Executive Compensation is a broad term for the financial compensation awarded to a firm’s executives. Executive Compensation packages are designed by a company’s Board of Directors, typically by the Compensation Committee consisting of independent directors, with the purpose of incentivizing the executive team, who have a significant impact on company strategy, decision-making, and value creation (Pay for Performance) as well as enhancing Executive Retention. Corporate executives have been receiving immense compensation packages specifically in the form of stock options. The purpose of the incentives is to align the goals of executives and stakeholders. Although theory encourages desirable behaviour, many a time executives take advantage of their governing position and engage in fraudulent activity to increase personal wealth at the expense of the corporations’ shareholders.
Organizations approach decisions about executive compensation in their own ways, and the way an organization does so depends on its circumstances, what it can afford, and the values and beliefs that drive its decisions about executive pay. Trustees and CEOs make decisions they think are best for their organizations.
2.0 FACTORS CONTRIBUTING TO EXECUTIVE COMPENSATION
2.1 Hiring The Best
The intentions begin with the board’s decision to hire exceptionally talented, highly experienced executives and continue with the board’s willingness to pay the salary required to hire and retain them. External recruiting tends to drive pay up. When organizations recruit seasoned executives from other, similarly sized organizations, they generally need to pay well above average, more than they would need to pay to promote an internal candidate.
2.2 Retention Factor
The intent to pay competitively drives up salary even for internally promoted executives and incumbents, however. Organizations whose policy is to pay at median increase pay faster than the rate of inflation for any executive paid less than median, and organizations whose policy is to pay at the 75th percentile continuously increase executives’ pay to stay ahead of the pack.
2.3 Performance Factor
The intent to pay above average in expectation of above-average performance drives up pay for all executives, whether or not they .Standard salary administration practices call for bringing salaries up to the intended level within a few years, as long as the incumbent performs reasonably well. Furthermore, incentive plans tend to reward institutional performance more than individual performance, so even average performers end up being paid above average.
3.0 CHARACTERISTICS OF EXECUTIVE COMPENSATION
3.1 Pay Packages
Executive pay packages differ substantially from typical salaried or hourly employee compensation because unlike typical employee pay, the vast majority of an executive’s pay is contingent compensation and structured only to reward the executive for actual, positive company performance and growth in shareholder value. To this end, executive compensation packages typically utilize six distinct compensation components includes base Salary, Short-Term Incentive, Long-Term Incentive, Employee Benefits, Perquisites and Severance/Change-in-Control Payments. A company’s Compensation Committee will structure their executive’s pay packages utilizing a combination of the above components to help achieve the company’s Pay for Performance and/or Retention objectives.
A core attribute of most Equity Compensation is the concept of vesting, which conditions the full ownership of the equity awards on the employee’s compliance with certain covenants. The vesting terms reinforce the incentive objective of equity awards by promoting retention while providing the employee with a disincentive to engage in certain detrimental behaviors during a set time period. These covenants typically come in two forms. The first form requires an employee to retain all or a portion of awarded shares until the employee reaches prescribed levels of stock ownership (ownership guidelines), reinforcing the link to shareholders. The second covenant requires a forfeiture of the shares if the employee elects to engage in certain detrimental behaviors during a specified period of time. (Perel, 2003). The most common of these are the conditions on restricted stock, which require employees to remain employed with the company for a certain period of time after the shares are awarded, but before the shares vest and provide full ownership. If an employee voluntarily leaves the company during the restriction period to work elsewhere, typically, the employee forfeits the opportunity to obtain full ownership of the shares. The result is different for an employee who retires from a company and continues to honor the covenants during the vesting period. In retirement, the company may prorate the vesting of unvested shares based on the amount of time since the award was granted or allow all outstanding restricted stock to continue to vest in retirement, giving the retiring employee greater ownership after the restricted period. (Bebchuk & Fried, 2003).
3.3 Equity Compensation
The majority of compensation of most executive pay packages comes in the form of equity, typically company stock or a derivative form of company stock. Equity compensation provides a strong incentive because it is based on the relationship between the value of the award and the performance of a company’s stock price. As the value of the company increases, the value of the equity increases, providing an incentive for the executive to strive to increase the company’s success and boost its market value. There are three primary types of Equity which are used in Executive Compensation:
Stock Options: A stock option gives the holder the right to purchase a share of company stock at a particular price for a set period of time, usually 10 years. The price at which the options may be “exercised” is usually the price of the company’s stock on the date the options are granted. If the company performs well, the stock price will increase over the exercise price, giving the options value and rewarding the executive for his role in the company’s success. Typically, such options may not be exercised for a period of time, usually between one and five years, before they “vest,” or can be exercised.
Restricted Stock: Shares of company stock which, despite being awarded as compensation, are not sellable by the recipient until a vesting schedule is completed. Although unable to sell shares of Restricted Stock before the vesting schedule is complete, owners enjoy all the other benefits of stock ownership, such as voting rights and dividends. If the executive leaves before the stock vests, the stock is forfeited. Restricted Stock is taxed on the amount received on the vesting date based on the closing market value of stock price. (Bebchuk & Grinstein, 2005)
Restricted Stock Units (RSUs) are a similar performing compensation tool as Restricted Stock RSUs represent a promise by an employer to pay an employee a certain number of company shares upon the completion of a vesting schedule and offer several distinct advantages compared with Restricted Stock. First, employers can issue RSUs without diluting the share base. Second, in issuing RSUs Company administrative costs tend to be lower because there are no actual shares to issue, hold, record, and track. And third, RSUs can make tax deferrals easier by simply delaying actual share issuance. Because RSUs represent a promise of future shares, owners of RSUs do not enjoy any rights of stock ownership.
Performance Shares: Shares of company stock awarded over a performance period if specific performance measures are attained. There are two types of performance measures: performance conditions and market conditions. Performance conditions are financial goals, like earnings-per-share or return-on-equity. Market Conditions on the other hand compare company performance to the market or a segment of the market, for example, total shareholder return v. peers. Performance periods are typically three years in duration with grants made on an almost annual basis resulting in overlapping performance periods. Performance shares receive differing accounting treatment depending on whether they are settled in cash or stock and whether they are a market or performance condition. (Matsumura & Shin, 2005).
4.0 FACTORS CONSIDERED FOR COMPENSTATION
4.1 Demand factor
The economic principle of supply and demand offers an explanation of the compensation market equilibrium. A job has economic value to the employer that created the position. The price to fill the position is determined by the forces of supply and demand (Perel, 2003). As with all other commodities, when the demand for a particular service increases, the price rises. If the supply of the commodity increases, the value of the service declines due to the abundance and competitive pricing. The position of an executive is not one that can be easily filled as it requires a certain degree of skill, experience, and knowledge of the industry resulting in a low level of supply. As demand for executives began to rise, firms increased their compensation packages in an attempt to keep talent within their firm. This increased wealth has escalated the reservation price of executives, specifically the older generation. As a result firms have to offer more in order to induce these individuals to work (Bebchuk &
5.0 PERFORMANCE AND COMPENSATION
The reputation of a CEO based on past performance directly correlates to compensation (Perel, 2003). Al Dunlap, also known as “Chainsaw Al” had the reputation of bringing a company in financial distress back on its feet, by making drastic changes in the company including massive layoffs, discontinuation of operations, and corporate restructuring. History shows that when Chainsaw Al was announced the CEO of a firm on the road to bankruptcy, stock prices experience vast increases. His reputation gave investors the confidence that the firm would become profitable once again.
CEOs of this influence do not come cheap, and firms are willing to grant generous compensation packages because of the investor confidence they bring along with them (Perel, 2003). In addition, the limited number of such CEOs enables them to demand higher levels of compensation (demand/supply: low supply = high cost). Unfortunately, paying this inflated level of compensation does not come with a guarantee that the reputable CEOs’ strategies/methodologies will be successful.
6.0 ETHICS AND STAKEHOLDER ANALYSIS
From the perspective of individual business ethics level, high compensation given to top executives may be justified due to the quality of people working in such sector and as part of their reward in fulfilling their job obligation. These top executive who are entitled to receive millions of dollar in bonus have done their job and create value for shareholder as well as enriching themselves, therefore they may see this bonus as nothing extraordinary. Top executive owning stock and stock options also losses most of the value during the crisis, highlighting that they also suffer from the crisis.
The coin flips when it comes to big organization. In the case of 2009 financial crisis in the US, investment banks failed and their stocks depreciated significantly up to 80% of its highest level. It was unethical for failing firms who receive government bailout to distribute bonus for its executives. It is unethical for a firm to pay bonuses while receiving help from taxpayer, though on the other side, it is unethical to defer bonuses that are obligated to executives. In this case, returning taxpayer money is a priority over distributing the bonuses. It is a fact that investment banks would fail without assistance from government and the bonuses would vanish with the firm. However, because of government decision to intervene in order to prevent further crisis, taxpayer become the most important stakeholder to be prioritized due to its good deed motives. Because of taxpayer position as the prominent stakeholder in the firms with government help; the government has a legitimate interest in the firm’s pay scheme. (Murphy, 2012) The ethical issue becomes association level as many investment banks go ahead and distribute huge amount of bonus and create an outrage among the public.
Current compensation schemes would be morally permissible if the voluntary actions of awarding such compensation harmonize with the voluntary actions of all stakeholders, providing justice is upheld (Micewski and Troy 2007, p. 22). However, high amounts of compensation linked to operational goals can encourage unethical behaviour to ensure continued pay levels and employment (Perel 2009, pp. 384, 386)
8.0 THEORIES AND FINDINGS
The utilitarian viewpoint is “concerned with consequences, as well as the greatest good for the greatest number of people” (Rodgers & Gago, 2003, p.191).This approach studies decisions in terms of benefits and harms it provides to stakeholders. The ethical decision is the one that results in the greatest benefit for the greatest number of stakeholders (Brooks, 2006). Under these circumstances excessive pay may be viewed as just if the receivers generate additional returns to the related stakeholders (Rodgers & Gago, 2003).This viewpoint makes an attempt to address the needs of all stakeholders, making investment more attractive.
8.2 Relativism theory
Relativism places moderate weight on liberty and equality.”Relativism is a meta-theory, which assumes that companies’ management uses themselves or the people around them as their basis for defining ethical standards” (Rodgers & Gago, 2003, p.191). Building on the independence issues discussed earlier, this approach would better align shareholder and executive self-interests thanks to the importance placed on outside stakeholder opinions. Under this approach, the same organization would have a different compensation policy in different geographical areas as the surrounding issues, rules, and laws between cities and countries differ. The compensation policy would reflect the majority stakeholders’ view of the importance of economic or social performances (Rodgers & Gago, 2003).
8.3 Virtue theory
The concept of fairness has a significant influence on the determination of appropriate compensation policies. Bender & Moir (2006) suggested several aspects of fairness that should be considered in determining equitable pay. Compensation committees fear of losing top talent due to uncompetitive remuneration. However the SEC disclosure requirements and an analysis of the demand and supply of CEO skills provide an accurate benchmark.
8.4 Egoist theory
The executive compensation policy is determined based on the perspective of the CEO, with little regard to the policy’s effect on stakeholders (Rodgers & Gago, 2003). Egoists are motivated to act in order to achieve their own short run interests. All related parties welfare is ignored in their pursuit unless their involvement will help attain the goals of the executives. Compensation packages are setup in a favorable light to executives giving an incentive to maximize profit at any expense.
An egoist corporate arrangement results when there is a lack of independence on the board of directors, giving the executives influential power over the corporation. The issue that is often omitted is that many directors also exhibit an agency problem, making it difficult for them to address the agency problem between shareholders and executives (Bebchuk & Fried, 2003). The title of a director is accompanied by a generous salary, prestige, and valuable business connections. Although boards of directors are established by the shareholders, CEOs play an important role in re-nominating directors back to the board, as well as determining directors’ perks and salaries. Therefore, directors have few reasons to oppose high executive pay if it falls within an acceptable region, as it would hurt their chances of being invited back to the company’s board (Matsumura & Shin, 2005). In addition, the fact that directors have minimal holdings in the subject corporation, gives them little incentive to oppose the CEO even if they viewed their director profile as unimportant (Bebchuk & Fried, 2003).
Pay between the executive team in a corporation must be perceived as fair. In this setting, pay is usually determined based on the relationship between pay and performance. Executives must be able to understand their pay differences by comparing their inputs to the corporation.
Executives must perceive their pay equitable in comparison to executive peers in comparable firms/industries. Executives will also expect to be paid better if their company performs better; else there will be a sense of inequity.
To avoid public outrage and ethical dilemma, company could defer the compensation of executives until the performance of the company itself improved and the bailout is paid. The amount of bonuses also should be capped to one third of total pay and must be paid in restricted stock. There is a proposal for incentive bonus to take form of only restricted stock and restricted stock options, which may not be sold or exercised until 2-4 years after leaving the company. It could be more effective in providing motivation for management to drive the firm with longer-term interest. (Romano & Bhagat, 2009)
Lastly, there should be an understanding amongst executives and employees compensation differences within the firm. It is understandable that the higher the position held in the corporate hierarchy the greater the compensation. Differences can be explained with regard to increased responsibility as well as greater skill, and education required to perform at that level. However, on average, executives are paid 209 times that of the average factory worker (Nichols & Subramaniam, 2001)
Public has been questioning the basis for executive’s high compensation in relation to firm performance. High compensation given to top executives has widened the gap of income inequality between top executives and the average Americans, leading to ethical issue if the pay is better distributed more equally among management levels and agency problem in the firm. Despite decades of research on executive pay, there are very many open questions, making it a ripe area for future research. Even seemingly fundamental questions, such as the causal effect of pay on from outcomes, and pay practices in private firms and for executives below the CEO, remain largely unanswered.
The values of the individual will determine whether or not unethical behaviour will surface. Many executives would not act unethically even if there was no chance of exposure. On the other hand, there are those that take every shortcut to reap personal benefits. Therefore, the root of this problem lies with individuals’ virtues and morals. Our surroundings have an impact on the things we value and the virtues we cultivate. It may be that in order to address these issues our society as a whole will needs to change.