Proeedings of the SIMS Annual Research Conference, SIMSARC 11

Author 1 Prof. Harshini Esther Faculty BBM dept. Alliance School of Management Bangalore India

Author 2 Atyukti Pachauri Student BBM dept. Alliance School of Management Bangalore India

Title : Executive Compensation Abstract

Executive compensation also known as executive pay is financial compensation that is received by an officer of a firm. Most often this compensation is a mixture of salary, bonuses, shares of company stocks and etc. This paper will be summarising the empirical and theoretical research on executive compensation and provides a comprehensive and up to date description of pay practices and trends in pay practices for the officers and also how executive pay affects the stock performance. Topics will cover different aspects like the level and the structure of the officers compensation which will include a detailed analysis of annual bonus plans, executive stock options, and option valuation, also, international pay differences, the pay setting process, the relation between the pay and the performance of the firm, the relation between pay performance sensitivities or subsequent firm performance, relative performance evaluation, executive turnover and the politics of officers pay. Also, it will discuss the increasing use of AGENCY THEORY in executive compensation so as furtherly discussing the effect of compensation packages to officers on the stock performance and on other various business evaluation factors. Keywords: Executive compensation, stock performance, agency theory, incentives

*This abstract or rather the research has been influenced by the ground reading tht has been done by us which includes browsing Wikipedia and then going through different previous articles on the executive

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compensation and the way it works and etc. Also, involves the reading of journals and accounting and various different such journals and reference points to arrive at it.

Introduction
Executive compensation is not a new term to any of us, but the meaning of it has evolved over time. There have been many changes over time in the concept of executive pay. It has been defined by many bodies and researchers, and one that we found fulfilling is mentioned below ; Financial times LEXICON has defined it as, The right amount to be paid to an executive for their work in the organisation. This right amount is the minimum amount that takes to attract and retain a qualified individual. This right amount is the compensation for the executive. Also Susan M Heathfield has defined it as, A combination of salary, incentives and bonuses etc designed for an executive like CEO, CFO, VPs and other upper level employees is known as executive compensation. From our understanding on reading about executive compensation from various sources what we have understood is, Executive compensation also known as executive pay is financial compensation that is received by an officer of a firm. Most often this compensation is a mixture of salary, bonuses, shares of company stocks and etc. It is an important part of corporate governance and is determined by the board of directors of the company. Its quite different from other employees compensation. The salary and other benefits are negotiated among the potential executive and the employer and are documented in a customized employment contract. There are 6 basic tools of compensation and they are : Salary Bonuses, which provide short term incentive plans Long term incentive plans Employee benefits Paid expenses Insurances (Golden Parachute)

Types of compensation: Stock options: In this executives are paid in equity. Restricted Stock: In this stock is 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. Tax issues: In this part of income that 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.

After understanding about executive compensation we were wondering why would such a simple pay matter will grab everyones attention apart from the fat amount and benefits that are received by some top end officers of a company. And we found out that there is a whole history to it internationally and in our nation too. While doing our reading from various articles we developed more interest into the topic and what we found out we are going to share it here. There have been few issues in the history of Modern Corporation that have attracted the attention garnered by the executive compensation. It has become a international issue debated in congress and routinely featured in front page headlines, television news shows and cover stories. Several inextricably linked factors have contributed to deep interest in the topic of executive pay. First is the undisputed excalation in CEO compensation, the median cash compensation paid to S&P 500 CEOs has doubled since 1970, and median total

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realized compensation (including the gains from exercising stock options) has nearly quadrupled. Second is the populist attack on wealth that followed the so called, excesses of the 1980s, associated with the perception that high CEO salary is coupled to layoffs, plants closings, and corporate downsizing (Murphy,1995, 1997). Third is the bull market of 1990s that is creating the windfalls for CEOs whose pay is increasingly tied to companys stock tied performance. These major events also resulted in explosion in academic research on executive compensation. Prior to 1980 there was only handful of studies done on executive compensation, that included pioneering works by Roberts (1956), Baumol (1959) , and lewellen and huntsmen (1970). Most of these early studies were focussed on whether the pay was more closely tied to company size or company profits and the answers to these were proving to be lost in multi collinearity problems. The modern history of executive compensation research began in the early 1980s and paralleled the emergence and general acceptance of agency theory [1]. The quintessential problem of Agency theory that was suggested by Berle and Means (1932) was the separation of the ownership and control in the modern corporations today. Early researches mostly documented the relation between CEO pay and company performance and a few actually examined if CEOs are terminated on following the poor performance or are rewarded on the basis of performance measured relative to the market or the industry. Accountants have explored whether accounting based bonuses lead managers to manipulate earnings and have compared the relative efficacy of accounting based and stock based performance measures [2]. Financial economists have studied the association between executive compensation and corporate performance, investment decisions, capital structures, dividend policies, mergers and diversifications [3]. Industrial organisation economists have documented the effects of regulation and deregulation on executive compensation and have examined the game theoretic effects of strategic interactions on compensation policy [4]. While most research in the area has evolved as tests or applications of agency theory, sociologists and organisational behaviourists have examined non agency theoretic issues such as social comparisons and the behavioural effects of wage dispersion [5]. Inspite of the exploding interdisciplinary literature, executive compensation has received relatively scant attention from labour economists. Executive compensation gives opportunities for the analysing the concepts that are central to labour economics. Compensation contracts are multi dimensional and complex, the publicly available data are relatively clean. Also, an increasing number of researchers are gaining access to data and on performance measures and bonus contracts and on individual compensation far below the top executive rank [6]. Indian context Now after our understanding of executive compensation we tried to align it to the Indian context. And we observed certain points like, most of the Indian companies are family businesses, which results in pay being arbitrary and also there is very less regulation. The average pay of top 5 CEOs on the basis of the last years records is 31.8 crores. Also the ILO in India reports that the labour productivity shot up by 84% between the years 1992 and 2002 and in the same year wages dropped down by 22%. This was the time when the CEO salaries have broken all time records. Infact even today top end compensation are growing much faster than U.S. This issue is more relevant in Indian economy due to inequality present in the country but it is missing the public debate that is happening in the U.S. And the reason for that is medias less social relevance and its developing interest in trivia more than the news. The objective of the paper is to foster to research in executive compensation by providing comprehensive and up to date description of executive incentive contracts and trends in pay practices for the officers and also how executive pay affects the stock performance. The paper will have the analysis of the level and structure of executive compensation packages and serves as a premier on executive compensation. Most executive pay packages contain of four basic components: a basic pay

Proeedings of the SIMS Annual Research Conference, SIMSARC 11

salary, bonuses that provide short term incentive plans, long term incentive plan and stock options. Also it will cover the relation between CEO pay and performance also by side, executive turn over and its relation to company performance. It will also have the politics of pay. Public disclosure of pay also guarantees the involvement of third parties virtually that can affect the type of contract written between the management and shareholder.

Proeedings of the SIMS Annual Research Conference, SIMSARC 11

Level and structure on Executive Compensation
Introduction Most executive pay packages contain of four basic components: a basic pay salary, bonuses that provide short term incentive plans, long term incentive plan and stock options. Executives also participate in employee benefit plans and also receive special benefits, that includes life insurances and supplemental executive retirement plans. Top executives increasingly negotiate formal employment contracts that last for five years and specify minimum base salaries, also target bonus payments (with or without guarantee) 120

100

80 Other 60 Options Bonus 40 Salary

20

0 1992 1993 1994 1995 1996 1997 1998 1999 2000 From the graphs above it is observed that the pay of CEO vary by their industry type. And also observed that the level of compensation has been increased over years substantially. It has to be understood by one that the compensation increases with the company size. International comparisons

Proeedings of the SIMS Annual Research Conference, SIMSARC 11

United States United Kingdom Switzerland India China (Shanghai) China (Hong Kong SAR) Canada Argentina 0% 20% 40% 60% 80% 100% Basic Compensations Variable Pay Benefits Perquisites

In the above figure the level and composition of CEO pay upto year 2003 in 8 countries has been shown, on the basis of data interpreted from Towers Perrins Worldwide Total Remuneration, 2003. Components of CEO pay Base Salary These salaries are typically determined through competitive benchmarking. This benchmarking is primarily based on general industry salary surveys and supplemented by detailed analysis of selected industry or market peers. A variety of pay percentiles are reported by the surveys, which typically adjust for company size either via size grouping or through simple log linear regressions of Log(Salary) on Log(Size). But the use of surveys in determining base salaries has several implications that are relevant to understanding level and trends in CEO compensation. As suggested by Baker, Jensen and Murphy (1988) and Rosen (1922) one of the implications Is the size adjustments in the survey instruments both formalize and reinforce the observed the relation between compensation and the company size. Another implication is that the survey leads to a ratchet effect in base salary levels. Apart from the above two another implication that has been observed is while the surveys adjust for company size and the industry they do not contain criteria that mostly considered relevant for predicting earning levels by most of the labour economists. Base salaries are a key component of executive employment contracts. Base salaries represent the fixed component in executive contracts. Also most of the components of are measured relative to the base salary levels. Annual Bonus Plans Virtually every profit making company offers an annual bonus plan covering its top executives and it is paid entirely on the basis of annual performance of a year. No bonus is received by an individual until a threshold performance has been showed by an individual, and a minimum bonus is paid to the individual on the basis of the threshold performance by the individual. Mostly this minimum bonus is expressed as the percentage of the target bonus. One result that emerges is annual bonus contracts are largely explicit with limited role for discrition but it is observed in a variety of possible ways. A few discretion can affect individual allocations but not the overall

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amount of the payouts and this can happen in cases where, boards can exercise discretion in allocating a fixed bonus pool among participating executives. Performance Measures Most of the companies use two or more performance measures to decide the bonus, less than half the companies depend only on a single measure. Mostly these multiple measures are additive and they can be treated like separate plans. Performance Standards There has to be a standard that has to be determined for every accounting measure of a particular bonus plan. There can be standards like, Budget Previous year Discretionary Peer group Timeless standards Cost of capital

Pay Performance Structures There are different ways in which the payouts of bonus plans are determined. There are plans like 80-140 and others and also modified sum of target approach etc. I didnt understand that. Incentive Implications To increase company profits virtually all annual bonus plans provide incentives. Incentive effects of performance measures Mostly accounting profits are the primary determinants of the executive bonuses.but there are two fundamental problems with the accounting measures: Accounting profits are inherently backward looking and short run. Accounting profits can be manipulated too.

Incentive effects of performance standards It has been observed that performance standards allow for some board level discretion. Performance standard creates problem whenever employees who are measured relative to the standard have influence over the standard setting process. Stock options These are the contracts that give its recipient the right to buy a share of stock at a prespecified strike price for a pre specified term. Over time, executive options typically become vested. These executive options are non-tradable, and are typically fortified if the executive leaves the firm before vesting. Also it has to be noted that stock options reward only stock price appreciation and not total share holder return, since the latter includes dividends. Other forms of compensation Restricted stock

Proeedings of the SIMS Annual Research Conference, SIMSARC 11

The grants are restricted i.e; shares are fortified under certain conditions. The possibility of forfeiture allows favourable tax treatments and accounting treatments. Long term incentives plan Apart from bonus plans on yearly performance many companies go for LTIPs that are based on rolling average 3 or 5 year cumulative performance. Who sets CEO pay? The major part of the controversies is due to the perception that CEOs decide their own pay. Whereas in reality in most of the companies, ultimate decisions are made by the outside members of the board of directors who are keenly aware of the conlicts of the interest between managers and the shareholders over the level of pay.

Relation between pay and performance

Introduction The relation between executive pay and performance has been rooted in agency theory: compensation plans are designed top align the interests of risk averse self interested executives with those of shareholders. Principal agent Theory and Executive Compensation Borrowing from the works of Mirrlees (1974,1976) , Holmstorm (1979) , Grossman and Hart (1983) and others, lets assume a CEO is taking an action a to produce scholastic shareholder value, x(a), receiving compensation w (x,z), and utility u(w,a) , where z is a vector of other observable measures in the contract. CEOs utility function and productivity function linking the CEOs action to output are common knowledge to both the shareholders and the CEO, but only CEO observes the action taken.