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There are two
major issues that must be dealt with when it comes to pay:
form of pay and level
of pay.
- The level
of pay is important as it gets the employee “in the
door.”
The form of pay is what we hope influences “good” behavior from
the employee.
Level of pay
The level of pay is the headline grabber. This is how much someone gets paid.
Executives at today's firms are paid much like professional athletes.
And like the pay of professional athletes, executive pay draw a great deal
of attention. For example, in 2000, the median pay in the utility industry
was over $2 million (source Conference Board). (It should be noted
that median is the better measure for examining Executive Compensation than
average because averages are driven disproportionately by outliers.)
Executives (and pro-athletes) are paid more than typical workers which draws
both attention and jealousy. They are even paid more (in 1999 62 times
more) than the President of the US.
Why does this make the news so much? In part it is human nature. People always want to know what someone el se is getting paid. When you add a bit of jealousy into the mix and you have the controversy that exists when someone gets more than someone else; example of this include professional athletes. entertainment stars, and executives.
Add to this jealousy the controversial pay plans that became public
knowledge during the 2002 corporate governance crisis and you have an emplosive
mix. The level of CEO pay has been going up faster than inflation and
faster than the pay of other employees. For example for the year
2000, the average
pay for CEOs crossed $10 million a year a rise of
16%. Of course it is nothing
new that CEO pay is rising faster than inflation and faster than overall
pay.
It has for a long time and this has drawn the ire of many including the
AFL-CIO (see below).
http://www.nytimes.com/2001/02/14/business/14PAY.html
T
he AFL-CIO regularly
complains about the level of Executive pay and has found a very interesting
way to
drive their point home: it allows you to compares your average pay from a
few years ago to now
with the average CEO pay. (indeed this really shows the power of
consistent compounding!) There are several reasons for this: increased
importance of CEO due to improving technology and a rising stock market
that makes options more valuable.
http://www.aflcio.org/paywatch/ceou_compare.htm
Why do Executives get paid so much? There are many theories.
- CEO's actions influence a large number of people. There pay is therefore only in line with the implications of their actions.
- Tournament: CEO pay is the reward for winning the CEO "tournament." Under this hypothesis, the CEO must be highly paid because so few will win the award. Thus, the expected payoff much be great enough to offset the risks and costs.
- A more cynical view is that CEOs are paid so much because they control the board of directors who sets their pay.
Form of Pay
The second part of the pay question is the form of pay. This is the compensation of the "make-up" of a pay plan. Executive pay packages are really a portfolio of various streams of income. The is where the form of pay plays a more important role in shaping actions.
There are three basic
types of executive pay:
Straight Salary
Accounting based-pay
Market-based pay.
Salaries
While lower level
employees generally get paid predominantly with a straight salary, this
is not
true for executives. According to the NY Times in 2000 straight salary
made up only
about 10% of an executive’s pay and
this portion was growing at only 4% per year.
Accounting-Based pay
Long-term incentive
plans are one example of accounting-based plans. They
are used because they are less volatile and in some ways insulate the
executive from stock-market
movements. As a percentage of total pay, they made
up about 12% of pay in 2000.
Most firms also have
some sort of accounting-based short-term bonus plan
in place. These have not grown much and are generally frowned upon as
they can lead the manager
to make short-term decisions.
One problem with accounting-based
plans is that managers often have at least some say in how the firm accounts
for various transactions. THus, a well intended Board may inadvertantly
create new acounting problems with the introduction of accounting based pay.
Market Based Pay
Types of market-based pay
Stock options
SAR
Restricted Stock
Phantom Stock
Market-based pay
makes up roughly 60% of CEO pay. This is largely the
result of trying to align manager incentives with shareholder desires.
Paying with options
has led to rising pay packages as the market climbed
through the 1990s and Mega-Option grants became the “norm” as “The average
executive received $6.5
million in options, an increase of 28 percent from
1999.” This in spite of the fact that options were included at only
one-third of their grant
value!
Why so many alternative pay plans? One big reason is that each form of pay has certain benefits in helping to reduce agency costs.
Shareholder-Manager Conflicts
Shareholders and Managers can fight about many things:
- Effort
- Time-Horizon
- Risk (Managers are concerned with total risk due to poor diversification)
- Empire Building
- Under-Leverage (i.e. lower than optimal debt levels)
- Over-retention (i.e. lower than optimal dividends)
Both accounting based and market based pay are designed to reduce these conflicts.
Accounting-based pay:
Examples:
time horizon problem can be reduced
with defined benefit pension plans
Effort problems with bonuses.
As a general rule, Market-based pay is probably the best for aligning
incentives managerial interests and Shareholder wealth, and thereby lowers
shareholder-manager conflicts.
How does market-based pay reduce conflicts?
Consider risk aversion. Due to poor diversification,
managers are more risk averse than shareholders. If managers are given
options (which increase in value with risk).
Summary of level of form
Much of both the level and form of pay can be quickly summarized
in these simple models.
Types of Firms that have
Firms have a higher level of pay
LOW--------------------------------------Level of Pay----------------------------------HIGH
tend to have (or are)
Assets in place
Growth options
Small
Large
Regulated
Unregulated
Rationale: where the CEO has a larger impact, more pay
---------------------------Form of Pay---------------------------
Straight Salary is a higher proportion
Market-based pay is more important
of pay at firms with
----------------------------------------------
Assets in place
firms with many growth options
Small Firms
larger firms
Rgulated Firms
unregulated firms
Within any given firm the following relationships show which type of pay
predominates..
CEO and Executives
Market-based relatively more important
Middle Management
Accounting-based relatively more important
Employees
Salary relatively more important
The pay at each level may (and generally is) made up of components of each,
but the above shows which form dominates.
Trends:
Most believe that CEO pay growth will be lower in in the coming years as the spotlight has been placed on it in the post-Enron world. There has been a very loud public outcry against large pay plans and a demand for increased transparency. This has led to better reporting of pay with some firms decinding to expense their options.
Additionally, as the stock market is well under its highs of the late 1990s, many are finding their options underwater which is forcing some tough decisions to be made: rewrite and take away the downside to managers, or
Of late there has been more attention on not only executive pay, but also Board pay.
A good but dated article on trends in pay plans (it is from 1999) is avalable from ChiefExecutive.net
Various Executive Pay Topics that will be covered in class (and eventually here as well)
Does pay matter?
Who sets pay?
Is pay really volatile?
Should underwater options be rewritten?
Relative pay plans
Everybody is above average
Heads you win, tails I lose? a look at severance pay plans
What color is your parachute?
Handcuffs
Non compete clauses
Why executive pay costs more than the benefits executives receive
International differences
A look into the future
Academic research on Executive pay
Academic research into executive pay is rich and interesting. The
acknowledged leader in this field is Kevin Murphy. He has several
excellent papers and
along with others has helped to shape the field.
The general findings are that CEOs are paid a great deal of money, that
the form of pay is changing
over time (more towards market-based), and US
executives are paid more than executives in other nations.
http://www.financeprofessor.com/488/notes/executivecompensation_levelandform.html
A summary article (over
90 pages) by Kevin Murphy is available through
SSRN. It can be found at
http://papers2.ssrn.com/paper.taf?ABSTRACT_ID=163914#Paper%20Download
As the above paper
is quite long, I summarized it for my classes:
http://www.financeprofessor.com/summaries/Murphy1998.htm
Kaplan (1994) looks at Executivbe Pay in the US vs. Japan. Here is
my summary
of the JF article.
Links on executive compensation
The primary source for most data on executive compenstaion is either
the firm or Edgar
and the firms' proxy statements. However there are many very useful
and helpdful sites that can help with your executive compansation study:
the Riley Guide
has an excellent collection of links tied to executive pay. Highly
recommended.
Business Week
and Forbes anually survey firms for both the amount of pay and the form
of pay. Interestingly they also tie it to managerial perofmance.
xpay.com
is very useful and has a plethora of cool links!
Execpay.com
is a nice thoughtful site. I especially recommend reading some of
their articles
and opinion pieces
.
Say what you want about the AFL-CIO , its Paywatch does a great job at monitoring (and complaining about) Executive pay. Try their pay comparison which while build on some faulty assumptions (growth will continue etc) is fun to dream.
Copyright FinanceProfessor.com 2003.
Permission granted for in class use.