FinanceProfessor.com

Executive Summary:

This is an exhaustive summary of the executive compensation. Looking at trends in level and structure of executive compensation both internationally and domestically, the paper documents the increase in CEO pay, the fact that US managers are paid more than their international counterparts, the pay-performance sensitivity has increased over the past 25 years. There is an excellent discussion of how each form of pay "works" and how stock options operate and the fact that their use has increased substantially.

Wow is all I can say! This is a compendium of information and probably should be several papers but like most papers by Murphy I highly recommend that you read it! Probably the most complete survey article on the topic, because of its length, this summary will be more a listing of interesting facts than some other summaries.

Murphy has made a review article that not only reviews past research (which there has been much) but also adds to the topic with some original work. He begins by showing that CEO pay has increased dramatically in the past 30 years. Figure 1 shows that the median CEO cash compensation of SP 500 firms has doubled in real terms since 1970 and the realized compensation (including realized stock option gains) "has nearly quadrupled." Interestingly he notes that financial research on executive compensation has grown even faster!

Section II In this section the author looks at the "level and structure of executive compensation packages and serves as a primer." Notably he shows:

1. Pay levels vary by industry with managers at electric utilities earning the least.
2. The level of pay has increased substantially. Specifically he shows that from 1992 to 1996 (in 1996 dollars) median pay levels increased 55% for manufacturing firms, 53% for financial firms, and 34% for utilities.
3. This gain is "largely attributable to increases in grant-date value" of executive stock options which "during the early 1990s replaced base salaries as the single largest component of compensation (in all sectors except utilities.)
4. Size matters. Larger firms pay their executive more. Brad, Jensen, and Murphy (1988) found a "pay-sales elasticities in the .25 to .35 range, implying that a firm that is 10% larger will be its CEO about 3% more." Rosen (1992) summarizes previous studies and finds that the pay-sales elasticity to be fairly constant across time and countries (Zhou 1997). That said, "recent data [shown in table 1] suggest that this relation has weakened."

Murphy also looks at international data from the 1997 Towers Perrin Worldwide Total Remuneration report. After warning about the difficulties of international comparisons (due to tax laws, insider trading rules, and the availability of options-for example prior to 1997 Japanese firms were not allowed to pay with options), the author reports that US managers are paid substantially more than those in other countries and that more of the US managers' pay is the form of stock-based pay. (Figure 4) Murphy speculates that these pay differences are shrinking and cites use of stock options North American firms using US firms in their "peer groups."

In the next 15 pages Murphy discusses each of the forms of compensation (salary, bonus, Long Term incentive pay, stock options, and other forms of pay). In each of these, there are many interesting facts. For example, most bonus plans are accounting based. They tend to be the 80/120 plan where no bonus is paid unless 80% of a standard (where the standard is set by either prior year, budget, discretionary, cost of capital, or peer group methods) is met and the bonus is capped at 120% of the standard. These standards can create conflicting incentives.

Stock Options: Although executive options could be designed in many ways, "there is little cross-sectional variation in granting practices: most options expire in ten years and are granted with an exercise prices equal to 'fair market value.'" Interestingly, very few firms actually reprice underwater options (possibly due to SEC disclosure requirements) but this may be an artifact of a bull market and the ability to reissue new options without canceling the existing options.

While options are popular (partially for alignment reasons, partially as a way of deferring taxes) and quite successful in aligning interests, they are not without their downside. For example, Lambert, Lanen, and Larcker (1989) as well as Lewellen. Lorderer, and Martin (1987) find that executive stock options may reduce dividends.

Valuing Options: Valuing Executive stock options is more difficult than most would expect. For starters, the options are long term and hence dividends and even volatilities are non constant which makes it difficult to use the Black-Scholes formula. Moreover, executives are undiversified and constrained in their exercise (example if they leave before vesting) things that lower valuation.

Tax Treatment of Executive Stock Options:

The granting of options is not a taxable event for either firm or executive.

There are two types of options: "Qualified" which are also called Incentive Stock Options and "non-qualified. For non-qualified options, the spread between the market price and the original exercise price constitutes taxable personal income to the executive and a compensation-deduction for the company." For qualified options the executive need not recognize the gain until the stock is sold whereupon the tax is a capital gains tax. (FWIW most older grants are non-qualified although that may change with the new lower capital gains rate.

Accounting for the option grants is different to say the least. Firms "incur an accounting charge equal to the 'spread' between the market price and the exercise price (amortized over the life of the option)." [Summarizer's note: by setting exercise price equal to grant day price no expense need be recognized.]

There are many theories (better alignment, bull market) to explain the tremendous growth in option use.

Other Interesting points brought out in the paper

• Although the initial pay proposal usually comes from the human-resource dept and outside consultants, it still must be approved by the compensation committee which is usually made up of at least some outside board members(must be to get deduction under IRS 162m)

• Outside hires of new CEOs has also gone up and is more prevalent at firms that have done poorly in the previous year. HOWEVER, this link seems to have gone down in the past decade.

Teaching Notes: the figures in this paper are excellent to get the point across to a class.

Figure 1 shows how CEO pay has increased.

Figure 4 shows international comparisons of CEO pay

Figure 5 shows how standard bonus plans work

Figures 6-8 show that Pay-Performance sensitivity has increased over the past 25 years. As it has increased with greater option use so too has volatility of the pay-performance sensitivity. (in fact it appears to be down for the 1992-1996 period).

Figure 10 shows that percentage ownership has remained relatively constant, but that the value of CEO's holdings has increased.

Figure 12 shows the age at which CEOs depart the company

Go back to Main Summaries Page

**************************************************************

Due to several requests, the non-Financial Pages have been de-emphasized but remember Finance is supposed to be fun

so I will be keeping these "fun" pages online.

**************************************************************

History Links

Fun Links

Running/Fitness/nutrition/yoga links

Hiking/camping/environment and Gardening

Diabetic cat links

Reading

   FastCounter by LinkExchange

Copyright 2002, 2003 for FinanceProfessor.com