Executive pay is financial compensation received by an officer of a firm, often as a mixture of salary, bonuses, shares of and/or call options on the company stock, etc. Over the past three decades, executive pay has risen dramatically beyond the rising levels of an average worker's wage.[1] Executive pay is an important part of corporate governance, and is often determined by a company's board of directors.
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There are six basic tools of compensation or remuneration.
In a modern US corporation, the CEO and other top executives are paid salary plus short-term incentives or bonuses. This combination is referred to as Total Cash Compensation (TCC). Short-term incentives usually are formula-driven and have some performance criteria attached depending on the role of the executive. For example, the Sales Director's performance related bonus may be based on incremental revenue growth turnover; a CEO's could be based on incremental profitability and revenue growth. Bonuses are after-the-fact (not formula driven) and often discretionary. Executives may also be compensated with a mixture of cash and shares of the company which are almost always subject to vesting restrictions (a long-term incentive). To be considered a long-term incentive the measurement period must be in excess of one year (3–5 years is common). The vesting term refers to the period of time before the recipient has the right to transfer shares and realize value. Vesting can be based on time, performance or both. For example a CEO might get 1 million in cash, and 1 million in company shares (and share buy options used). Vesting can occur in two ways: Cliff vesting and Graded Vesting. In case of Cliff Vesting, everything that is due to vest vests at one go i.e. 100% vesting occurs either now or a later point in time at year X. In case of graded vesting, partial vesting occurs at different times in the future. This is further sub-classified into two types: Uniform graded vesting (e.g. Same percentage i.e. 20% of the options vest each year for 5 years) and Non-uniform graded vesting (e.g. different proportion i.e. 20%, 30% and 50% of the options vest each year for the next three years). Other components of an executive compensation package may include such perks as generous retirement plans, health insurance, a chauffered limousine, an executive jet[1], interest free loans for the purchase of housing, etc.
Executive stock option pay rose dramatically in the United States after scholarly support from University of Chicago educated Professors Michael C. Jensen and Kevin J. Murphy. Due to their publications in the Harvard Business Review 1990 and support from Wall Street and institutional investors, Congress passed a law making it cost effective to pay executives in equity.
Supporters of stock options say they align the interests of CEOs to those of shareholders, since options are valuable only if the stock price remains above the option's strike price. Stock options are now counted as a corporate expense (non-cash), which impacts a company's income statement and makes the distribution of options more transparent to shareholders. Critics of stock options charge that they are granted without justification as there is little reason to align the interests of CEOs with those of shareholders. Empirical evidence shows since the wide use of stock options, executive pay relative to workers has dramatically risen. Moreover, executive stock options contributed to the accounting manipulation scandals of the late 1990s and abuses such as the options backdating of such grants. Finally, researchers have shown that relationships between executive stock options and stock buybacks, implying that executives use corporate resources to inflate stock prices before they exercise their options.
Stock options also incentivize executives to engage in risk-seeking behavior. This is because the value of a call option increases with increased volatility (see options pricing). Stock options also present a potential up-side gain (if the stock price goes up) for the executive, but no downside risk (if the stock price goes down, the option simply isn't exercised). Stock options therefore can incentivize excessive risk seeking behavior that can lead to catastrophic corporate failure. If they are short-term vesting, they can also incentivize short-term
In the Financial crisis of 2007-2009 in the United States, pressure mounted to use more stock options than cash in executive pay. However, since many then-proportionally larger 2008 bonuses were awarded in February, 2009, near the March, 2009, bottom of the stock market, many of the bonuses in the banking industry turned out to have doubled or more in paper value by late in 2009. The bonuses were under particular scrutiny, including by the United States Treasury’s new special master of pay, Kenneth R. Feinberg, because many of the firms had been rescued by government Troubled Asset Relief Program (TARP) and other funds.[2]
Executives are also compensated with restricted stock, which is stock given to an executive that cannot be sold until certain conditions are met and has the same value as the market price of the stock at the time of grant. As the size of stock option grants have been reduced, the number of companies granting restricted stock either with stock options or instead of, has increased. Restricted stock has its detractors, too, as it has value even when the stock price falls. As an alternative to straight time vested restricted stock, companies have been adding performance type features to their grants. These grants, which could be called performance shares, do not vest or are not granted until these conditions are met. These performance conditions could be earnings per share or internal financial targets.
Cash compensation is taxable to an individual at a high individual rate. If part of that income can be converted to long-term capital gain, for example by granting stock options instead of cash to an executive, a more advantageous tax treatment may be obtained by the executive.
The levels of compensation in all countries has been rising dramatically over the past decades. Not only is it rising in absolute terms, but also in relative terms.
During 2003, about half of Fortune 500 CEO compensation was in cash pay and bonuses, and the other half in vested restricted stock, and gains from exercised stock options according to Forbes magazine.[3] Forbes magazine counted the 500 CEOs compensation to $3.3 billion during 2003 (which makes $6.6 million a piece), a figure that includes gains from stock call options used (the options may have been rewarded many years before the option to buy is used).
The categories that Forbes use are (1) salary (cash), (2) bonus (cash), (3) other (market value of restricted stock received), and (4) stock gains from option exercise (the gains being the difference between the price paid for the stock when the option was exercised and that days market price of the stock). If you see someone "making" $100 million or $200 million during the year, chances are 90% of that is coming from options (earned during many years) being exercised.
The typical salary in the top of the list is $1 million - $3 million.[4] The typical top cash bonus is $10 million - $15 million.[5] The highest stock bonus is $20 million.[6] The highest option exercise have been in the range of $100 million - $200 million.[7]
Senior executives may enjoy considerable income protection unavailable to many other employees. Often executives may receive a Golden Parachute that rewards them substantially if the company gets taken over or they lose their jobs for other reasons, like incompetence. This can create perverse incentives.
One example is that overly attractive Golden Parachutes may incentivize executives to facilitate the sale of their company at a price that is not in their shareholders' best interests.
It is fairly easy for a top executive to reduce the price of his/her company's stock - due to information asymmetry. The executive can accelerate accounting of expected expenses, delay accounting of expected revenue, engage in off balance sheet transactions to make the company's profitability appear temporarily poorer, or simply promote and report severely conservative (e.g. pessimistic) estimates of future earnings. Such seemingly adverse earnings news will be likely to (at least temporarily) reduce share price. (This is again due to information asymmetries since it is more common for top executives to do everything they can to window dress their company's earnings forecasts).
A reduced share price makes a company an easier takeover target. When the company gets bought out (or taken private) - at a dramatically lower price - the takeover artist gains a windfall from the former top executive's actions to surreptitiously reduce share price. This can represent 10s of billions of dollars (questionably) transferred from previous shareholders to the takeover artist. The former top executive is then rewarded with a golden handshake for presiding over the firesale that can sometimes be in the hundreds of millions of dollars for one or two years of work. (This is nevertheless an excellent bargain for the takeover artist, who will tend to benefit from developing a reputation of being very generous to parting top executives).
Similar issues occur when a publicly held asset or non-profit organization undergoes privatization. Top executives often reap tremendous monetary benefits when a government owned, mutual or non-profit entity is sold to private hands. Just as in the example above, they can facilitate this process by making the entity appear to be in financial crisis - this reduces the sale price (to the profit of the purchaser), and makes non-profits and governments more likely to sell. Ironically, it can also contribute to a public perception that private entities are more efficiently run reinforcing the political will to sell of public assets.
Again, due to asymmetric information, policy makers and the general public see a government owned firm that was a financial 'disaster' - miraculously turned around by the private sector (and typically resold) within a few years.
There are a number of strategies that could be employed as a response to the growth of executive compensation.
Many newspaper stories[15] show people expressing concern that CEOs are paid too much for the services they provide. In Searching for a Corporate Savior: The Irrational Quest for Charismatic CEOs, Harvard Business School professor Rakesh Khurana documents the problem of excessive CEO compensation, showing that the return on investment from these pay packages is very poor compared to other outlays of corporate resources.
Defenders of high executive pay say that the global war for talent and the rise of private equity firms can explain much of the increase in executive pay. For example, while in conservative Japan a senior executive has few alternatives to his current employer, in the United States it is acceptable and even admirable for a senior executive to jump to a competitor, to a private equity firm, or to a private equity portfolio company. Portfolio company executives take a pay cut but are routinely granted stock options for ownership of ten percent of the portfolio company, contingent on a successful tenure. Rather than signaling a conspiracy, defenders argue, the increase in executive pay is a mere byproduct of supply and demand for executive talent. However, U.S. executives make substantially more than their European and Asian counterparts.[15]
Shareholders, often members of the Council of Institutional Investors or the Interfaith Center on Corporate Responsibility have often filed shareholder resolutions in protest. 21 such resolutions were filed in 2003.[16] About a dozen were voted on in 2007, with two coming very close to passing (at Verizon, a recount is currently in progress).[17] The U.S. Congress is currently debating mandating shareholder approval of executive pay packages at publicly traded U.S. companies.[18]
The U.S. stood first in the world in 2005 with a ratio of 39:1 CEO's compensation to pay of manufacturing production workers. Britain second with 31.8:1; Italy third with 25.9:1, New Zealand fourth with 24.9:1.[19]
The U.S. Securities and Exchange Commission (SEC) has asked publicly traded companies to disclose more information explaining how their executives' compensation amounts are determined. The SEC has also posted compensation amounts on its website[20] to make it easier for investors to compare compensation amounts paid by different companies. It is interesting to juxtapose SEC regulations related to executive compensation with Congressional efforts to address such compensation.[21]
In 2005, the issue of executive compensation at American companies has been harshly criticized by columnist and Pulitzer Prize winner Gretchen Morgenson in her Market Watch column for the Sunday "Money & Business" section of the New York Times newspaper.
A February 2009 report, published by the Institute for Policy Studies notes the impact excessive executive compensation has on taxpayers:
U.S. taxpayers subsidize excessive executive compensation — by more than $20 billion per year — via a variety of tax and accounting loopholes. For example, there are no meaningful limits on how much companies can deduct from their taxes for the expense of executive compensation. The more they pay their CEO, the more they can deduct. A proposed reform to cap tax deductibility at no more than 25 times the pay of the lowest-paid worker could generate more than $5 billion in extra federal revenues per year.[22] Although a proposal such as this one would tighten controls on pay to executives, this study does take into consideration (or at least does not address) the tax obligations of the individual (CEO) that receives this compensation. Every dollar that is deducted from the firm's income is subject to the personal tax of the individual receiving such pay.
Unions have been very vocal in their opposition to high executive compensation. The AFL-CIO sponsors a website called Executive Paywatch [2] [23] which allows users to compare their salaries to the CEOs of the companies where they work.
In 2007, CEOs in the S&P 500, averaged $10.5 million annually, 344 times the pay of typical American workers. This was a drop in ratio from 2000, when they averaged 525 times the average pay.[19]
To work around the restrictions and the political outrage concerning executive pay practices, banks in particular turned to using life insurance policies to fund bonuses, deferred pay and pensions owed to its executives.[24][25] Under this scenario, a bank insures thousands of its employees under the life insurance policy, naming itself as the beneficiary of the policy. Bank undertake this practice often without the knowledge or consent of the employee and sometimes with the employee misunderstanding the scope of the coverage or the ability to maintain employee coverage after leaving the company. In recent times, a number of families became outraged by the practice and complained that banks should not profit from the death of the deceased employees.[24] In one case, a family of a former employee filed a lawsuit against the bank after the family questioned the practices of the bank in its coverage of the employee. The insurance company accidentally sent the widow of the deceased employee a check for a $1.6 million that was payable to the bank after the former employee died in 2008. In that case, bank allegedly told the employee in 2001 that the employee was eligible for a $150,000 supplemental life insurance benefit if the employee signed a consent form to allow the bank to add the employee to the bank's life insurance policy. The bank fired the employee four months after the employee consented to the arrangement.[24] After that employee's death, the family collect no benefits from the employee life insurance policies provided by the bank, since the bank had canceled the employee's benefit after the firing. The family claimed that the former employee was "cognitively disabled" because of brain surgery and medical treatments at the time of signing the consent form to understand fully the scope of insurance coverage under the bank's master insurance benefit plan.[24]
The practice of financing executive compensation using corporate-owned life insurance policies remain controversial. On the one hand, observers in the insurance industry note that "businesses enjoy tax-deferred growth of the inside buildup of the [life insurance] policy’s cash value, tax-free withdrawals and loans, and income tax-free death benefits to [corporate] beneficiaries."[26] On the other hand, critics frowned upon the use of "janitor's insurance" to collect tax-free death benefits from insurance policies covering retirees and current and former non-key employees that companies rely on as informal pension funds for company executives.[27] To thwart the abuse and reduce the attractiveness of corporate-owned life insurance policies, changes in tax treatment of corporate-owned insurance life insurance policies are under consideration for non-key personnel. These changes would repeal "the exception from the pro rata interest expense disallowance rule for [life insurance] contracts covering employees, officers or directors, other than 20% owners of a business that is the owner or beneficiary of the contracts."[27]
A study by University of Florida researchers found that highly paid CEOs improve company profitability as opposed to executives making less for similar jobs.[28]
On the other hand, a study by Professors Lynne M. Andersson and Thomas S. Batemann published in the Journal of Organizational Behavior found that highly paid executives are more likely to behave cynically and therefore show tendencies of unethical performance.[29]
Proposed reforms include bonus-malus systems, where executives carry down-side risk in addition to potential up-side reward.
In Australia, shareholders can vote against the pay rises of board members, but the vote is non-binding.[30] Instead the shareholders can sack some or all of the board members.[31]
There are some examples of exceptionally high chief executive officer pay in the early twentieth century. When the United States government took control of the railroad industry during the 1910s, they discovered enormous salaries for the railroad bosses.[32] After the Securities and Exchanges Commission was set up in the 1930s, it was concerned enough about excessive executive compensation that it began requiring yearly reporting of company earnings to help reign in abuse.[33] These examples show that exceptionally high CEO pay is not a new phenomenon, just perhaps not as common as today.
Anecdotal evidence for the General Electric corporation suggest that after examples of excess early last century and the Great Depression, following World War II executive pay remained fairly constant at GE for almost three decades.[34] This may have been in part due to high income taxes on the wealthy. To get around this, companies like General Electric began to offer stock options in the late 1950s.[35] The United States government eventually pared down the income taxes on the wealthy – from 91% in the 1950s, to 28% in the 1980s.[36] Thus the level of pay for GE’s top three managers increased at a slow rate of about two percent per year from the 1940s to the 1960s but this period of little growth was followed by a rapid acceleration in top management pay. Mostly encouraged by the increasing use of stock options since the 1980s and of restricted stock since the 1990s. From the 1970s to the present, the compensation of the three highest-paid officers at GE has grown at the significantly higher annual rate of eight percent yearly.
The years 1993 -2003 saw executive pay increase sharply with the aggregate compensation to the top five executives of each of the S&P 1500 firms compensation doubling as a percentage of the aggregate earnings of those firms - from 5 per cent in 1993–5 to about 10 per cent in 2001–3.[37]
The Financial Crisis has had a relatively small net effect on executive pay. According to the independent research firm Equilar, median S&P 500 CEO compensation fell significantly for the first time since 2002. From 2007 to 2008, median total compensation declined by 7.5 percent.[38] A sharp decline in bonus payouts contributed most to declines in total pay, with median annual bonus payouts for S&P 500 CEOs dropping to $1.2 million in 2008, down 24.5 percent from the 2007 median of $1.6 million. Additionally, 20.6 percent of CEOs received no bonus payout at all for 2008.[38]
On the other hand, equity compensation changed little from 2007 to 2008, despite the market turmoil. The median value of option awards and stock awards rose by 3.5 percent and 1.4 percent, respectively. Options maintained its place as the most prevalent equity award vehicle, with 72.2 percent of CEOs receiving option awards. In 2008, nearly two-thirds of total CEO compensation was delivered in the form of stock or options.[38]