Executive compensation has been at the forefront of discussion for a long period of time. Analyzed by academics, highlighted by the media, questioned by Congress, and scrutinized by the general public, the topic warrants much debate. In the 1990’s, total executive compensation increased substantially as companies began offering stock option programs; CEO’s of S&P 500 saw an average increase of 150%. 1 While many top U. S. executives continued to receive enormous compensation options throughout the economic downturns of 2001 and 2008, none was more apparent than those in the Automotive Industry.
While the Big Three, comprising of General Motors, Ford, and Chrysler, were facing insurmountable debt and possibly bankruptcy, top executives were receiving some of the highest reparations ever experienced by directors of the companies. The case study as presented in Managing Human Resources, Sixteenth Edition by Snell and Bohlander brings to mind the fact that during 2011, Ford CEO, Alan Mulally, received $53. 5 million in stock awards. 2 Many discussions can be derived from this statement. However, a basic understanding of modern corporate compensation structures must first be realized.
Along with understanding these compensation structures, knowledge of the views on economic rent and optimal contracting must also be developed. 2. 0 Corporate Compensation Structures Corporate compensation structures have changed drastically within the past several decades. With an ever increasing gap between top executive and average production worker compensation payouts, controversy envelops this issue from every angle. In 1965 the average CEO earned 24. 2 times the average production worker. In 2008, this ratio was 277. 3 times more. 3 Compensation to executives comes in five different forms: 1. Salary 2.
Short Term Incentives (bonuses) 3. Long Term Incentive Plans (LTIP) 4. Paid Expenses (Perquisites) 5. Insurance (Golden Parachute) 2. 1 Salary A salary is a structure of payment paid by an employer to an employee. This can be in various forms or amounts. When talking about executive salaries, it is generally stated in a contract for a given period of time. The common measure of salary is based on one fiscal year and measured as the base salary, or the minimum payment made to an employee. 2. 2 Short Term Incentives (bonuses) Short term incentives and bonuses are compensations tied to short run performance indicators. Short term incentives are generally formula-driven while the term bonus oftentimes is a discretionary payout.
These can come in many forms of payment ranging from cash payouts to company stocks. During flourishing economic times, bonuses can be a large part of an employee’s compensation structure. Conversely, when companies face economic hardships, bonus payouts should reflect this trend. It has been noted when employees receive bonuses on a consistent basis, they begin to view them as another portion of their salary and develop a sense of entitlement. 2. 3 Long Term Incentive Plans (LTIP) Long term incentive plans are similar to short term payouts in the form of payment. Specifically cash payouts or company shares. The distinct difference in the two is the vesting requirements. Vesting refers to the period of time in which a person must be employed by a company before they realize value of a given payout. Vesting restrictions can come in various forms ranging from percentage increases over time to 100% realization at a given date. 2. 4 Paid Expenses (Perquisites)
Paid expenses are often referred to as fringe benefits or perquisites. The IRS defines legal fringe benefits that are tax deductible. This may include items such as the following: a. Athletic Skyboxes/Suites b. Executive Dining Room c. No Cost Loans d. Transportation Services and Chauffeurs e. Relocation Expenses 5 Paid expenses are beneficial to both the employee and the employer. It provides creative compensation for employees and allows employers to deduct the compensations as business expenses. 2. 5 Insurance (Golden Parachute)
Insurances have in recent years taken on the term ‘Golden Parachute’. This refers to lucrative benefits provided to top executives of a company in the event of losing employment. 6 The original reasoning for this was in the event of a company being taken over by another firm, top executives would be compensated in the event of a loss in employment. In recent years, these benefits have been awarded to executives even when the company was not taken over. These can be in many forms of payment such as stock options, bonuses or severance packages. 3. Optimal Contracting and Rent Extraction Views How CEOs are compensated has been categorized into two popular views. The first being the optimal contracting view and the second being the rent extraction view. Under Optimal Contracting, boards of directors will act on behalf of shareholders and their interests to structure compensation plans for CEOs to minimize tax burdens, firm costs and meet the reservation wage of a the CEO. 6 The rent extraction view takes into account the value of economic rent CEOs are able to extract from a board of directors.
Economic rent for labor is due to some exclusivity of a laborer generally caused by skill or celebrity. Under the rent extraction view, CEOs are thought to influence compensation structure for personal gain at the expense of the shareholder. 7 This view implies that inefficient or iniquitous boards allow suboptimum payouts to CEOs at the expense of shareholders, thus creating economic rents. 4. 0 CEO Compensation Increase Exponentially One question posed by the case study is, “Are CEOs and key corporate executives worth the large pay packages they receive? In order to answer this question, one must first evaluate the compensation landscape of modern day CEOs. In 1990, the average CEO earned a total compensation package of $2. 62 million. At the highest point in 2007, this average increased to $17. 12 million.
So what was the increase caused by? While regular salaries and bonuses increased from $1. 62 million to $4. 01 million over this time period, the more significant increase was through stock gains and other compensations where an increase from $934,000 in 1990 to $13. 1 million in 2007 was observed. 8 So why the sudden increase in stock gains and other compensations? In 1990 Michael C. Jensen and Kevin J. Murphy published “CEO Incentives – It’s Not How Much You Pay, But How” in the Harvard Business Review. This article helped change the view on CEO compensation structures in the United States. The authors provided evidence that top executive salaries in the 1980’s were actually lagging those of the 1930’s. They stated that CEO compensation should not be ranked by how much an executive is paid, but how they are paid. A CEOs whose wealth was tied to a change value of shareholder wealth had a better compensation that a CEO who had a higher monetary compensation. This analysis lead to the increase of stock options for CEOs and top corporate executives. However, this type of compensation structure has unintended consequences tied to it. Stock options create incentives for executives to participate in risk seeking activities. It creates a positive gain if the price of stock goes up, but no downside risk. So what value do CEOs offer companies and their shareholders?
Just as the NFL places value stellar athletic performance and so-called super human ability, so does corporate America. In the extremely competitive market of CEO headhunting, the stakes could never be higher. Companies today are facing lightning fast technological advances, corporate espionage, global competition, extremely tight profit margins, innovative startups and an indiscriminate number of other issues that need to be managed by top executives. Companies not only need leaders, but also visionaries, innovators and calculated risk takers.
This combination of person can be extremely difficult to find, employ and retain. When it comes to the question as to whether or not CEOs and top executives are overpaid, the question can irrevocably be answered YES, oh wait, and NO. While with many of the top S&P 500 CEOs making exorbitant amounts of money, the average private company CEO with at least $5 million or more in revenue earn less than $405,000. 10 So while CEOs may have some control over their compensation plans, as Marc Hodak from Forbes stated, “ Boards generally make excellent choices for CEOs, often from a very limited pool of talent.
When they fail, it’s usually for lack of a crystal ball, not because of an endemic breakdown in governance. ”11 5. 0 Compensation Limitations The next question the case study poses is: “Should corporate executives receive compensation packages no larger than a certain percentage of the pay of hourly workers? ” The answer to this question will most definitely be different depending on whom it is asked of. Those whom are reaping tremendous benefits from the turnaround of the Ford Motor Company may have a different answer than those from Lear Corporation.
In 2006 when Alan Mulally was brought on as the new CEO of Ford Motor Company, the company lost $17 billion. In 2010 it earned its largest profit of $6. 6 billion in over 11 years. 12 This prosperity has trickled throughout the industry to its 164,00013 employees, various dealerships and shareholders who saw an increase stock value of $1. 56 to $14 per share. Conversely, Lear Corporation, a supplier of car parts for the automotive industry has recently closed 28 factories, eliminated more than 20,000 jobs and decimated its stock value; all the while seeking payouts of $5. million to former CEO Robert Rossiter and $20. 6 million to key executives and various other employees. 14 Arguments can be formed on both sides of this issue. Caps on compensation cry out facets of socialism and communistic tendencies, while skyrocketing corporate payouts cry out disparity between the rich and the poor. In free-market capitalism, prices are allowed to reach their equilibrium without intervention from the government, while the role of government is to protect the rights of life, liberty and property.
So it raises the question, how far should the government go to protect these rights? This is a philosophical question that has no one right answer and is at the very center of the issue of corporate corruption and greed. This idea of greed drives our economy and was described in this famous passage in, The Wealth of Nations, by Adam Smith: “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.
We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantage. ”15 So at what point should government intervene on one’s self interest? Should it be when one’s compensation is 20 times the average worker or should it be when it is 1,000 times? There is no question that greed is viewed as a negative quality, however when the possibility of promoting self-interests of personal prosperity exists for everyone, society as a whole will benefit. 6. 0 Compensation Reform
As the debate over corporate compensation continues, the United States Government and Securities and Exchange Commission (SEC) have intervened to try and allow the processes and structures to be more transparent for investors and shareholders. They have done this in several ways, first being through the Internal Revenue Service (IRS). The IRS makes auditing corporate compensation packages a routine activity during the examination of companies. Secondly, the SEC has adopted new rules for full disclosure of the actual size and value of top executive compensation packages for companies publicly traded on the NASDAQ and NYSE.
Thirdly, congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. As the text states, it gives shareholders of a company a “say on pay”. However, this “say on pay” is just as the quotations disparagingly alludes; shareholders are offered a non-binding vote on executive compensation and golden parachutes. 16 These means that shareholders are given an opportunity express their opinion, however the final decision is still left with the board of directors.
So the question as to whether or not these non-binding voter rights will have an effect on corporate compensation packages is questionable. 7. 0 Conclusion Although corporate compensation plans have many issues and negative consequences, it is a necessary part of a free-market society. Where self-interest is the primary driver for innovation, technological advancement and an overall increase in the standard of living for a society as a whole, efforts must be made constantly, and with vigilance, to promote transparency and accountability.