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Management Compensation

JEM100 - Corporate GovernanceDoc. MPhil. Ondřej Schneider, Ph.D., McKinsey Chair

Prof. Ing. Michal Mejstřík, CSc

12/11/2007

Jana Procházková

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

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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

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Levels of management

Managerial compensation follows the hierarchical structure of an organization Top management

1-5 % of the organization’s 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)

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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

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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

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Difference between 'Management' and 'Executive'

in U.S large publicly traded corporations two separate spheres

Executive body

Management Body

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Components of managerial compensation

base pay, bonuses (short term incentives), capital appreciation plans (long term

incentives), deferred compensation and benefits

(including perquisites/perks).

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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 tableData in national currencies:

County Position Low Average High Bonus %

CEO 187 603 239 778 479 557 37,3CFO 93 359 133 848 440 238 22,4

CEO 367 466 469 665 939 331 37,7CFO 182 874 262 185 862 351 22,4

CEO 3 925 703 5 017 514 10 035 028 37,3CFO 1 953 747 2 801 071 9 213 003 22,4

Great Britain

Germany

Czech Republic

Source of data: www.salaryexpert.com - salary calculator

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Comparison between management and Executive Compensation

Annual salary comparison tableData in EURO:

County Position Low Average High Bonus %

CEO 265 083 338 806 677 614 37,3CFO 131 916 189 127 622 056 22,4

CEO 367 466 469 665 939 331 37,7CFO 182 874 262 185 862 351 22,4

CEO 144 375 184 528 369 057 37,3CFO 71 853 103 015 338 825 22,4

Great Britain

Germany

Czech Republic

Source of data: www.salaryexpert.com - salary calculator

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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

Kmart

Webvan

Mattel Inc.

Former CEO Chuck Conaway filed the country's largest retail bankruptcy, after which he (and other Kmart executives) still received bonuses. 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 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 stock price dropped 70%, but she still walked away with over $10 million.

Source: Jennifer Dixon, "Departure of Kmart Chief Raises Questions about Severance Package," Detroit Free Press,March 12, 2002.

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Executive pay compared to blue-collar workers in the U.S.A.

Source: Business Week

Year CEO salary compared to blue-collar worker 1980 42 times1990 85 times 2000 531 times

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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 compensationChevron 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 Corporation’s 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 Corporation’s 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

long-term 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.jsp?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