Management Compensation
JEM100 - Corporate Governance
Doc. MPhil. Ondej Schneider, Ph.D., McKinsey Chair Prof. Ing. Michal Mejstk, CSc
12/11/2007
Jana Prochzkov
Julia Neue Robert Warren
Tony Mikes
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Outline
Introduction to Management Compensation Comparison between Managerial and Executive Compensation
Chevron case example
Principal Agent Problem
Mitigating Principal Agent problems
Concluding remarks
Introduction to Management Compensation
Specifications of managerial work
very difficult to describe various types of task on day to day bases
internal role directing an organizational unit (leadership) external role
developing relationships outside the organization
Levels of management
Managerial compensation follows the hierarchical structure of an organization
Top management
1-5 % of the organizations workforce Developing goals and strategies to keep the organization effective Concerned with the problems extending years in the future
Responsible for the total operation (CEO and executive VPs)
the owners through the board of directors see them as the trustees of their sources their compensation is connected with the success of the organization as a whole as well as their own indeed, it has been found that managerial system which did not focus on critical organization outcomes were ineffective (Schuster, Management Compensation)
Levels of management
Lower management
first line mangers = supervise the work of non-managerial employees compensated as a percentage of wage of the people they supervise
Middle management
a larger number of managers information channel between top managers and supervisors specific function in the organization and coordinate other functions in the organization compensation related to the function being managed, managerial surveys decrease over the past years in order to reduce bureaucracy
Difference between 'Management' and 'Executive'
Management group Executive group
exists within the management group top, president, vise-president, chief differentiated position within the organization
In many international locations and within small to medium-sized North American firms, the terms managers and executives are used interchangeably
However
Difference between 'Management' and 'Executive'
in U.S large publicly traded corporations two separate spheres
Executive body Management Body
Components of managerial compensation
base pay, bonuses (short term incentives),
capital appreciation plans (long term incentives),
deferred compensation and benefits (including perquisites/perks).
Aspects of compensation plans
commitment
managers associate themselves with the organization
difficult to turn off the job even in their leisure time
decision making
core of managerial work
particularly broad framework of decision-making under uncertainty
primarily conceptual decision-making
orientation
focus on getting the job done in the organization
power needs
enjoy controlling a situation and having a strong influence on the outcome of events
the idea of status
managers spend an enormous amount of time at work have heavy responsibility
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Other ways to determine the level of pay
Management by objective
based on individual definition of performance
measurable standards are developed by the manager himself and his supervisor
performance is evaluated towards the objectives at the end of a period by both parties jointly
drawbacks
hold managers to the objective that are out of date in case the world is too dynamic
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Other ways to determine the level of pay
Pay for performance
It has been found that the perception would lead to higher pay is more important than the fact
Generally, there is nearly no relation between pay and performance with managers measured from a sample of 600 middle- and lower-level managers. However, those who were the most highly motivated felt that pay was important to them and that good performance would lead to higher wage
In many cases it is hard for the managers to see the connection between performance and pay
rewards are deferred the goals are not clearly expressed
It cannot be taken for granted that paying for performance is worth doing
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Bonus standards short term incentives
a manager receives a bonus because some standard was met in the past period
organizational (productivity, cost saving)
job related (job outcomes, performance of particular activities) usually paid in cash
based upon the base pay of the managers
e.g. assume that the organization wished to maintain a minimum return on assets of 10 percent. The managers may receive 20 percent of base pay if the organization achieves a 10 percent return on assets and an additional 5 percent of base pay for each 5 percent increase in return on assets over 10 percent.
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Long term incentives stock options
Is used to tie the managers to the long term success of the organization
primarily motivates top management
granting managers the right to become a part of shareholders
ownership and control come closer together
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Stock Option Possibilities
Stock Option Plan
managers are offered stock at a set price
Stock Appreciation Rights (SAR)
work like stock options but the managers do not have to buy the stock
the manager receives from the organization the difference between the current market value of the stock and the stated option value of the stock
however, the amount of possible gain is limited
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Stock Option Possibilities
Restricted stock plans
the manager is granted a certain number of shares of stock as a bonus but may not sell those shares until certain conditions have been met (such as certain performance, employment for certain years)
Phantom Stock plans
In these plans the manager is awarded units that represent shares of stock. These units typically mature at some time, ordinarily four to six years. At maturity the manager is paid the then-current value of the stock or the difference between the original value and current value.
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Stock Option Possibilities
Performance share plans
the manager is granted performance units that represent shares of common stock. He or she earns these shares through the performance of the organization.
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Issues with stock options
Managers may be inclined to inflate the value of the company so as to inflate the value of their stocks options.
Enron Apple Computer
WorldCom
Global Crossing
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Deferred compensation
Retirement benefits Golden parachutes
provides pay and benefits to an executive after being terminated due to a merger or acquisition
reasons for doing so
limit the risk of unforeseen events business expenses
Perks
designed to satisfy special needs of the managers, especially top managers
may include a car, entertainment expenses, and club memberships. services such as free medical examinations, low-cost loans, and financial or legal counseling
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Comparison between management and Executive Compensation
Annual salary comparison table Data in national currencies: County Position Low
Average 239 778 133 848 469 665 262 185 5 017 514 2 801 071
High 479 557 440 238 939 331 862 351 10 035 028 9 213 003
Bonus % 37,3 22,4 37,7 22,4 37,3 22,4
Great Britain Germany
CEO CFO CEO CFO CFO
187 603 93 359 367 466 182 874 3 925 703 1 953 747
Czech Republic CEO
Source of data: www.salaryexpert.com - salary calculator
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Comparison between management and Executive Compensation
Annual salary comparison table Data in EURO: County Position Low
Average 338 806 189 127 469 665 262 185 184 528 103 015
High 677 614 622 056 939 331 862 351 369 057 338 825
Bonus % 37,3 22,4 37,7 22,4 37,3 22,4
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Great Britain Germany
CEO CFO CEO CFO CFO
265 083 131 916 367 466 182 874 144 375 71 853
Czech Republic CEO
Source of data: www.salaryexpert.com - salary calculator
Interesting note: Pay rises in all circumstances
The CEO is truly underpaid. The consultant reports this to the Compensation Committee, and the executive's salary is increased.
The CEO is not underpaid and the company is doing well. The consultant is asked to compare the executive's salary to a set of companies who are known to pay highly. The result is a recommendation to raise the executive's pay. The CEO is not underpaid and the company is not doing well. The consultant finds management lamenting that with these low wages, turnover is inevitable. The consultant then suggests a raise to prevent turnover.
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Examples Former CEO Chuck Conaway filed the country's
largest retail bankruptcy, after which he (and other Kmart executives) still received bonuses. Kmart While Kmart laid off 22,000 workers without severance pay, Conaway walked away with $9 million. George Shaheen left the online grocery company a few months before it closed its doors, taking a Webvan severance package of $375,000 per year for life. (If he dies, his wife still receives the compensation.) While Jill Barad was at the reigns of Matel, the Mattel Inc. stock price dropped 70%, but she still walked away with over $10 million.
Source: Jennifer Dixon, "Departure of Kmart Chief Ra ises Questions about Severance Package," March 12, 2002. Detroit Free Press,
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Executive pay compared to blue-collar workers in the U.S.A.
Year CEO salary compared to blue-collar worker 1980 42 times 1990 85 times 2000 531 times
Source: Business Week
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Differences in the pay of managers and blue collar workers explained
5 Motivational models:
1. The equity model
if the manager is earning such high salary, his contribution should be equally great
contradictions
2. The performance-motivation model
questions whether it is the manager or other environmental factors that lead to results of the company
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Differences in the pay of managers and blue collar workers explained
3. Agency theory
managers agents of the stockholders
in the general assumption, interest of the shareholders and managers are the same, but in practice not. Shareholders thus attempt to align the interest of top management with their own by designing attractive compensation packages
4. Tournament theory
promotion is viewed as tournament and the high pay is the price of winning
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Differences in the pay of managers and blue collar workers explained
5. Social comparison theory
people need to evaluate themselves in comparison to others thus managers of one company must be paid similarly to managers of another
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How is pay established?
Board of Directors = Compensation Committee
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Executive compensation
The compensation of every employee is decided by the company owners through the board of directors and the management team (or "management committee"). There may be a 'personnel and compensation committee' that deals specifically with labour compensation. Employee compensation may be negotiated with a workers union. Management team compensation is often left to the company.
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Executive compensation
Five tools of compensation:
base salary
short-term incentives
long-term incentives (LTIP) employee benefits
Perquisites
In a typical modern US corporation, the CEO and other top executives are paid salary plus short-term incentives or bonuses.
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Management compensation
Chevron management committee example:
The purpose of the Management Compensation Committee of the Board of Directors of Chevron Corporation is:
1. To discharge the responsibilities of the Board of Directors of the Corporation relating to compensation of the Corporations executives; 2. To assist the Board of Directors in establishing the appropriate incentive compensation and equity-based plans and to administer such plans;
3. To produce an annual report on executive compensation for inclusion in the Corporations annual proxy statement; and
4. To perform such other duties and responsibilities enumerated in and consistent with this Charter.
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Mitigating the Principal-Agent problem
Managers have strong incentives to gamble on risky projects that impose potentially large losses on the firm's fixed claim holders. Moral hazard :
investment-risk choices made by management are not readily observable by depositors and regulators
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Firms response to threat by:
Altering top-management compensation as a way of influencing managerial return and risk-taking incentive Bank lenders may impose measures (such as imposing more restrictive loan covenants) to protect their investments in troubled firms. Senior managers' compensation may be tied to the successful resolution of the firm's bankruptcy or debt restructuring, or is based on the value of payoffs to creditors.
From CEO Compensation in Financially Distressed Firms: An Empirical Analysis pg 456
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Firms response to threat by:
Replacing top managers:
One-third of top management may be replaced in a given year around default, and those who remain often take substantial cuts in their salary and bonus.
Average inside replacement CEO earned 35% less than his or her predecessor. Average outside replacement CEO earned 36% more than the CEO he or she replaced.
Outside replacement CEOs, who represent almost 60% of new CEO hires, also typically receive large grants of stock options as part of their compensation (to turn the company around).
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Firms response to threat by:
Deferred compensation:
Deferring part of the managements compensation until the firm's financial restructuring was completed.
reduces legal fees and other costs that increase directly with the amount of time that firms spend renegotiating their debt contracts.
firms respond to financial distress by
basing more of senior managers' compensation on longterm stock-based performance measures,
cuts in their cash compensation (including bonuses).
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Concluding remarks
The components of managerial compensation are:
base pay,
bonuses (short term incentives),
capital appreciation plans (long term incentives), deferred compensation and benefits (including perquisites/perks).
Principal Agent Problems can be mitigated through a variety of methods
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Sources:
http://www.eridlc.com/onlinetextbook/chpt20/text_main.htm Schuster, Management Compensation www.salaryexpert.com Jennifer Dixon, "Departure of Kmart Chief Raises Questions about Severance Package," Detroit Free Press, March 12, 2002 Business Week http://www.cnb.cz/www.cnb.cz/cz/financni_trhy/devizovy_trh/kurzy_devizoveho_trhu/prumerne_mena.j sp?mena=USD http://www.x-rates.com/
PLEASE PROVIDE FULL CITATIONS
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Hall, Brian J., Murphy,Kevin J. The Trouble with Stock Options Journal of Economic Perspectives. Vol. 17(3), Summer 2003
"A Theory of Bank Regulation and Management Compensation." The Review of financial studies Spring 2000 Vol. 13, No. 1,
Chang, Chun. "Payout Policy, Capital Structure, and Compensation Contracts when Managers Value Control" The Review of Financial Studies, Vol. 6, No. 4. (Winter, 1993)
Gilson, Stuart C., Vetsuypens, Michael R. "CEO Compensation in Financially Distressed Firms: An Empirical Analysis." The Journal of Finance, Vol. 48, No. 2. (Jun., 1993) Hadlock, Charles J., Lumer, Gerald B. "Compensation, Turnover, and Top Management Incentives: Historical Evidence" The Journal of Business, Vol. 70, No. 2. (Apr., 1997) http://news.bbc.co.uk/1/hi/business/5131990.stm
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