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Executive Compensation

There are two main things to look at when discussing executive compensation:

Level of Pay
Form of Pay

It is the level of pay that gets the person to be an employee for your firm. It is the form of pay that leads to work from the employee. That is, the level of pay gets the employee in the door, the form aligns incentives and gets the person to do the work that you desire.

Level of Pay

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. (http://www.orst.edu/dept/pol_sci/fac/sahr/prceo.htm)

Economic theory of pay

You want to pay people such that the marginal cost equals marginal productivty

Problem; hard to measure....
Example: MoneyBall..even in baseball it is very difficult to measure marginal productivity

Consequently various methods have been devloped to approximate this marginal productivity

Hourly
Salary
Piecemeal
Bonus and commission
Accounting based pay
Market Based pay

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)

Accounting-based pay is an attempt to reduce some of these conflicts and to align incentives.

It has the advantage of paying people more for what they control and less for what is outside their control. (for example, a market-wide collapse is beyond the fault of any manager but a manager with market-based pay will likely suffer the consequences.)
Examples: bonus based on ROA, ROI, EVA etc.
Problems: managers may act to increase the relevant ratio at the expense of shareholders (example: reduce depreciation, use operating leases to keep assets "off-balance sheet")

Market-based pay is proabbly the best for aligning incentives managerial interests and Shareholder wealth, this thus lowers shareholder-manager conflicts.

Market-based pay makes up over 50% of CEO pay and is generally responsible for the headline numbers that we sometimes see. (www.ExecPay.com)

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).

All have advantages and disadvantages. Moreover, all are used.

Pyramid:

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.

Benefits and disadvantages of each

Form of Executive Pay:

Salary-the way most people get paid but actually makes up a small portion of Exceutive pay (12% in 1999)
Accounting-based pay (example Bonus)
Market-Based pay (example Options)

More "unusual" Types of pay

Stock
Restricted Stock
Phantom Stock
Dividend Units
Stock Appreciation Rights (SARs)

LEVEL OF PAY

How much are they paid?

A lot!

The AFLCIO obviously is upset about the high levels of pay and have created a data base of the pay of CEOs at many large firms
http://www.aflcio.org/corporateamerica/paywatch/
http://www.aflcio.org/corporateamerica/paywatch/ceou/database.cfm

Additionally, CEO pay has been growing much faster than the average worker's pay.
http://www.aflcio.org/corporateamerica/paywatch/ceou/ceou_compare.cfm (cool site if we can beleive the numbers! Amazing. It allows you to compare how fast your pay changes relative to CEO pay.)

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. (SHAQ vs. George Miken)
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.

Is it too much?

In 1974 the Yankees signed Catfish hunter to a $3.75 million Five year contract and everyone was convinced it was the end of the sport. 30 years later players are making well over $10 million with some MUCH higher. Alex Rodriguez signed a 10 year 275 million contract. And yet baseball continues to pay the big bucks. Much the same has happened in the business world.

Steven Levitt once wondered why drug dealers live at home, the answer to the question might also have something to say about levels of pay at firms.

"There's only one small problem with the theory of "greed gone wild." The U.S. economy is the envy of the world-the only major one to flourish over the last few years. The question is: Does the U.S. economy grow despite the excesses of CEO pay? Or does America's philosophy of CEO compensation provide U.S. companies with a global competitive advantage? "
http://www.chiefexecutive.net/mag/147/article2.htm

CEO pay and social issues
There are observations that by using compensation packages which focus managers’ attention toward maximizing shareholder wealth, workers are enjoying greater job and retirement security than are citizens of other developed nations (Kay, 1998). There are also arguments that the linking of CEO compensation to the economic performance of the firm has contributed to improving the global competitiveness of U.S. firms, which, in turn, has improved the economic benefits for all (Fisher, 1998). From a broader perspective of social issues research, there have been indications that improved firm economic performance has been correlated with higher levels of corporate social performance (e.g., Waddock & Graves, 1997).
http://www.westga.edu/~bquest/2000/ceo.html

http://pioneerplanet.com/archive/ceopay/
http://papers2.ssrn.com/paper.taf?ABSTRACT_ID=163914#Paper%20Download

Here is an interesting article on differences in pay across countries by Thomas (2003)
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=407600

The debate as to whether board makeup impacts pay is not easy.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=392595

Links and Papers

Probably the best paper on executive compensation (by the acknowledged expert Kevin Murphy (who happens to also be a nice guy and really good teacher-I had him and throughly enjoyed his class!) http://papers2.ssrn.com/paper.taf?ABSTRACT_ID=163914#Paper%20Download
The above paper is quite long, so I summarized it for my classes:
http://www.financeprofessor.com/summaries/Murphy1998.htm

Other very good executive compensation links:

Execpay.com has an excellent recap of the trends we are seeing in executive pay. Highly recommended!