execu compen

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© Oxford University Press 2015. All rights reserved.

Dipak Kumar

Bhattacharyya

Compensation

Management, 2e


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Chapter 11

Executive Compensation


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Introduction

Executive compensation correlates with organizational performance.

There are three main areas of focus in executive compensation:

Understanding the criteria

Understanding the consequences

Mechanism to determine executive compensation


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Components of Executive Compensation

Components of executive compensation are:

1. Variable pay such as bonuses, commissions, and profit sharing2. Base pay such as salary and perquisites3. Employment status such as promotions and termination

Effective executive compensation packages typically comprises of the following

components:

base salary annual incentives long-term capital accumulation

deferred compensation arrangements supplemental benefits and perquisites special severance and retirement arrangements employment and change of control agreements(golden parachutes)


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Emerging trends in executive compensation

Following are some emerging trends in executive compensation.

• Increase in the number of corporate meltdowns is now dragging executive

pay and corporate governance into the public domain.

• Business conditions are putting pressures on existing pay levels and

structures.

• Corporate restraint and accountability make controlling executive

compensation a major issue in tough economic times.• Executive compensation movements at the median of the market are

getting subdued over the years.


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Executive compensation theories

Most executive compensation theories centre on the theories of firms. With profit

maximization as the core objective, firms rely heavily on their executives. This

syndrome encourages executives to expect above normal compensation.

Theories of executive compensation centres on following issues:

• Organizations need to identify executive compensation options that help

them derive benefits of performance satisfaction and increased executiveretention.

• Perquisites and supplementary benefits represent a very small fraction of

executive compensation due to tax burden.

• Organizations need to design tax-efficient long-term incentive packages.

•Organizations link executive compensation to sales maximizationhypothesis.


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Executive Compensation theories

• Other important economic determinant of executive compensation isthe performance of the firm. Executives are accountable for the firm’sperformance. Hence, their compensation is linked to the results of organizational performance.

• Executive compensation can also vary with the type of industry. Forexample, the compensation packages in the service sector are higherthan those of the manufacturing sector.

• Another important economic variable is the difference in value of human capital.

• Political and social factors also influence executive compensation.

Important theories of executive compensation are as under:

Agency theory, which suggests designing of executive compensation based on themutual interests of the agents (executives) and shareholders (principals).

Tournament theory, which views executive compensation as the prize in a series of tournaments or contests among middle and top-level managers.




Social comparison theory, which suggests designing executive compensation bycomparing it with similar individuals.

Balance sheet approach, which aims to provide expatriates compensation basedon the standard of living they normally enjoy in their own country.

Headquarters-based pay, which refers to executive compensation to all accordingto the rate used at headquarters.

Golden handcuffs, which refers to payment of above market rate executivecompensation.

Competency-based pay, which refers to a pay directly related to the kinds andlevels of competencies required in the performance of the work or job




Golden parachutes, which refers to the practice of providing pay and benefits toexecutives after their termination resulting from a change in ownership or a

corporate takeover.

Cafeteria plan, which gives executives the option to choose different types of benefits, which is commonly known as the cafeteria plan.

Profit-sharing plan, which provides direct or indirect payments based on the

organization’s profitability, apart from regular compensation.



Executive Compensation Design

Executive compensation design process links compensation criteria such as

organizational performance or size to compensation consequences such as pay at

risk.

Such process or mechanism is categorized into two forms—the process that

centres on contract and the process that involves direct monitoring of the

executive.

Organizations that follow the contract process make it a time-bound employment

offer, which becomes a legal arrangement. Contracts specify criteria for

compensation, basis of compensation (in the form of schedules), and some

predictable conditions for linking compensation consequences to criteria.

Direct monitoring is a behavioural approach to monitor the performance of the

executive. It is a subjective evaluation. It is based on the principles of agency

theory.



Typical executive compensation component



Executive compensation and organizationalstrategy

Organizations need to design executive compensation to reward the work, which will then

by default fulfill organizational strategy.

Designing executive compensation in the era of economic uncertainty, while rationalizing

expectations of the executives and fulfilling organizational strategy, is a very challenging

task.

Following are some action plans to meet this strategic intent, while retaining a trade-off

between executive compensation and organizational objectives:

Optimize the cost of compensation for health and welfare benefits, while identifying

vendors.

Rationalize the compensation budget by restructuring the deferral components of

compensation.

Optimize the cost of retirement benefits using funded pension assets through stock

build-up.

Identify wasteful HR costs by reviewing and restructuring the terms of contracts.



Different criteria of executive compensation

Some important perspectives of executive compensation are:

Strategy criterion - The strategic dimension of executive compensationfocuses on the rising cost of compensation, which for many organizations istheir second biggest expense.

Role or position criterion – This criterion links executive compensationto job position as a strategy to stimulate others to achieve the same results.

Individual characteristics criterion –

This criterion argues that theamount of human capital possessed by executives inf luences theirproductivity and, thus, should influence their compensation.

Performance criterion – This criterion emanates from the agency theory approach, which suggests linkage of executive compensation to the firm’s

performance. Behaviour criterion – This criterion is associated with the monitoring

mechanism, and executives take strategic initiatives while making asubjective analysis of business decisions. Therefore, executivecompensation design based on behaviour criterion makes sense.



Different criteria of executive compensation

Size criterion – As per this criterion, size of the organizations is the determinant

of executive compensation.

Market criterion – This criterion argues that market forces (supply and demand

for executive talent) determine executive pay.

Peers compensation criterion – This criterion suggests that the compensation

of selected peers may play a role in setting executive pay. It is based on theprinciples of social comparison approach.


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Say on Pay and Executive Compensation

Excessive executive compensation even at the cost of stakeholders’ interest has

now become a global issue.

Increased compensation to those in the C-suite, even when the organization is

struggling to survive is common across the world.

Say on pay is a movement, which gives opportunity to company’s shareholders to

oppose or approve executive compensation by voting against or for it.

Such shareholder endorsement on executive compensation has almost now

become essential in public limited companies. .

In India also say on pay movement is visible.

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