Week 11 - Executive compensation Flashcards
2 views on Executive compensation
-
Optimal contracting
- compensation is set optimally and designed to address PRINCIPAL-AGENT problems
- executives work in the BEST INTERESTS of the SHAREHOLDERS
» on average tends to be this view, but there are some instances of rent ext. view -
Rent extraction {suboptimal}
- the EXECUTIVES are in control of the board and can design their own compensation contract/policies that BENEFIT THEMSELVES
- executive pay comes at the EXPENSE of the shareholders
Typical executive incentive-compensation package
- base salary
- short-term incentive plan (typically paid in cash + subjective bonus)
- long-term incentive plan (typically paid in equity)
- other pay
eg. pension, perquisites, severance pay, STOCK OWNERSHIP GUIDELINES (where the “incentives” are for most executives; but NOT reported in the compensation table, hence the table might be misleading)
3 benefits of such High stock ownership for CEOs (where their INCENTIVES lie)
- Resolve issues of NONCONGRUITY
ie. measures changes in shareholder value directly
» share price is the most congruent measure since giving shares to the CEO is the most direct way to align CEO interests to interests of the firm - Resolve issues of RISK
- huge upside potential, which a manager can control to some extent
» shifting risks to executives, who can influence the risks - Resolve MYOPIA PROBLEMS
ie. share price is the MOST LONG-TERM MEASURE there is, as it is based on expectations of future firm value
» share price is VERY SENSITIVE to long-term decisions
» using targets can make CEOs become myopic
2 reasons why executives potentially value the high stock ownership incentives “differently”
Depends on executives’ level of RISK AVERSION!
- 100 billion in shares {market value} ≠ 100 billion in cash
ie. selling so many shares will crash the share price - There exists significant UNCERTAINTY around the VALUE of share- and options-based compensation
Considerations in valuing executive compensation {by CEOs}
The more RISK AVERSE, the LOWER VALUE you attach to the options b/c all their wealth are in the firm, ie. NOT DIVERSIFIED {not allowed to sell?} and so exposed to risk.
- Need a LARGE RISK PREMIUM to compensate CEOs for the large amount of risk they are exposed to, for them to accept the risky contract with uncertain payoffs
- therefore, the subjective value can differ a lot from the “objective” value
Pay = Risk-adjusted pay + Risk premium
What 3 factors does risk premium depend on?
After removing risk premium, salaries are more or less similar globally.
Thus, most of CEO pay is “pay for RISK”
Risk premium
1. Risk aversion
2. Constrained wealth (%)
^^cannot observe exact value but can make assumptions
3. Riskiness of EQUITY INCENTIVES {ie. how risky the firm is, can be estimated}
If most of CEO pay is “pay for risk”,…
1. If equity shares are the main incentive vehicle to compensate for risk, then why do the majority of executives still have these COMPLEX INCENTIVE PLANS? ie. the role of “small” bonus plans?
eg. why do firms bother with all the small incentives like bonuses for executives if already have many incentives in place such as $1m shares?
- “small” executive cash bonuses have individual incentives (to change individual BEHAVIOUR) + to incentivise entire TEAM and other managers
- used to encourage mutual monitoring and to facilitate coordination across the top management team as a whole - if bonuses gave individual incentives, their importance would not expect to decrease over a CEO’s tenure…
- …thus, primarily included to make the incentives more CREDIBLE for other employees throughout the org, again for coordination purposes
*note that payments related to these incentives are reported in the summary compensation table
If most of CEO pay is “pay for risk”,…
2. How SENSITIVE is pay to changes in risk? Why? (Gabaix and Landier, 2010)
Very sensitive.
- between 1980 and 2003, the sixfold increase in US CEO pay matched the sixfold increase in firm size (market capitalisation) during that time
Why?
- can HIRE BETTER CEOs by paying more
- although some individuals might just be SLIGHTLY better than others, these small differences are magnified by firm size -> making large sums of pay worth it
-> “economics of superstars”, similar logic applies to top sports players, ie. best football players are paid much more money b/c everyone wants them although they might only be marginally better than the 5th best player
- therefore, very small difference in outcomes can have HUGE IMPLICATIONS for LARGE FIRMS
- the model suggests that the best CEO (compared to the 250th best) can “only” add 0.016% to the firm’s market value, but for Apple this is still ~475 million (almost half a billion!)
How do we determine the LEVEL of CEO pay?
COMPENSATION BENCHMARKING to the MARKET LEVEL of pay
= firms consider the pay levels of other firms
» this is different from RPE, which is benchmarking performance
» may use same/diff. firms since compensation is primarily about labour market while performance evaluation is about product market
How do we determine the LEVEL of CEO pay? ref. to the papers (Gabaix and Landier, 2010) + (Bizjak et al., 2008)
- CEO pay & the Lake Wobegon effect
- no firm wants to admit paying below average compensation but always say paying average (or higher), so there will always be another firm paying higher than that benchmark…
- …then another firm pays higher that THAT firm as a benchmark etc. -> compensation will MECHANICALLY INCREASE for bad reasons -
Rent extraction perspective
- another study argues that benchmarking is simply a rent extraction tool for executives to justify INCREASING OWN SALARY by benchmarking against companies that pay HIGHER - (Bizjak et al., 2008) High salaries are necessary and OPTIMAL to pay to RETAINING good CEOs
^opposing view to rent extraction - (Gabaix and Landier, 2010)
- if {only} 10% of firms want to pay their CEO only HALF as much as their competitors, then the composition of all CEOs decreases by 9%
- however, if 10% of firms want to pay their CEO TWICE as much as their competitors, then the compensation of all CEOs doubles
