Chapter Thirteen

Compensating Executives

Who are executives?Executive compensation plans provide favorable tax

treatment. IRS recognizes employees who play major role in company’s policy decisions:

Key employees:

Officer having annual comp > $130k ($5k increments starting 2003)

5% owner of the employer

1% owner and annual comp > $150k

Highly compensated employees:

5% owner

Annual comp > $80k in 2000 (indexed for inflation)

Employee was among top 20% employees ranked by comp in the preceding year & elected by employer for this plan.

Figure 13-1

Examples of Key Employees

ChiefExec. Officer

President

ExecutiveVP

VPHR

DirectorHR

VPMftg.

DirectorMftg.

VPFinance

DirectorFinance

VPAccounting

DirectorAccounting

ManagersSupervisorsAccountantsClerical Staff

VPMarketing

DirectorMarketing

ManagersSupervisorsFin. AnalystsClerical Staff

ManagersSupervisors

HR SpecialistsClerical Staff

ManagersSupervisors

Prod. WorkersClerical Staff

ManagersSupervisorsSpecialists

Clerical Staff

Executive Compensation Packages

Core CompensationBase Pay:

It does not accord to the rational process used for other jobs.

Bonuses:

Discretionary bonuses = f(profits, financial condition, business conditions, future prospects)

Performance-contingent bonuses = f(perf. criteria); see perf. Criteria in table 13-7.

Predetermined allocation bonus = f(profits)

Target plan bonus =f(minimal standard)

Short-term incentives: Profit and gain sharing plans

Table 13-7

Corporate Performance Measures (1 of 3)

Size» Sales» Assets» Profits» Market value» Number of employees

Growth» Sales» Assets» Profits» Market value» Number of employees

Table 13-7

Corporate Performance Measures (2 of 3)

Profitability» Profit margin» Return on assets (ROA)» Return on equity (ROE)

Capital Markets» Dividend yield» Total return to shareholders» Price/earning ratio» Payout

Table 13-7

Corporate Performance Measures (3 of 3)

Liquidity» Current ratio» Quick ratio» Working capital from operations» Cash flow from operations

Leverage» Debt-to-equity ratio» Short-term vs. long-term debt» Cash flow vs. interest payments

Executive Compensation Packages (cont’d)

Deferred Core CompensationStock compensation: intended to create a sense of ownership &

alignment of interests with those of shareholders.

Incentive stock options: future stock purchases resulting in (potential) capital gains –not taxable until stock is disposed, not when options are granted.

Nonstatutory stock options: do not qualify for favorable tax treatment –pay income tax on the diff. between discounted price and stock fair market value.

Restricted stock: executive cannot dispose of stock for a predetermined period –often 5 to 10 years.

Discount stock options: stock granted at rate below market value.

Stock appreciation rights: award payment based on the difference in stock price.

Golden parachute: Extend pay & benefits 1 to 5 years after termination.

Table 13-2

Employee Stock Terminology

Stock option. A right granted by a company to an employee to purchase a number of stocks at a designated price within a specified period of time.

Stock grant. A company’s offering of stock to an employee. Exercise of stock grant. An employee’s purchase of stock using

stock options. Disposition. Sale of stock by the stockholder. Fair market value. The average value between the highest and

lowest reported sales price of a stock on the New York Stock Exchange on any given date. The Internal Revenue Service specifies whether an option has a readily ascertainable fair market value at grant. An option has a readily ascertainable fair market value if the option is actively traded on an established stock exchange at the time the option is granted.

Executive Compensation Packages (cont’d)

Fringe compensation: Enhanced protection

Supplemental Life Insurance:

Split-Dollar

Death Benefit Only

Group Term Life Insurance

Supplemental Retirement: caps qualified annual earnings to $200k in 2003, indexed for inflation afterwards.

Perquisites (Perks): status, personal comfort or business tools; cross-cultural differences.

Table 13-4

Common Executive Perks

Company cars

Financial services

Legal services (for example, income tax preparation)

Recreational facilities (for example, country club and athletic club memberships)

Travel perks (for example, first-class airfare)

Residential security

Tickets to sporting events

Principles and Processes for setting executive compensation

Executive Compensation Consultants: strategic analysis, identification of competitors, potential conflict of interest.

Board of Directors: 10 external + 3 internal members; interplay between director and CEO compensation.

Avg. annual CEO compensation in 2003 = $15.7 million.

Differentials with avg. entry-level job in 1980 = times 42.

Differentials with avg. entry-level job in 2000 = times 475.

Firm size.

Directors’ pay in their primary job –implications for directors’ selection.

Cross-cultural differences: U.S. differentials do not have a parallel in Europe or Asia.

Principles and Processes for setting executive compensation (cont’d)

Agency Theory: executives do not share the interests of shareholders –agency problems between agent and principal.

Tournament Theory: lucrative compensation as prize in a series of increasingly competitive contests among lower-level managers.

Social Comparison theory: CEO compensation = f(board members’ own compensation, CEO compensation in similar companies).

Figure 13-2

CEO Compensation as a Tournament

Professional(for example, financial analyst)

Manager

Director

VicePresident

Pres.

Chief Executive Officer

Co

mp

en

sat

ion

($

)

Conflicts Faced By Corporate Directors

Help set strategic plans that affect profits.

Face the possibility that disgruntled stockholders may sue over corporate strategies that are unprofitable or unpopular.

Direct Compensation to Corporate Directors

Annual retainer Attendance fees Fees for participation on subcommittees Increasing emphasis on director

rewards that link to corporate performance» More pay is stock-based

Major Benefits Offered to Directors

Retirement programs Matching director’s gift to college or university Deferral of cash compensation until

retirement Grants to charity Medical insurance Payment of spouses travel expenses Death benefits

Supervisor Compensation

Supervisors and lower-level managers: internal equity problem when there is little incentive to take over extra responsibilities of supervisory job & make less than top-paid supervised employees.

Most companies prefer to pay supervisors a 5 to 30% differential with top-paid subordinate.

Do you know anyone who has turned down a supervisory or managerial job or have you heard of such a case? What was the motivation for turning down the job offer? Do you think that corporations would have more and more problems convincing people to accept supervisory jobs in the future? Besides a salary differential, what would you recommend that employers do to make supervisory jobs more appealing?

Discussion Question 13-1

Professional CompensationDual-career tracks for scientists and engineers:

prevents losing technical talent and/or unwanted moves into management. IBM example:

Executives IBM Fellow

Functional management Sr. technical staff

Senior Senior

Development Advisory

Project Staff

Mgmt. Ladder Technical Ladder

Table 13-5

Securities and Exchange Commission Disclosure Requirements for Executive

Compensation

Stock option and stock appreciation right tables Long-term incentive plan table Pension plan table Performance graph comparing the company’s stock price

performance against a market index and a peer group Report from the compensation committee of the board of

directors explaining compensation levels and policies Description of the directors’ compensation, disclosing all

amounts paid or payable Disclosure of certain employment contracts and golden

parachutes

Discussion Question 13-2

The recent fallouts of ENRON and other corporations have partly been blamed on greedy executives who manipulated the business to benefit from their stock options. Stock options were intended to align the interests of executives (agents) and their principals (stockholders). One of the criticisms has been the absence of a downside for executives in stock options. Do some library or internet research on this issue to ascertain why stock options failed to achieve their intended goal in cases such as ENRON. Research also alternatives to stock options -but also involving stock- that corporations are employing nowadays; be sure to understand why those alternatives are more effective than stock options.