Executive Compensation:
Something Old, Something
New
Marianna Makri
& Luis R. Gomez-Mejia
Hot Topic

Executive compensation has been a
hot HR topic because of:
• High visibility
• Frequently perceived unfairness
(particularly in North America)
• Importance
Corporate Governance Rating

A good corporate governance rating
sends a signal to potential investors
that the firm is a better investment
because presumably the board of
that firm is working for shareholders
as opposed to cozying up to the CEO
Executive Compensation Package

Can either be a motivational tool
encouraging executives to pursue
strategic decisions that are in the
best interest of shareholders or it can
be designed to reinforce the wrong
strategic choices
The CEO Pay Package



Two out of three CEOs have seen
their pay go up in the last couple of
years
Only a small percentage of the
differences in pay among CEOs could
be explained by differences in the
performance of their firms
CEOs who were making more money
were also running larger companies
What Does Pay Mean?


Large pay packages are flagged as a
sign of weak boards that are too
cozy with management and not
looking out for shareholders
Low ratings signal that the board is
ineffective in monitoring the CEO
which can in turn hurt the firm’s
stock price
The Role of Risk in the Executive
Compensation Contract


Employment risk - the possibility that the
executive will be terminated either due to
unsatisfactory performance or due to
change in control
Compensation risk - the potential
unpredictability in the executive’s future
pay represented mainly by the proportion
of stock options in the total pay package
The Role of Risk in the Executive
Compensation Contract Continued

Business risk - the uncertainty
surrounding the firm’s competitive
environment
Components of the Pay Package

Fixed pay – salary and benefits
• Typically smaller than variable pay
• Firms can only write off one million
dollars in fixed pay
• Most companies top off salaries at about
one million dollars
Components of the Pay Package
Continued

Variable pay – bonuses and stock
options
• Draw the CEO’s attention to
performance results and can serve to
align the goals of the company and its
shareholders with the personal goals of
the executive
Recent Environmental Changes
Affecting CEO Risk



Shareholder activism
Sarbanes-Oxley Act (SOX)
SEC disclosures
Shareholder Activism


Proxy resolutions sponsored by union
and public pension funds, aimed at
cutting CEO pay, are winning
extraordinary victories
If shareholder activism keeps
spreading it will ignite a good
amount of reform
The Sarbanes-Oxley Act (SOX)


SOX holds the new generation of
CEOs personally accountable for their
companies' financial statements
Some worry that SOX forces CEOs to
place more focus on the internal
control environment and the short
term as opposed to focusing on the
long term
SEC Disclosures

The SEC voted on an expansion in
disclosure requirements for executive
pay including:
• The dollar value of every benefit that
executives derived from their
employment
• Companies should report the extent to
which executives sell shares given to
them as variable pay
SEC Disclosures Continued

Additional SEC disclosures include:
• Companies should disclose not just the
amounts paid but also the criteria based
upon which those bonuses were
awarded
• Companies should annually disclose the
dollar value of the package that each
executive will receive upon exit in the
case of a change in control, termination
or retirement
Managing Executive Risk


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Stock options
Pay for performance
Change-in-control provisions
Stock Options


Stock options are the right to
purchase stock at a predetermined
price
Restricted stock is a right granted to
purchase during a specified period,
at the market price on the date of
the option, a specified number of
shares
Stock Options Continued

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Restricted stock is replacing stock
options in executive benefits
packages due to changes in
accounting standards
Restricted stock is not as tied to
organizational performance as stock
options
Pay for Performance


Tying executive compensation to
specific performance guidelines can
be counterproductive
CEO performance should be tied to
broader metrics that go well beyond
financial measures such as
leadership and innovation
Pay for Performance Continued


SOX provisions increase business risk
for CEOs leading to risk averse
business strategies
Link pay to performance very loosely
and motivate them with restricted
stock options
Change in Control Provisions to
Manage Employment Risk


Golden parachute clauses have
increased in popularity
Golden parachutes are payments in
the form of cash, an acceleration of
vesting or other benefit that occurs
in connection with a change in the
ownership or control of a company's
stock or assets
Golden Parachute Provisions

Typical golden parachute provisions
include:
• a lump-sum payment equal to typically
three times the base salary plus bonus
• accelerated vesting of deferred
compensation and supplemental
executive retirement plan (SERP)
benefits
Golden Parachute Provisions
Continued

Additional golden parachute
provisions include:
• Additional age and service credit during
the severance period (typically three
years) for purposes of pension
calculation
• Accelerated vesting of equity awards
Linking Pay to Performance


Individuals in positive contexts can
become risk averse while individuals
in negative contexts can become risk
seeking
An ideal level of risk needs to be
determined for the executive and the
extent that pay is tied to
performance
The Risk Environment

Firms operating in highly
competitive, high-risk environments
need to pay more to attract and
retain high quality executives than
firms operating in low risk
environments
The Risk Environment Continued


The proportion of variable pay needs
to be balanced by the potential to
earn more money
Total pay should be highest in
settings where risk is greatest for the
CEO such as high technology firms or
family controlled firms
CEO Pay in High Technology Firms

High technology firms need to
reward CEOs by using multiple
performance criteria including:
• Financial indicators
• Emphasis on innovation
• Support of basic research
CEO Pay in Family Firms

Family firms differ from non family
firms in two major ways:
• Executives who are members of the
family exhibit a greater desire to retain
control of the firm stemming from a
strong personal attachment
• Employment and compensation risk is
highly concentrated in the firm
CEO Contracts in the Family
Business


Contracts should be more
transactional with specific
performance provisions for family
CEOs
Contracts should be more relational
for CEOs outside of the family to
protect them from unfair judgment
Conclusion


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There are a wide variety of ways to
design CEO contracts
The provisions of these contracts can
impact the firm performance
The environment in which the firm
operates should influence the CEO
contract