Executive Compensation
The importance of Executive Compensation Alignment
Sean McCollum
Bellevue University
1
Executive Compensation
Abstract
This paper explores the problems in executive compensation that can lead to
organizational failure. Empirical along with case study examples are presented to show how
poorly aligned executive compensation can promote executive behavior that is not aligned with
long-term shareholder value, instead promoting short term profit incentives. This paper also
explores some methods and practices that can be implemented to properly align executive
compensation with long-term shareholder values and organizational objectives.
2
Executive Compensation
The importance of Executive Compensation Alignment
Executive compensation has been a hot button issue since the recent economic crash.
CEO’s were making millions upon millions of dollars a year all the while leading organizations
that were at best marginal performers. Many experts have question the fairness of what top
executives are paid and many believe that their pay should be tied in to their performance.
Top executives can make anywhere from twenty to nearly 300 times that of the
employees. In fact executive pay has greatly exceeded the performance of top executives in
most of the organizations nationwide. Most executive incentives are tied to short-term securities
trading performance. This type of incentive encourages executives to engage is risky business
ventures for short term gain instead of focusing on the long term objectives of the organization.
This is exactly what happened to the housing market where mortgage companies were buying
high risk mortgages and bundling them, then selling them off to other organizations for profit.
Eventually this practice that was very profitable in the short term eventually backfired and led to
the near collapse of the housing market. The other issue is that the fact that this type of incentive
tends to promote unethical behavior.
Empirical Evidence on Executive Compensation
So where is the disconnect between executive compensation and performance. One
theory is that there is a separation of ownership and control (Lin, Kuo, & Wang, 2013). This is
where power is granted by the owners and or board of directors to top executives to control and
make decisions on behalf of them. Once this power is turned over, little oversight is exercised
over the executives to ensure their actions are in line with the owner and shareholders’ interests.
This lack of oversight enables many executives to exercise control over organizational
objectives, and if their goals are short term and profit motivated many problems can arise. So
3
Executive Compensation
with an obvious disconnect and the lack of oversight what if anything can be done to not only
pay executives fairly and align their actions with the shareholders’ interests.
Lack of oversight, poor alignment of executive compensation, Executive influence over
the board of directors, and failure to properly hire CEOS based on performance measures are just
a few of the key factors that have led to the failure of many organizations, and were also
contributing factors in the recent economic disaster. So if the key problems have been identified
what can be done to fix them. Several empirical studies have been conducted; two will be
detailed in the following paragraphs that will cover some of the possible solutions to fix the
executive compensation problems.
Empirical Evidence
In an empirical study that was conducted examining 903 firms between 2007 and 2010
they noted that three things are related to total CEO compensation; the three factors were CEO
experience, CEO share holdings, and the size of the board of directors. The study found that
there was no link between pay and performance which means that the CEOs pay is not impacted
on the performance of the organization. This is one of the major problems that are bringing
many organizations to their knees, when executives are being over compensated for marginal to
sometimes poor performance. The study found that the biggest factor that affected CEO and
executive compensation was the size of the organization.
Another empirical study that examines the relationship between CEO compensation and
past performance will be explored. This study examines a sample of 15,512 CEOs from 1993 to
2006 (Banker, Darrough, Huang, & Plehn-Dujowich, 2013). This study sought to determine the
best way to get the biggest bang for the buck when picking top executives. Salary and bonuses
were noted as playing different roles but with the same goal, and that is to fix the agency
4
Executive Compensation
problem; salary should be based on past performance, and bonuses should focus on current
performance and should promote future performance (Banker, Darrough, Huang, & PlehnDujowich, 2013). In the study Executives were rated on ability types, the higher the ability the
more the bonus can affect their performance (Banker, Darrough, Huang, & Plehn-Dujowich,
2013). One way that was mentioned was to look at the past performance, if a CEO or top
executive is a high performer the best way to compensate them was determined to be higher
salary and a bonus that is lower but that focuses on current performance and geared to promote
future performance. Overall the study found that past performance is the biggest indicator for
future performance; however past performance had a negative correlation to bonuses. So an
organization that is looking to hire a young CEO or executive with little or no past performance
to evaluate, the organization should offer less salary and a larger performance based bonus to get
a greater return on investment. If they are hiring a seasoned CEO with a proven track record of
results then it would be safer to offer a higher salary and a lower bonus.
Pay for Performance sounds like a fairly simple concept, and it is mentioned in nearly
every study that has come about in regards to executive performance and compensation since the
recent economic crash. The major problem that organizations face is weeding out executives
that are unethical, but that is easier said than done when a large majority of unethical business
practices that executives are accused of are a direct result of the compensation plans. Take the
housing market for example many of the mortgage lenders were involved in unethical business
practices for years, and if you looked at a CEOs from many of these organizations simply based
on past performance then they would be considered top performers. So this shows how pay for
performance can be a tough theory to nail down.
5
Executive Compensation
Fannie Mae Case Study
Here is a case study that shows exactly how improperly aligning executive compensation can
lead to not only poor performance, but unethical behavior, and ultimately can lead to the
downfall of the entire organization. This is important to understand, because when organizations
are impacted by poor performance of executives due to the executive compensation plans, it not
only affects the executives and the organization, but the employees are also dramatically affected
in wake of the failure. This case study is on Fannie Mae, an organization so large that its
unethical business practices affected the entire United States economy, and the global economy;
it was deemed a company too large to fail. There were four problems with the executive
compensation packages that were associated with its failure.
1. Perverse incentives: Executives were rewarded for reporting higher earnings and were
not held accountable or required to return any of the compensation they received if the
earnings they reported were not accurate (Bebchuk & Fried, 2005).
2. Pay decoupled from performance: retirement incentives did not align with organizational
performance (Bebchuk & Fried, 2005).
3. Soft landing: There were few if any repercussions or punishment handed down to
executives who failed or lied to inflate numbers, some even received large severance or
retirement packages (Bebchuk & Fried, 2005).
4. Camouflage: Fannie Mae made efforts to cover up the total value of executive’s
retirement packages (Bebchuk & Fried, 2005).
The four factors above are not just problems that caused Fannie Mae to implode, it was
happening in many of the organizations that were either bailed out or went out of business
entirely during the economic crisis. This case study is important because it shows what can
6
Executive Compensation
happen when executive pay and compensation is poorly aligned with organizational strategy.
This falls into the idea of rewarding A and expecting B. Executives were rewarded for high
earning reports, but there was no punishment for over reporting, which led to executives cooking
the books and greatly over inflating the profits to increase their own compensation packages
(Bebchuk & Fried, 2005). When a majority of the housing market lenders were behaving in the
same manner, billions upon billions of dollars were being reported as profit, when in fact the
actual earning was nowhere near what was reported. This created a huge bubble in the housing
market, and when it was determined that the housing market was worth dramatically less than
what was reported the bubble popped and the housing market crashed.
Many organizations compensation to executives can be manipulated and executives are
allowed to buy and sell their shares as they see fit; the problem this creates is that executive are
influenced to inflate profits and are focused on short term gain instead of long term shareholder
value (Bebchuk & Fried, 2005). The compensation packages offered to executives at Fannie
Mae included large bonuses that were dependent upon reported earnings, the number of shares
given to the executives depended on the previous year’s earnings, a grant program dubbed the
“earnings per share challenge option grants” was started to reward executives for reaching
certain profit margins, and executives were allowed to buy and sell their shares as they saw fit
(Bebchuk & Fried, 2005). Looking at the way the compensation packages were set up, it is easy
to see how this is a recipe for disaster. There is not one incentive in the plan above that would
motivate executive performance toward long term shareholder value; they instead reward
executives that focus on short term profits. What is disturbing is the fact that these types of
incentives are offered to top executives in many organizations across the United States. This
type of executive compensation seems to be an enormous problem throughout the business
7
Executive Compensation
world. The government, society, and even the European Union have called for reform. Some
steps organizations can take will be explained in the following sections.
Obviously there is a huge disconnect between what companies expect from executives
and how they compensate them to perform. As mentioned above Fannie Mae is only one of
many organizations that offer compensation plans that promote focus on short term goals, greed,
unethical behavior, and a self-serving attitude separate from organizational strategy. There has
been a recent nationwide call to rethink how top executives are compensated to better align their
motives and performance with that of the shareholders and the organization. So exactly how can
organizations develop executive compensation plans that get a return on investment, promote
ethical behavior, and align executive performance with long-term shareholder value and
organizational strategy.
First it is important to realize that not every organization is the same, there may be as
many executive compensation plans as there are organizations. Second it is important to decide
who determines or has input in determining executive compensation.
Human Resources Role in Executive Compensation
Who should have a say in executive compensation? The current method is either not
dependable or is corrupt, there needs to be more oversight to maintain the integrity of the system.
Human resources for the most part has kept their hands clean when it comes to executive
compensation, but with the bad press that this topic has generated, human resources can no
longer sit idly by and allow policies and procedures that are detrimental to organizational
performance to persist.
What is human resources role in executive compensation? The answer to this question
will be answered below, because human resource has more than one role when it comes to
8
Executive Compensation
executive compensation. First and foremost human resources must make the executive
compensation plan as transparent as possible ensuring that people understand that not every
executive is overpaid and that compensation differences are okay (Glavin, 1992). Do not defend
executives that fail, if they are performing they should be paid well, but if they do not perform,
do not reward them for their failure (Glavin, 1992). Human resources can provide a format for
executive compensation in proxies; compensation disclosure is crucial because if it is not done
correctly a third party will step in and ensure it is done (Glavin, 1992). The most critical role
human resources play is in executive compensation decisions is in the management of the
executive compensation committee (Glavin, 1992). Human resources should ensure that the
committee knows its role and makes sure that the committee knows the outcome if the CEO or
executives do not meet pre-determined performance targets (Glavin, 1992). Finally if there are
any issues that cannot be resolved the executive compensation committee is permitted to hire a
third party consultant (Glavin, 1992). If the organization wishes to know if the compensation
plan is fair is to take a close look at the plan and ask, would we be willing to print this on the
front page of a major magazine or newspaper?
Government Regulation
Another recommended solution to the executive compensation problem in the aftermath
of the economic disaster was government regulation. After the economic crash many people
called for government regulation to control executive compensation and bonuses, especially after
many top executives received large bonuses after the companies were bailed out by tax payer
money. But, is government regulation the answer? There has been just as many, if not more
documented cases of greed and corruption in the government as in the private sector.
9
Executive Compensation
Government reform tends to do just the opposite of reform in most cases, not that the
government has bad intentions when attempting to impose regulations, but the government has
so many laws and regulations to enforce that usually key factors are usually overlooked.
For example, 25 years ago the government sought to place a special tax on golden
parachute payouts that were above three times annual pay to executives, the result was exactly
the opposite of what they wished to achieve; 70 percent of the 1000 largest companies had
golden parachutes and those same companies raised the amount of the golden parachutes to just
under the limit to exactly three times the annual pay, which avoided the special tax all together
(Schmurman, 2012).
Another good example is from 1994 when the government sought to control the amount
of executive pay by making salaries that were over one million no longer tax deductible, and in
response companies did two things: they raised the base pay to one million, and began to offer
stock options that were not affected by the new tax (Schmurman, 2012). The two examples
above show that organizations are able to not only circumvent any regulations imposed on them
by the government, but in many cases are also able to even benefit from them. The government
sector and the private sector need to remain separate, but in order for organizations to ensure that
the government stays out of their affairs, they must conduct themselves in a manner that does not
draw unwanted attention due to unethical business practices and overcompensation of
executives.
Compensation Alignment
It is understood that each organization is unique and compensation packages will vary
from one organization to the next, but there are certain steps that organizations can take to ensure
that executive compensation is not only fair to the executive but competitive enough to recruit
10
Executive Compensation
quality talent and also align it with organizational objectives and be able to create long-term
shareholder value. One statement was mentioned in nearly every book and research article on
the subject of executive compensation since the near economic collapse, “pay for performance”,
sounds simple, but in fact it is quite complex. To be able to pay for performance the
organization must have a clear understanding of the organizational strategy, a solid structure,
clearly stated organizational objectives, know the shareholders vision for the organization and
then be able to align the top executives compensation to conform to these standards and
expectations, and depending on the complexity of the organization this may not be an easy task.
European Union Recommendations
Rewarding executives for rises in market value that were not a result of executives,
camouflaging executive compensation, pay and bonuses not aligned with long term shareholder
value, failure to discipline executives that fail to meet organizational objectives, and allowing too
much freedom when it comes to buying and trading stocks were some of the factors that can lead
to disaster anywhere they are in practice. And it is these practices that led to an economic crash
that not only affected the United States economy, but also had a huge impact on the global
economy. The economic disaster brought about a lot of world attention and resulted in the
European Union giving several recommendations on how to resolve many of the problems
created by the greatly flawed executive compensation plans that were in place.
After the housing market crash several recommendations were made by the European Union
to help bring executive compensation in line with performance:
1. Redirect focus to the variable components of pay
2. Suggested that those variable components should:
a. Be capped
11
Executive Compensation
b. Be based on established performance goals and must be measurable
3. Recommended that severance packages should:
a. Not be more than two years of fixed salary
b. Not be paid in the event an executive is terminated for cause or relieved for poor
performance
4. Compensation should focus on long term shareholder value not short term profits
5. Any shares would require a three year vesting period
6. Set a limit on the number of shares executives are allowed to hold until the end of their
employment
7. Deferments of component pay
a. Claw back provisions included in executive compensation contracts (repayment
of performance based pay, when performance does not meet pre-determined
goals) (van Zyl Smit, 2010).
The above steps outlined by the European Union are a great outline for companies to follow, but
as mentioned not all organizations are the same so common sense must apply.
Conclusion
The biggest thing an organization can do is assure that pay for performance is the number one
priority when considering executive compensation. Once the compensation plan is developed,
disclosure and transparency is crucial, give people an accurate picture total executive
compensation. The key for the board of directors is to create value for the shareholders by
maximizing value, using the compensation it provides its executive to meet this goal. The
problem however is that the board of directors is many times influenced by management (top
executives), so involving human resources in deciding executive compensation can help reduce
12
Executive Compensation
much of the influence. (Bebchuk, Fried, & Walker, Managerial power and rent extraction in the
design of executive compensation, 2002) One final note, if an organization would not want its
executive compensation plan printed or broadcast on television for millions to see, and then it is
probably the wrong plan to be using.
13
Executive Compensation
References
Banker, R. D., Darrough, M. N., Huang, R., & Plehn-Dujowich, J. M. (2013). The Relation
Between CEO Compensation and Past Performance. The Accounting Review, 1-30.
Bebchuk, L. A., & Fried, J. M. (2005). Executive Compensation at Fannie Mae: A Case Study of
Perverse Incentives, Nonperformance Pay, and Camouflage. Journal of Corporation
Law, 807-822.
Bebchuk, L. A., Fried, J. M., & Walker, D. I. (2002). Managerial power and rent extraction in
the design of executive compensation. The University of Chicago Law Review, 751-846.
Glavin, W. F. (1992). Human Resources Role in Executive Compensation. Rethinking Corporate
Compensation Plans (pp. 18-21). New York: The Conference Board, Inc. .
Lin, D., Kuo, H.-C., & Wang, L.-H. (2013). CHIEF EXECUTIVE COMPENSATION: AN
EMPIRICAL STUDY OF FAT CAT CEOS. International Journal of Business &
Finance Research , 27-42.
Schmurman, M. (2012). Are Executives Paid Too Much. Fort Worth Star-Telegram. Fort Worth,
Farmington Hills, United States of America: Greenhaven Press.
van Zyl Smit, J. (2010). Executiive Compensation. Accountancy SA, 12-14.
14
Executive Compensation
15