Executive compensation

From Wikipedia, the free encyclopedia

Executive compensation is how top executives of business corporations are paid.

Contents

The compensation of every employee is decided by the company owners through the board of directors (in the case of the most highly compensated executive positions) and the management team (or "management committee") (for everyone else). The board of directors may have a personnel and compensation committee that deals specifically with labor compensation.

In some countries the employee compensation may be negotiated with a workers union. The workers union will in many cases deal with for example a minimum wage limit and will not deal with the management team compensation but instead leave that to the company.

There are five basic tools to compensation (or reward) in US organizations. These are: base salary, short-term incentives, long-term incentives, benefits and perquisites. In a typical modern US corporation, the CEO and other top executives are paid salary plus short-term incentives or bonuses. This combination is referred to a 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 highly paid CEO would get 1 million in cash, and 1 million in company shares (and share buy options used).

Other components of an executive compensation package may include such perks as generous retirement plans, a health insurance, a chauffered limousine, an executive jet, interest free loans for the purchase of housing, etc.

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 ([1]). Forbes magazine counted the 500 CEOs compensation to $3.3 billion during 2003 (which makes $6.6 million a piece) (notice that that includes gain 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 (Immelt). The typical top cash bonus is $10 million - $15 million (Henry R. Silverman). The highest stock bonus is $20 million (Fuld). The highest option exercise have been in the range of $100 million - $200 million (Reuben Mark).

Supporters of stock options say that they align the self-interest of the CEO to that of the company, since options are only valuable 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 make the distribution of options more accountable to shareholders. Detractors of stock options charge that they are granted excessively and managements' misbehave in options backdating such grants. Stock options have also been criticized because they could cause a conflict of interest in which the CEO artificially raises the current stock price to cash in stock options at the expense of the long term health of the company, althought this is problem for any type of incentive compensation that goes unmonitored by directors. For various reasons, including the accounting charge, concerns about dilution, and recent negative publicity related to stock options, companies have reduced the size of grants to executives.

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 alternative to straight time vested restricted stock, companies have been adding performance type features to their grants. These grant, 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.

Salary is taxable to an individual at a high individual rate. If part of that income can be converted to capital gain, for example by granting stock options to executives, a more advantageous tax treatment may be obtained.

There are many controversies about executive compensation:

Many people [1] believe that CEOs are paid too much for the services they provide, while others[citation needed] believe that a good CEO can have a positive effect on the company's performance and, therefore, that high compensation is needed to attract the best talent. Some argue that since the CEO's pay is set by the board of directors, with the CEO determining the selection, tenure, and committee assignments of directors and most often selecting the compensation consultants as well, an unhealthy conflict of interest occurs and prevents effective price competition (see http://www.theyrule.net). 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.

Judging which CEO's are overpaid is a complex issue. Many articles focusing on high CEO pay simply survey the executives who received the most overall money in a particular year even though the vast majority of that might be from selling stock or exercising options that were obtained over many years and were never sold before (unlike other CEO's who might regularly sell stock or exercise options). The articles often rely on analysis from corporate governance firm The Corporate Library and its editor, Nell Minow. In addition many indirect corporate perquisites are possibly not included in these figures. Stock options for example, allow the CEO to buy the stock at a certain value later down the road. If the CEO makes his company do well the going price down the road can be much higher and the CEO could buy shares for his option price. If this hurdle looks sufficient many critics are assuaged, but there is an additional, more hidden factor that the options may be "repriced", that is the hurdled lowered halfway through the game.

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.[1]

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.

  1. ^ a b Letter From Washington: As U.S. rich-poor gap grows, so does public outcry. Bloomberg News. International Herald Tribune. Retrieved on February 18, 2007.
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