James Wells
Catherine Koene
Pamela Feldkamp
Josh Proksch
Lorcan Duffy
Francis Moniz
What is Executive Compensation
• Agency contract between firm and manager
• Align interests of owners and managers by
basing managers compensation on one or
more components of managers performance
Incentive Contracts Necessary?
• Fama argues that managerial labour market
controls the moral hazard
• Manager has a reputation for creating higher
payoffs for owners, manager market value
increases
• Manager with a poor reputation, will suffer a
decline in market value
Arguments For and Against
• Manager can in short time hide effects of
shirking in the short run
• Opportunistically manipulate earnings
however GAAP does prevent certain
transcretions from occurring
• Agent/Executives past payoffs does not
perfectly predict whether or not individuals
“work hard”
Bushmen, Engel and Smith
• Analyzed firms from 1970-2000
• Net income is partially informative about
manager performance
• Higher cash awarded by compensation
committees accompanied by increased
investor probability of higher returns
RBC Executive Compensation Plan
4 Components:
1. Salary, paid in cash
2. Short term incentive plan bonus awards paid in
cash or if the executive elects, in deferred share
units, where deferred share units are converted
into RBC common shares after 3 years.
3. Mid-term incentive plan awards paid in deferred
share units
4. Long-term incentive plan awards paid in stock
options (ESOs)
Total Compensation
• Total compensation is usually positioned relative
to the median of a peer group of similar large
companies
– Total compensation can vary substantially above or
below the median for individual executives as well as
in general depending on
• Bank
• Segment
• Individual Performance
• Ex. If ROE is in top 3rd of peer group, total compensation is
adjusted upwards by 15% and vice versa
The Plan:
Short-term Incentives
• For each business segment RBC sets annual target
levels of Net Income growth and ROE
– For individual executives, bonus depends on both
overall bank performance and segment performance
relative to targets
– Payments are further adjusted for individual nonfinancial performance measures
• such as, goals with respect to risk and cost management,
new revenue incentives etc.
– Bonus also may be adjusted up or down depending on
ROE performance of the peer group
The Plan:
Mid-term Incentives
• Number of deferred share units awarded
depends on the share price performance over
the previous 3 years
• Further adjusted depending on share price
performance relative to the peer group
• If ROE target is not achieved, no deferred
share unit awards are made
The Plan:
Long-term Incentives
• ESO exercise price is based on RBC share price around the
award date. i.e. intrinsic value=0
• ESOs have 10 year term with vesting rate of 25% per year
for the first 4 years
• Executives are required to hold minimum amounts of RBC
common shares
– E.x. president and CEO must hold 8 times their salary
– Requirement extends for 2yrs following retirement
Note: bonus deferrals, vesting periods for deferred share units
and ESOs, and required share holdings, decrease the ability
of executives to diversify their investment portfolios which
causes them to bear firm-specific risk
Changes to the Plan
• Amounts of salary and incentive awards are set
by the RBC board which is advised by its
Compensation Committee
• Need Compensation Committee since like all real
compensation contracts, RBC’s plan in incomplete
• Board has discretion to deal with the effects on
compensation of an unanticipated outcome
– E.x. awards were still given out in 2008 even though
ROE target was not met
Incentive Effects
• Annual bonus awards are mainly based on
reaching financial targets
• Short and Mid-term incentive awards depend
largely on current year’s performance,
creating incentive to maximize current year’s
levels of earnings and ROE
– This can be at the expense of the firm’s long run
interests and opportunistic earnings management
Incentive Effects Continued…
• However, ESOs issued through the long-term
incentive plan and the requirement of large
share of ownership is in place to make
executives more interested in the long-term
success of the firm
– This will hopefully reduce executives from being
tempted to engage in opportunistic practices to
increase short-term earnings
Proposed Changes to RBC’s
Compensation Plan
• Greater weight on individual non-financial
performance measures relative to financial
performance measures
• Increases in required executive stock holdings
• Provisions to claw back bonuses in cases of
fraud or misconduct
• These changes are intended to help to
lengthen decision horizons
Compensation Risk
• RBC’s plan imposes compensation risk on
managers
• What is Compensation Risk?
– It is when Economy- and Industry-wide events,
which may not be informative about the
manager’s effort, will affect both earnings and
share prices, hence the amounts of current and
future incentive awards
Net Income and Share Price
• Banker & Datar showed that lower “noise” I
net income and greater sensitivity to manager
effort then
• Greater portion of net income to share price
in determining managers overall performance
Sensitivity of Net Income
• Increased by moving towards current value
accounting which highlights changes faster
• Reduces accuracy and precision which
therefore reduces net incomes usefulness
• Full disclosure of low persistence items,
compensation committee able to take into
account and better measure manager
performance
Share Price
• Heavily influenced by effects of economy wide
factors
• Market wide factors add volatility to share
price
• Does however reveal additional payoff
information and should be used
Short and Long Run Payoffs
• Net Income tends to be more heavily
influenced by short term goals and horizons
• Share based compensation tends to reflect
more long term goals and horizons
• Mixing the two allows for adjustments to be
made in the even of market wide factors,
positive net income, yet share price not at
exact levels can still result in compensation
Short and Long Run Effort
• This confuses me can you do this part Josh?
Risk
• More risk managers bear, the higher their
expected compensation
• Not enough risk, the firm suffers from low
manager effort, too much manager may under
invest in risky projects
• Relative Performance Evaluation
• Measuring difference between net
income/share price compared to that of a
peer group of similar firms
Conservative Accounting
• Delays recognition of unrealized gains and
discourages premature revenue recognition
• Constrains manager’s ability to inflate current
earnings
• Conservative Earnings however give manager
little incentive to invest in risky projects
• Employee Stock Options encourage managers
to invest in long term profits
Employee Stock Options
• Encourage upside risk and impose little
downside risk and promote excessive risk
taking
• ESO were the driving force behind WorldCom
and Enron
• CEO’s who had significant share holdings were
frequently responsible for restating financial
positions compared to CEO’s with small share
holdings
The Politics of Executive Compensation
• Many have argued that top managers are
overpaid
• In 1990 an article was published arguing that
managers were not overpaid, but that their
compensation was not related enough to
performance
• They found CEO’s salary increase by only $2.59
per $1000 increase in shareholder wealth
• They also found that the standard deviation
between CEO wages and regular employees were
nearly identical
The Power Theory of Executive
Compensation
• Suggests that executive compensation in
practice is driven by manager opportunism,
not efficient contracting
The Power Theory of Executive
Compensation (Cont’d)
• Set forth by Bebchuck, Fried, and Walker
– Agree that managers have sufficient power to
influence their own compensation
– That they use this power to generate excessive
pay
• At the expense of shareholder value
• If this happens, managers receive more than
their reservation utility
The Power Theory of Executive
Compensation
• What it actually means:
– It questions the efficiency operation of the managerial
labour market
• Like behavioural finance questions efficient securities market
theory
• The source of the power is from the ability of the
CEO to influence the board of directors
– By influencing their appointment
– By managers fear of anti-management reputation
• Will effect interaction with other directors
• Reduce likelihood of appointment to other boards
Outrage
• The limits to managements power
– If compensation awards become too high
• Negative publicity
• To limit this: camouflage
– Hire a compensation consultant
– Tie total compensation to a peer group
Questions Raised by the Power Theory
• Why are ESO awards not adjusted downwards
for gains that are not under manager control?
• Why do managers have so much freedom to
control the exercise of ESOs?
Additional Support
• Provided by Core, Holthausen and Larcker
• Study showed that a significant portion of CEO
compensation is explained by corporate
governance variables
– Poorer governance is associated with greater excess
compensation
• Ways to guard against this:
– Sarbanes-Oxley Act and other governance
– Full disclosure provided by accountants
– Regulations by the SEC
Regulations About Executive
Compensation
• SEC Required firms to give more disclosure of
their executive compensation in 1992
• Similar requirements adopted in Canada in 1993
– A detailed explanation of the compensation of the five
highest-paid executives
– A report from the compensation committee justifying
these pay levels
– A Compensation Discussion and Analysis
– Extensive disclosure of share-based compensation
– Information on late timing ESO awards
– Information of any golden parachutes
Conclusions
• Labour markets reduce severity of moral
hazard
• Important to have a delicate balance of
incentives, risk and decision horizon
• Political Controversy is a result of CEO’s
exploiting their power to increase
compensation
• Accounting must provide full disclosure, and
ensuring stock options are expensed