An executive compensation plan is an agency contract between the firm and its manager that
attempts to align the interests of owners and managers. Although these compensation plans are
consistent with agency theory predictions, they are far more complex because they involve a mix
of incentive, risk, and decision horizon considerations.
Managers are assumed to be risk adverse but unlike investors they cannot diversify their
compensation risk. Consequently, executive compensation plans are designed to control risk
while still maintaining effort motivation.
Some of the risk-reducing approaches are:
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Having more than one performance measure
Adding a threshold level of performance in the bonus plan (ie a bogey)
Making available stock options that lower the downside risk
Having a compensation committee for the review of compensation for the manager
Using relative performance evaluation (RPE)
One major problem with compensation contract design is that the full impact on net income
of current manager effort is usually not observable in time to form the basis of incentive contract.
The payoff observability problem is even greater if we recognize that manager effort is a set of
activities, rather than a single activity. Some of these activities have longer-run implications
than others do. Given these problems of using current net income as a payoff measure, we can
see why share price might be a better measure. With efficient securities markets, share prices
will “properly reflect” all that is know about prospective payoffs from current manager actions.
Share price includes the information content of net income itself. However, share price is
affected by economy-wide events such as interest rate changes, which impose risks beyond those
inherent in the firm. Also, the presence of noise traders means that share prices do not perfectly
aggregate public information. Therefore, the use of share price as a payoff measure may impose
excess risk on managers. To the extent that net income is relatively insensitive to economy-wide
factors and to noise trading, the inclusion of both share price and net income in the compensation
contract is important in attaining an efficient contract. Moreover, the relative proportion of stock
price-based and net income-based payoff measures in the compensation plan is also important in
attaining an efficient contract and having desirable risk-reduction properties for management.
Another approach in reducing compensation risk is to add a bogey to the bonus plan. A
bogey exempts the manager from paying the firm if it should suffer a loss. This reduces the
manager’s downside risk. Stock options also reduce the manager’s downside risk since the
lowest they will be worth is zero. Fear of personal bankruptcy is not the best way to motivate a
manger to work hard; the reason being that the manager may adopt only safe operating and
investment strategies whereas shareholders’ interests may be better served by riskier ones.
Therefore, limitation of downside risk is important. But, it works both ways, since downside risk
is limited, upside risk should also be limited; otherwise the manager would opt for operating and
investment strategies that are far too risky for the shareholders’ best interests. For this reason,
compensation plans should impose both caps on incentive remuneration as well as bogeys.
A further risk-reducing approach is to filter the manager’s incentive pay through a
compensation committee. By doing this the committee can take exceptional circumstances into
account that a bonus formula could not. And as a result, reduces the manager’s compensation
risk.
The final approach in reducing compensation risk is the use of a relative performance
evaluation. RPE is a process of setting bonuses or other incentive awards in relation to the
average performance of other firms in the industry. Therefore, the systematic or common
industry risk will be filtered out of the compensation plan, especially if the number of firms in
the industry is large. As a result, RPE is more highly correlated with manager effort than net
income itself and therefore less risky. However, there is no strong evidence in support of this
approach. One reason being, basing compensation on both share price and net income
accomplishes a similar result of that of an RPE.
The theory of executive compensation suggests that the relative proportions of shareprice-based and net-income-based incentives are critical in the attainment of an efficient
compensation contract.
Lambert and Larcker (1987) (LL) studied the relationship between managers’ cash
compensation and firm performance. They found that the relative proportions of accountingbased and market-based compensation vary as the theory predicts. In particular they found:
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ROE more highly related to cash compensation than return on shares.
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The above relationship was strengthened when net income was less noisy relative to
return on shares because as a result net income better reflected manager effort.
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The above relationship for growth firms’ tended to be lower. The reason being historicalcost-based net income tends particularly to lag behind the real economic performance of
a growth firm.
Consequentially, the LL study provides empirical evidence consistent with agency theory.
Executive compensation attracts political controversy due to the large amount of
compensation that is often involved. Some argue that executives as a group are overpaid,
pointing to low sensitivity of executive compensation to firm performance, especially when
performance is poor. Where others argue that executives are not overpaid, pointing out that the
amount of compensation received is very small relative to the shareholder values created and that
managers cannot diversify away their compensation risk.
Regulators have reacted to this controversy by requiring increased disclosure of executive
compensation, on the grounds that the managerial labour markets and the shareholders of
individual firms can act if pay becomes excessive.
Jensen and Murphy (1990) (JM) reported that CEO’s were not overpaid, but that their
compensation was far too unrelated to performance. They found that over time, the variability of
CEO’s and regular workers’ compensations were almost the same. They based this finding on
the fact that CEO’s did not bear enough risk to motivate good performance.
The role of monitoring manager performance, thereby enabling efficient compensation
contracts, is as important to society as the role of communicating useful information to investors.
Executive compensation plans are important to accountants because it improves the proper
operation of managerial labour markets and motivates productivity, which is just as important as
improving the proper operation of capital markets and the efficient allocation of scare capital in
the economy.
Quiz
Q1
In a perfectly efficient managerial labour market incentive contracts are not beneficial in
reducing moral hazard.
True or False
Q2
An executive compensation plan is:
a) A compensation plan designed to ensure that executives are rewarded fairly for their
effort.
b) What executives receive upon retiring from the firm. Also know as a golden
handshake.
c) A way of increasing the wage of executives without having to spend the companies
money.
d) A method of compensation created with the purpose of aligning the interests of the
managers with the owners.
e) A way of ensuring that managers get paid way more than anyone else.
Q3
If the labour markets were perfectly efficient, who would get paid the most in the current
period?
a) A manager who had a great year last year, and has been doing well in the current
quarter.
b) A manager who did badly last year but should do better in the future.
c) A manager who is doing very well in the current period, but had a very disappointing
year, last year.
d) A manager who has lost his job and is collecting EI.
e) If labour markets were perfectly efficient everyone should be paid equally.
Q4
As the seniority of managers increases incentive awards become more:
(a) qualitative
(b) quantitative
(c) both increase equally
(d) none of the above
Q5
The mix of short- and long-term incentive components in an executive compensation plan
is important.
True or False
Q6
The threshold level of performance before incentive compensation becomes payable is
called a cap.
True or False
Q7
Why is the payoff from manager effort usually not observable in time to form the sole
basis of an incentive contract?
1)
2)
3)
4)
Share price is a better measure of manager performance.
Accounting profit often lags the exertion of manager effort.
Losses on credit sales for the period have to be estimated.
Managers often have a short-run decision horizon.
Q8
The Theory of Executive compensation states that:
a) Net income alone is a better payoff measure
b) Share price alone is a better payoff measure
c) Net income and share price together are better payoff measures
d) Neither net income or share price are good payoff measures
Q9
Which of the following statements is/are true with regards to compensation contracts:
a) Share price is sensitive to economy-wide events
b) Share price is sensitive to noise traders
c) Net income is sensitive to economy-wide events
d) Net income is sensitive to noise traders
e) a) and b)
f) c) and d)
Q10
The LL study provides empirical evidence consistent with agency theory.
True or False
Q11
Executive compensation plans are designed to control the decision horizon considerations
but not compensation risk. True or False
Q12
Share price as a payoff measure in compensation contracts reduces the risk on managers.
True or False
Q13
Using an RPE for management compensation reduces the systematic risk managers are
subject to in their compensation plan.
True or False
Q15
In order to have the most efficient compensation plan one must look to reduce manager’s
downside risk only.
True or False
Q16
The Jensen and Murphy study reported that CEO’s were overpaid and that their
compensation was far too unrelated to performance.
True or False
Q17
Executive compensation attracts political controversy because of the large amount of
campaign donations made by executives.
Q18
An executive contract is an application of the agency theory.
True or False
Q19
There are only two measures of performance in an executive contract: Share price and
Net Income.
True or False