Lesson 3.
2 - Executive Compensation
Learning Objectives
After reading this chapter you should be able to:
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Define Executive Compensation
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Understand Components of Executive Compensation
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List different Executive Benefits and Perquisites
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Understand Executive Compensation as Psychological Compensation
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Designing Effective Executive Compensation
Introduction
The financial payments and non monetary benefits provided to high level management
in exchange for their work on behalf of an organization. The types of employees that are
typically paid with executive compensation packages include corporate presidents, chief
executive officers, chief financial officers, vice presidents, managing directors and other
senior executives.
A well-designed executive compensation plan focuses on a number of important
objectives. It attracts and retains the talent necessary to lead complex organizations to
success. It aligns the interests of executives with those of shareholders. It focuses the efforts
of executives on achieving the organization’s business goals, both short- and long-term.
Finally, it provides programs that are regarded as credible and responsible by investors
and other stakeholders, and that meet legal and regulatory requirements. While these
objectives have not changed, the manner in which companies are achieving these objectives
is evolving rapidly. This is unfolding in a context of growing demands for transparency
and accountability. An organization developing an executive compensation program will
improve its chances of success by following five approaches:
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First, define the organization’s short- and long-term strategies, objectives and key
measurements.
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Second, vest responsibility for executive compensation in a compensation committee
consisting of independent board members.
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Third, take a total rewards perspective by looking at each component of the
compensation program as part of a portfolio of provisions rather than stand-alone
items.
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Fourth, establish the executive compensation portfolio to provide an appropriate
allocation of base and variable (at risk) compensation, short- and long-term programs
and performance incentives versus retention and attraction incentives. The optimal
mix will vary by company.
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Fifth, make the program as simple as possible.
Performance Objectives and Measurements
All executive compensation programs and decisions should derive from the
performance objectives and measurements of the participating executives. Traditionally,
executives’ performance measurements have been focused on hard financial metrics such
as earnings-per-share, total shareholder returns, revenue and profit before tax. In recent
years, there has been an increasing concern that an excessive focus on financial results will
actually cause a decline, over time, in financial performance. The argument is that financial
results are the result of doing everything else well. Executives should also be measured on
that. Executive performance has normally been measured against the organization’s pre-
established targets. An emerging practice is to measure company performance, and reward
executives based on the organization’s performance relative to that of a designated group
of similar companies (usually in the same industry). Since publicly available performance
data from other companies is almost all financial in nature, so are comparative performance
metrics.
Executive Benefits and Perquisites
Company practices on benefits and perquisites differ widely. The general trend is
towards a reduction in special provisions for executives. For benefits, the most common
practice is for companies to provide the standard insurance programs to their executives.
Where the amount of a benefit provision is contingent on income (life or disability
coverage, for example), some companies will adjust the standard maximums for coverage to
reflect the higher levels of income that will need to be replaced in the event of the death or
disability of an executive. Similarly, for companies with defined benefit pension programs,.
Applying the standard income tax maximums for registered pension plans will result in
executives exceeding the maximum benefit levels. Some companies will bridge this gap
through supplemental executive retirement plans. These plans cannot be financed from a
pension fund. Payouts are treated as regular business expenses. A large portion of executive
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compensation is based on incentive wards rather than salary. As a result, companies have
to decide whether income-contingent benefits such as pensions should be calculated on
the executive’s salary only, or on salary and bonuses. Perks should be congruent with the
company’s desired culture. A hierarchical organization will tend to have more. A flatter,
more egalitarian organization, or one with an active board or shareholders, will tend to
minimize perks. Justifiable perks are usually related to the nature of the demands of the
executive’s job. For example, memberships in golf clubs, social clubs or business associations
are sometimes provided for the purpose of customer meetings and networking.
Psychological Compensation
While compensation discussions tend to focus on financial provisions, a total
rewards approach also looks at non-financial or psychological compensation. This is
directed at more intrinsic motivators. An executive’s psychological compensation is most
likely to come from the characteristics of his or her work environment or individual nature.
Examples include congruence between work and values, degree of autonomy, relationships
with peers and more senior executives or board members, relationships with the people
they lead, the opportunity for visible achievement and public recognition, intellectual
and professional challenge and the ability to have an impact outside the company by
being involved in charitable, educational, public policy or other community endeavors. In
summary, executive compensation has become a subject of considerable public scrutiny.
The result has been a marked improvement in transparency and accountability,
compensation program design and governance. Boards and compensation consultants
are becoming more creative in developing incentive programs tailored tore ward specific
individual performance and behaviors. The prerequisite for an effective executive
compensation program is a clear understanding and definition of the organization’s
business objectives, performance drivers and performance measurements. Once these have
been established, the design of a total rewards package becomes an exercise in crafting an
appropriate mix of the various executive compensation components to drive the behaviors
required to achieve the organization’s short- and long-term objectives.
Components of Executive Compensation
In crafting the executive compensation program, companies need to determine
where they want to position their compensation relative to the market. Most want to be
at the market median, while a substantial minority seeks to be above market. One major
challenge in establishing market-competitive compensation provisions for executives is
identifying an appropriate group for benchmarking. That benchmark can consist of direct
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competitors, companies with comparable revenue or employee populations, companies in
the same region and companies that the organization would like to emulate. The executive
compensation portfolio can be made up of six elements.
1. Base Pay
This comprises a decreasing portion of executives’ total compensation. That is a
natural corollary of the increasing importance of incentive-based rewards. In recent years,
base pay annual increases for executives have averaged only a few tenths of a percentage
point more than increases for the broader employee population.For chief executive officers
(CEOs) of companies in the S&P/TSX Composite Index, base pay averaged about one-third
of total compensation.
It averaged about one-fifth for the 60 largest companies on the index. The mechanics
of executive base pay programs are much the same as for other employees. Executives earn
increases based on individual performance, internal equity and competitive market rates
for comparable positions. The percentage of total compensation made up by base pay is
inversely proportional to the executive’s ranking in the organization.
2. Non-Discretionary Cash Bonuses
These are a significant element of executive compensation. They are the largest
incentive compensation component in organizations that are privately held, and where
stock-based incentive programs are not applicable. Non-discretionary bonuses are tied to
the achievement of measurable targets. There is usually a threshold level of performance
required before any payout is made, a target level of performance at which the target payout
is made and a higher level of performance at which the maximum allowable payout is made.
These bonuses are usually based on performance within a fiscal year. The shorter time
frame for measuring and rewarding performance is consistent with short-term (quarterly
and annual) shareholder expectations.
3. Discretionary Cash Bonuses
These bonuses are not linked to specific performance measurements or targets.
Discretionary bonuses may be appropriate where company performance is weak, thresholds
for non-discretionary cash bonuses have not been met and where there is a need to provide
additional compensation to key executives for retention purposes. In some cases they are
used for valued achievements that are not rewarded through other components of the
compensation package. Despite these opportunities, they are decreasing in use.
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4. Stock Options
Stock options, or other share-based instruments, are intended to align the interests
of executives with those of shareholders by encouraging executives to increase share prices.
A stock option program provides an executive with the option to buy shares — typically
at the Fair Market Value (FMV) of the stock as of the day the option grant is issued. Some
companies have begun to price options above the FMV so that the options will not have
any value unless the stock price attains a stipulated increase in value. The options usually
vest over a period of three to five years. The option recipient usually has five to 10 years
from the option grant date to exercise the options. One emerging trend has companies
making the vesting of options dependent on the achievement of specified performance
objectives, rather than simply on the passage of time. Stock options do not completely align
the interests of executives and shareholders. Unlike direct share ownership, stock options
do not entail the possibility of financial loss, and do not reflect returns to shareholders via
dividends. Accordingly, an increasing number of companies are requiring executives and
board members to have a defined amount of personal share holdings. One of the criticisms
of stock options is that, in a bull market, even poorly managed companies experience an
increase in share price. That rewards executives even when their organization’s performance
is below average. Companies can mitigate this risk by pricing options above the FMV as of
the date of the grant, or by providing shorter time frames (perhaps five years rather than
10) for the exercise of options.
Conversely, well-run companies may experience a decrease in share price during
a bear market. That can have a significantly negative impact on executive morale and
retention. In such cases, some companies have chosen to revalue their options (reduce
the price at which they can be converted into shares). This can be perceived as sheltering
executives from the pain felt by shareowners, which violates the principle of aligning
the interests of executives and shareholders. Option revaluation is becoming rare. A less
controversial approach to this problem is to reduce the stock option component of the
executive compensation package, and to increase the bonus component (especially non-
discretionary bonuses based on the individual’s performance rather than the share price).
5. Stock Appreciation Rights
These are like stock options, except that the recipient does not actually have to buy
and then sell the shares vested. Stock appreciation rights involve notional stock. They have
the advantage of providing cash compensation if the share price increases, but not diluting
shareholder equity. They are often used by multinational corporations for executives in
countries where stock option programs are not allowed by law.
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6. Share Unit Plans
Under stock option and stock appreciation rights plans, executives are compensated
only on the increase in the value of the shares over the option price. Under share unit
plans, executives receive the full cash value of each share unit granted rather than just the
appreciation of the share price. Depending on the plan, the share unit holder may receive
cash or actual stock at the point of exercise. Share unit holders will also normally receive
the same dividends as regular shareholders Because each share unit has more value than a
stock option, fewer units need to be granted to provide the same compensation value to the
executive. Share unit plans can be criticized for rewarding executives even though the stock
price may have declined. Also, because of the smaller number of units typically granted,
there is less upside (compared to stock options) for increases in share price. However, they
encourage executives to protect or increase the existing value of shares, and to preserve or
enhance dividend yields. Income gained under share unit plans is currently taxed, upon
receipt, as ordinary income. There are three types of share unit plans:
Restricted Share Units
These units vest under a predetermined schedule, typically at the end of a specified
period such as three years.
Performance Share Units
These are increasing rapidly in popularity as an alternative or complement to
traditional stock options. Performance share units vest depending upon the achievement of
certain predefined and time-bound performance objectives.
Deferred Share Units
With these units payment is deferred until the executive’s employment with the
company ends. They direct executives’ attention to the long-term performance of the
organization. An unintended consequence of deferred share units may be to encourage
executives to leave if they anticipate a significant reduction in share price.
Steps in Designing an Effective Executive Compensation Program
1. Analyze Existing Benefit Plans and Executive Compensation Arrangements
One of the first things you will want to do is review the benefits provided under
the standard package of employee benefit plans that will be offered to the key employee.
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Analysis of the base retirement and tax-deferred savings plans is necessary in order to
identify gaps in coverage and opportunities that maximize benefits provided under the
available limits. In other words, do the math. Addressing what is needed or desired can only
be accomplished after determining what is already being provided.
For existing executive compensation arrangements, you will want to determine if
the programs still meet their primary objectives and remain in compliance with current
regulatory and legislative requirements. You will also want to analyze the administrative
requirements and costs of the benefit program to ensure that it remains affordable and
efficient. Finally, as with any employee benefit plan, you will want to ensure that the
executive compensation package that is being offered or considered is not only adequate,
but also understood and appreciated by the key employee.
2. Establish Primary Plan Objectives for Executive Compensation Program
This step basically asks the question, why are we considering development of a
supplemental executive compensation package?
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Is it simply to provide the key employee with additional retirement contributions
above and beyond those provided by the standard employee benefit plans?
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Is it to restore benefits lost under these standard plans due to the IRS limits placed
on compensation or nondiscrimination testing?
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Is it to provide the key employee with additional salary deferral opportunities?
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Is it to attract or retain the services of a key employee or to reward performance?
The answer to these questions will help identify the most appropriate executive
compensation arrangement for the circumstance. “Yes” answers to the first three questions
can, in many cases, be accomplished without complex plan designs and—depending on
the amounts under consideration—within the established limits of eligible nonqualified
deferred compensation plans. Plans with an objective of recruiting and retaining the
services of key employees generally tend to be more complex in design and involve higher
compensation limits.
3. Identify Optimal Plan Design Features
Once you have determined the plan’s primary objective, you will want to gauge the
relative importance of certain design features from an institutional perspective. A common
consideration is the issue of public disclosure and/or Form 990 reporting. In the case of
a highly recruited athletic coach, these issues generally tend to get played out in the local
media and are difficult to manage. However, the type of plan selected will determine when
or how the compensation is disclosed. (Note: all public institution information is subject
to state open records laws, and independent institutions must disclose all compensation in
the Form 990.)
Other considerations include determining the importance of protecting the benefit
from the institutions’ creditors, whether future service requirements are required, and when
benefits are to be made available. (Some plans, such as 457(f) arrangements and 457(b) plans
of tax-exempt organizations, must be “unfunded,” whereby the assets remain the property
of the institution and must be made available to creditors until they are distributed.)
Design features such as rolling risks of forfeiture, the use of non-compete agreements, or
requirements for performance of consulting services following separation from service are
generally no longer available.
4. Determine Tax and Distribution Strategy
Of great importance to both the institution and the key employee is the tax liability
and distribution strategy associated with the executive compensation plan selected.
Although tax-exempt and governmental employers do not have the same tax incentives
as for-profit organizations when establishing executive compensation arrangements, some
plan designs have bookkeeping requirements that must be considered. The institution also
must determine the importance of employer control of the assets and benefit distributions
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prior to and after vesting or before retirement. Of particular concern to the key employee
are the individual tax consequences of the benefits during the accumulation phase, upon
vesting, prior to distribution, and following separation from service. Rules vary by plan
type and must be analyzed carefully.
5. Select Appropriate Financing Methodology
Depending on the type of executive compensation plan under consideration, an
institution will need to base its financing strategy on projections of future assets, benefit
liabilities, and cash flows. Simply put, how is the institution going to pay for or account for
the benefits promised?
Common financing arrangements include:
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Cash/lump-sum settlement (pay as you go).
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Shadow account (defined interest and earnings assumptions).
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Institutionally owned annuity/mutual fund accounts.
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Institutionally owned life insurance policy.
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Use of Rabbi Trust, Employee Trust.
From the key employee’s perspective, various funding arrangements tend to involve
a trade-off between the level of security provided on the underlying benefits and the
amount of tax deferral that can be achieved. Certain executive compensation arrangements
have maximum contribution limits placed on them with the benefit of spreading out the
tax liability over time upon distribution while others provide for unlimited contribution
amounts but are heavily taxed upon vesting or distribution.
6. Establish Guidelines for Periodic Review and Evaluation
As previously mentioned, a successful executive compensation program begins and
ends with good governance and compliance with all legislative and regulatory requirements.
It is critical to review these arrangements on an annual basis to ensure they remain consistent
with the institution’s overall compensation philosophy, policies, and practices and are in
compliance with applicable laws and regulations.
While the focus of this article centered on the types of executive compensation
packages most commonly used in higher education, the annual review should take into
consideration the total compensation package: base salary, benefits, short- and long-
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term incentive programs, and perquisites. It is also important to ensure that all executive
compensation plans are well documented, including the decision-making process and
procedures that went into their development. And finally, good governance requires
involving all of the key stakeholders (human resources, finance/business office, and legal
counsel) and clear communication between senior leadership and the institution’s governing
body.
CASE STUDY
Executive Compensation Strategy in Fortune Furnitech
Fortune Furnitech is a state-of-art modular furniture manufacturer, started with an
initial ` 500 crores investment, by raising a term loan from different financial institution
and about 65 percent contribution from the traditional family business. The group has a
traditional family history of woodcraft manufacturing. Leveraging the family trend, the
present owner Asim singh and his wife Ragini ventured into this business. Asim Singh has
toured extensively all over the world with his father, right from his childhood. According to
Mr.singh, India has top quality berg woods in its North-eastern states, which are imported
by countries such as the USA. However, Indian use them as firewood, because of lack of
awareness. The company launched an ambitious plan to manufacture and sell hardwood
furniture worldwide, as their study indicated that the Indian market for furniture is still
unorganized, and the affluent class used imported furniture made out of concentrated wood
dust or waste products.
To achieve this goal, the company recruited the best designers, business heads, and
production people worldwide. Many designers were either Italian-born or trained in Italy.
The biggest challenge the company faced was in designing managerial compensation.
Management compensation received attention primarily because of its performance
implication and strategic fit in Fortune Furnitech. The HR manager claimed that it
had a positive effect on the company’s financial performance and recommended the
appropriateness of different compensation for specific strategic situations. However, he
could not convince the top management of the need to formulate an executive compensation
package accordingly.
Asim Singh only considered such alignment for executives on the board, arguing that
their achievements was traceable. The HR manager argued that compensation cost in the
company was the second largest expense category, the first being the cost of raw materials
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and other implements (excepting labour). Hence, it has to be managed strategically, aligning
with the performance of the organization and its fit with overall organizational strategy.
He supplied extensive literature to sell his argument. He complained that the organization
did not have a well-documented compensation philosophy, despite this evidence. Some
incentives were also counter productive. He argued that it is time to develop executive
compensation, de-emphasizing the immediate financial gains and tagging it with long range
strategy of the organization. After listening to the HR head’s argument, the CEO directed
him to develop a model that may work in the organization.
Question
1. Imagine you are the HR Manager. Design the appropriate pay model for executives
of the organization.
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