Executive Compensation
Trevor Hunter
MOS 4422
Corporate Governance
King’s University College
Executive Compensation
 One of the most contentious governance
issues because it is hits at some of the most
basic human emotions:
 Greed
 Morality
 Envy
 Social justice
Executive Compensation
 The debate:
 Market forces determine pay vs. justifiable
compensation
 Need to pay for good talent vs. nobody is worth
that much
 CEOs earn their pay like everyone else vs. simply
lining their pockets at the expense of
workers/customers/shareholders
Executive Compensation
 My bias:
 Get all you can get – if the Board is stupid
enough or derelict enough in their duty to
allow you to get paid more than you deserve
than good for you
Executive Compensation
 Fuel for the fire1:
 Average 2010 pay for top 100 CEOs in Canada: $8.4
million – 27% more than 2009
 2010 average Canadian salary: $44,346 – 1.1% more
than 2009
 2010 minimum wage earner average salary: $19,798
 CEOs earned on average 189 times what their average
employee earned – in 1995 the difference was only 85
times
1Canada’s
CEO Elite 100, Hugh MacKenzie, Canadian Centre for Policy Alternatives. 2012
Executive Compensation
 Fuel for the fire:
 John Paulson, hedge fund manager, earns $4.9 billion in 2010,
while funds he manages are down nearly 50%2
 Other examples3:
Name
10-year Pay
10-year ROI performance
Ken Lewis, CEO, Bank of America
$180 million
-37%
Kenneth Chenault, CEO, Amex
$164 million
-50%
Louis Carey Camilleri, CEO, Altria Group
$135 million
+7%
Ivan G. Seidenberg, CEO,Verizon
$164 million
-54%
Jeffrey B. Immelt, CEO, GE
$126 million
-59%
2http://www.forbes.com/profile/john-paulson/
3 http://www.businessweek.com/investor/content/sep2009/pi20090923_783858.htm
Executive Compensation
 Types of compensation, reason for types
 Setting compensation
 Pay for performance
Executive Compensation
Purpose:
 You have to pay your senior executive –
there is a cost to the their adding value
 Attract and retain the best
 Reduce agency risk
 Provide incentives for them to perform to
the best of their abilities
Executive Compensation
Risk:
 You have to pay your senior executive –
there is a cost to the shareholders if they
don’t add value
 How do you make sure they act in the
shareholders’ best interest?
 The folly of hoping for “A” while rewarding
for “B”.
Executive Compensation
 One of the most important jobs of the BOD
is to set the compensation for the CEO and
senior executives in a way that minimizes
shareholder risk, encourages appropriate
behaviours and does not allow the CEO to
engage in activities that entrench themselves
Setting Executive Compensation4
Define a compensation policy that rewards not just
the achievement of goals but meeting the
philosophy of the goals:
Balance between short and long term objectives (reduces
risk of making cuts that increase short term share price but
negatively affect long term performance)
Indicate the amount of risk the Board is willing to take
(must differentiate between general industry risk and risktaking)
4Adapted
from: Charan, R., 2005, Boards that Deliver: Advancing Corporate Governance from Compliance
to Competitive Advantage. Jossey-Bass.
Setting Executive Compensation
Examples of considerations:
Strategy – profits or market share?
Resource allocation – to which areas of the
business should resources be allocated (sales –
short term; R&D – long term)?
Borrowing – What is the appropriate level of
debt?
People – are the right people being trained or
hired or retained?
Setting Executive Compensation
Set multiple objectives to achieve goals:
 Many pay for performance programs fail because
the objectives are too narrow and too far
removed from what the Board actually wants the
CEO to do
 One objective (i.e. Increasing shareholder return
or EPS) does not capture the range of behaviours
needed from executive to ensure sustained
performance
Setting Executive Compensation
Reflects mix of short and long term objectives –
single objectives can be manipulated too easily
Examples:
Short term
Improve operating cash flow by x% in one year
Meet specific margin and sales goals
Don’t let debt go beyond x level
Long term
Differentiate brand from competitors
Increase number of low-cost suppliers
Setting Executive Compensation
Set multiple objectives to achieve goals:
 Board should not indicate specific ways in which
objectives should be met
 Important to have objective, agreed to measures
of success to eliminate questions as to whether
they have been achieved
Setting Executive Compensation
Match objectives with cash and equity:
Compensation plans are most effective when the
time horizons are matched with those of the
objectives
Cash best used for annual objectives and equity for
long term
Balance is dependent upon industry and
environment
Setting Executive Compensation
Setting the cash component:
Often a combination of base salary and
performance bonus
There are tax implications regarding salary – in
the USA as of 1993, salaries of over $1million are
not tax deductable so you see many firms with
salaries at $1million but total compensation much
greater. Often additional cash is in the form of a
“guaranteed bonus”
Setting Executive Compensation
Setting the equity component:
Should have a long term orientation to avoid
punishing or rewarding CEO for uncontrollable
environmental factors
Equity instils a sense of ownership in CEO
matching her/his interests with those of
shareholders by making them shareholders –
eliminates agency risk
Setting Executive Compensation
Setting the equity component:
What sort of equity?
Stock options
Performance share units
Restricted share units
Many ways to manipulate share price that do not follow
firm performance or long term shareholder wealth
maximization
Risk of shareholder wealth dilution due to over issue
Pricing the value of options can change performance
A Defensible Process for Executive
Accountability Design & Compensation Setting5
 What is Management accountable for ?
 5 Levels of CEO accountability
 Board must agree and can’t establish pay for
performance or compensation peer group
comparison with out proper setting of levels of
work, metrics & targets
 Expert advise in accountability design required to
meet legal test of an “Informed Board” - NOT the
same as compensation expertise
5©
Copyright 2005, MVC Associates International
A Defensible Process for Executive
Accountability Design & Compensation Setting5
 Linked to 3 to 5 year business targets & relative
equity market performance
 Defensible benchmarking market comparisons and
peer groups - apples to apples
5©
Copyright 2005, MVC Associates International
Defensible Compensation Benchmarking
Practices ?5
 Most current practices fail to JOB MATCH roles
and calibrate compensation data before creating
averages, median and 75th percentiles from
industry peer group comparisons, resulting in
ratcheting up of CEO / executive pay
 Mathematically impossible for everyone to be in
75th percenitle!
 Un-calibrated compensation data could ratchet
median upwards by 30 % to 70 % +
5©
2004 MVC Associates International
Defensible Compensation Benchmarking
Practices ?
 Current market comparison practices are
REALLY comparing CEO and other executive
roles / compensation across 5 Levels of Work
Complexity and thus are mixing up apples and
kiwi’s - practices not truly defensible & further
ratcheting up pay
© Copyright 2004, MVC Associates International
Copyright © 2004 MVC Associates International
New Paradigm For Accountability Design,
Job Matching & Compensation Calibration5
 Accountability Design
 Innovation Complexity
• Planning Complexity & Decision Authority
• Resource Complexity
• Financial Management Complexity & Results
• Leadership Complexity
• Customer / Stakeholder Complexity
5©
2004 MVC
Associates
International
© Copyright
2004,
MVC Associates
International
Net
Operating
Profit
After
Tax
(NOPAT)
Divided
by
Cost
of
Capital
Accountability Design,
Incentive System Design
&
Equity Market Valuation
Products
&
Services
Current
Operations
Future
Process
Innovation
Current
Operations
Future
New
Products
& Services
Future
New
Business
Models
Current Operational Value Future Innovation Value / Organization Value Added-OVA ™
Competitive Advantage / Forecast Period
Copyright © 2004 MVC Associates International
© Copyright 2000, MVC Associates International
Bullet Proofing The Board /Compensation
Committee = Good Governance5
 Can the Board demonstrate it was informed and
truly independent ?
 Hired appropriate outside advisors - not just
compensation consultants ?
 A level of arm’s length contracting with
management as a “Fiduciary” for the
shareholder?
5©
Copyright 2005, MVC Associates International
Bullet Proofing The Board /Compensation
Committee = Good Governance5
 Can the Board demonstrate Process & Judgment
in Setting CEO / Executive Accountability and
Level of Work ?
 Courts said NO Process / No Judgment about
“Strategic Duty” for shareholders then “Lack
of Good Faith” and NO “Business Rule”
protection, resulting in loss of indemnification
& D&O Insurance Coverage
5©
Copyright 2005, MVC Associates International
Bullet Proofing The Board /Compensation
Committee = Good Governance5
 Can the Board demonstrate process & judgment
in compensation decision making?
 Level of work & CEO accountability relative to
executive compensation ?
 3 to 5 yr performance analysis relative to
executive compensation ?
 Have they used metrics that create long term
value ?
 Has the Board made sure they were fully
informed ?
5©
Copyright 2005, MVC Associates International
An Informed & Independent Board # 1
(Level of Work, Level of Exec Capability & Exec Pay)5
1. CEO demands 2 times total compensation increase based on wrong
external benchmarks - comparing more complex levels of CEO work
/compensation
2. Board looks at the CEO role & required level of work/accountability
to sustain the business & targets minimum level 3 CEO accountable
role is required:
•Planning 5 to 10 years out given changing technologies/customers
•Need to create new business model
•Need to return company to positive return on invested capital
3. Board assesses CEO current capability as - “Great Operator” - CEO
Level 1 capable!
4. Board does NOT agree to compensation demands, given GAP of
required level of work (CEO 3) versus current CEO level 1 leadership
capability & starts external search
© Copyright 2005, MVC Associates International
5
An Informed & Independent Board # 2
(Level of Work and Compensation Benchmarking)5
1.
2.
3.
4.
5.
Board reviews executive compensation report from leading
global compensation consulting firm
Board challenges peer group selection and medians /
percentiles in report given majority of 11 peer group
companies selected were significantly more complex
enterprises - based of levels of work /accountability
Board moves targeted total compensation from above
median to 25th percentile - 35 % DOWNWARD
adjustment / calibration
CEO watches and agrees with the rationale!
Compensation consultant watches from the sidelines as
report and lack of robust job matching/compensation
calibration methodology is challenged
5©
Copyright 2005, MVC Associates International