21
Q

Explain the role of non-monetary benefits in executive compensation.

A

These include perks like insurance, retirement benefits, and sabbaticals, adding value to the total compensation package.

22
Q

Why might a CEO be rewarded during an industry boom unrelated to their actions?

A

External factors like market trends can raise firm profits, leading to higher pay even without direct contributions from the CEO.

23
Q

How does board independence influence executive pay?

A

Independent directors are less likely to have social ties with the CEO, making them more objective in setting compensation.

24
Q

What problem arises from directors’ reluctance to oppose the CEO on pay issues?

A

It can lead to excessive compensation packages that don’t align with company performance.

25
Q

How does CEO compensation relate to shareholder value in large firms?

A

Research shows that pay-performance sensitivity is often lower in large firms, where managerial wealth increases only modestly with shareholder wealth.

26
Q

What is meant by “managerial human capital”?

A

It refers to the unique skills and knowledge a manager brings to the company, which is often not easily transferable.

27
Q

Why might governance reduce “pay-for-luck”?

A

Good governance limits the CEO’s ability to manipulate pay to reflect external positive outcomes unrelated to their performance.

28
Q

Why is performance-based compensation often controversial?

A

Because it can be difficult to separate true managerial effort from results driven by luck or external factors.

29
Q

How does shareholder activism influence executive compensation?

A

Shareholders can pressure boards to establish pay structures that better align with performance, reducing excess pay and skimming.

30
Q

What impact do industry conditions have on CEO pay?

A

Industry booms or downturns can affect CEO pay, sometimes rewarding or penalizing them based on market factors beyond their control.

31
Q

What role does benchmarking play in setting executive base salaries?

A

Benchmarking uses industry standards to determine appropriate pay levels for executives, especially at peer companies.

32
Q

How do CEOs benefit from non-discretionary vs. discretionary compensation during lucky periods?

A

Both types can increase due to luck, but discretionary compensation (bonuses) can be adjusted to reflect performance perceptions.

33
Q

What is the main takeaway from Bertrand and Mullainathan’s findings on CEO pay?

A

CEOs are often rewarded for lucky outcomes as much as for actual performance, but strong governance can mitigate this trend.

34
Q

Why is it challenging to separate luck from genuine performance in CEO pay?

A

Many factors influencing a company’s success are external, making it difficult to attribute specific outcomes to CEO actions alone.

Corp. Governance and CSR (5 decks)

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