In recent years, executive compensation has come under harsh scrutiny in literature and the media. Compensation structure and high salaries has brought this issue into the spotlight throughout the business world. Executive performance can directly affect shareholder value and the success of the organization. This is why the alignment of an executive’s performance, salary, and benefits have long been under examination by financial experts. In this paper, I would like to examine the different types, and ways an executive’s compensation is calculated.
Executive compensation is not easily understood as there can be as many as a dozen or so variables such as: salary, bonus, benefits, stock options, pension contributions, deferred income, and long-term compensation. Additionally, there can also be non-monetary benefits as well such as: company car, financial counseling, and tax preparation. Each of these variables in compensation are considered a type of pay, and how they are actually administered is called the mix of pay (Finkelstein & Hambrick). Consideration of type and mix of pay precisely indicates the complexity of CEO compensation packages today. Some potential potential determinants of type and mix of pay may include: firm strategy and life cycle, tax policy and the extent of agency problems within an organization. Additionally, because the pay of a CEO of a public organization is that of public information which is published annually, this may be used to make direct comparisons, and the availability of the pay information may serve as a guideline when examining the factors related to the potential CEO compensation package.
Besides attracting and retaining the best talent in a CEO, it is also important that the CEO is able to address the individual organizations needs. Directly responsible for determining the pay of a CEO, the Board of Directors or one of its committees to determine the role of the CEO and motivation which help to guide them through determining the appropriate type and mix of compensation. Nine out of ten large public companies have an executive compensation committee. These committees usually consist of three to five outside directors who are responsible for establishing the mode of compensation and performance targets for top management.
“Firstly, compensation can be viewed as a function of supply and demand. Secondly, it can be viewed as a function of how much the executive is expected to contribute to the performance of the firm. (Finkelstein and Hambrick).” Two major determinants of CEO compensation are: (1) market factors and (2) the power and preferences of the board and CEO. Additionally, along with the CEOs proven and expected contributions, market factors and the managerial labor market are important influences on the boards beliefs regarding the CEOs worth to the organization at that time (Boyd).
These determinants each count for some variance in determining the appropriate compensation package that is in alignment with management and shareholder interest. Beyond market factors, CEO compensation can be influenced by political processes, as CEO and board members differ in power and preferences, the compensation determined will reflect those differences (Finkelstein & Hambrick). However, the strategy used should generate returns for investors, accurately measure management performance, and implement a pay practice that is fair to shareholders and drives business results.
Before the Board of Directors or Compensation Committee can determine the appropriate compensation package for their CEO, they must understand why effective managerial pay strategies are important to the organization, this is the role of the board under agency theory (Boyd). An agency problem can occur when a CEO has no invested financial interest in the outcomes of his decisions. This means that a CEO with no or minimal equity ownership would have substantially different goals than a CEO with equity ownership (Walsh and Seward). Specifically when there is little or no ownership the incentive for the CEO could be to focus on maximizing their own wealth other than the organizations. Whereas a CEO with equity ownership will have incentives directly related to maximizing shareholder value.
CEO pay may also vary due to internal and external market influences. For example, the way the person becomes CEO may be reflected in the pay. CEOs recruited from outside the firm may require a premium in pay as incentive to switch firms, whereas those promoted internally may accept relatively les in pay for the status and privileges associated with the promotion (Decktop). However, board members are very sensitive to paying less for an internal candidate than the competition so pay is usually raised to retain their service (Finkelstein and Hambrick). Critics argue that external successors may receive a premium in the form of non-contingent compensation, this could represent the external successors for fore-gone return to their old firm-specific skills, and for risk associated with the lack of new firm-specific skills. Most firms hire from within the organization for at least two reasons related to skills: First: firms value the resulting fit between the skills of the CEO and the organization and second, firms have better information about the skills of an internal than the external candidate (Harris and Helfat). In addition, the board is usually reluctant to turn outside an organization for a new CEO, as it is argued that this admits to internal deficiencies.
Firm size and firm performance may affect the choice of the successor and be linked directly to how they are compensated. Traditionally a CEOs main concern should be the maximization of shareholder value. However, stock price may not always be the best indicator of a CEOs contribution to the firm. Trachial explains, “empirical evidence suggests that numerous economic factors render stock returns too noisy and insensitive to a manager’s actions to make it the primary factor is setting compensation (Traichal)”. In addition, Traichal suggests specifically that, shareholder returns and accounting returns be used for performance measurement. However Finkelstein and Hambrick suggest, that
A CEOs pay in bigger firms tend to pay more because the CEO oversees substantial resources, rather than the ability of the firm to pay more because of the number of their heiarchial pay levels (Finkelstein and Hambrick). Additionally, Finkelstein and Hambrick argue that performance related programs are increasing. These programs usually relate to meeting certain predetermined measures of performance, both personal and corporate. Typically, these programs extend over a period of years, but some are short-term. Traditionally a CEO may be paid based on results of prior years performance.
Beyond market factors, CEO compensation can be influenced by political processes, as CEO and board members differ in power and preferences, the compensation determined will reflect those differences (Finkelstein & Hambrick).
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Chief Executive Compensation: A Synthesis and Reconciliation
Finkelstein, S.School of Business Administration, University of Southern California, Los Angeles, CA
Hambrick, D.Graduate School of Business, Columbia University, New York NY
Walsh, James P.On the Efficiency of Internal and External Corporate Control
Seward, James K.MechanismsThe Academy of Mangement Review, Vol. 15, No. 3. (July., 1990), pp.421-458
Traichal, Patrick A., The Relationship Between Pay-For-Perfomance Contracting and External Monitoring. Managerial Finance, 68(21). (1999)