# Executive compensation

Executive compensation is composed of both the financial compensation (executive pay) and other non-financial benefits received by an executive from their employing firm in return for their service. It is typically a mixture of fixed salary, variable performance-based bonuses (cash, shares, or call options on the company stock) and benefits and other perquisites all ideally configured to take into account government regulations, tax law, the desires of the organization and the executive.[1]

The three decades from the 1980s saw a dramatic rise in executive pay relative to that of an average worker's wage in the United States,[2] and to a lesser extent in a number of other countries. Observers differ as to whether this rise is a natural and beneficial result of competition for scarce business talent that can add greatly to stockholder value in large companies, or a socially harmful phenomenon brought about by social and political changes that have given executives greater control over their own pay.[3][4] Recent studies have indicated that executive compensation should be better aligned with social goals[5] (e.g. public health goals[6]). The rate of executive pay is an important part of corporate governance, and is often determined by a company's board of directors.

## Types

In a modern corporation, the CEO and other top executives are often paid a salary, which is predetermined and fixed, plus an array of incentives (bonuses) commonly referred to as the variable component of the remuneration package.

The variable component of compensation or remuneration can be broken down into three time frames:

### Short-term incentives (STIs)

As employees rise through the ranks in the business, it is likely that short-term incentives are added to their total remuneration package. The combination of Fixed Pay and Short Term Incentive is referred to as Total Cash Compensation (TCC). Short-term incentives usually are formula driven and have some performance criteria attached (typically pre-agreed KPIs) depending on the role of the executive. For example, the Sales Director's performance related bonus may be based on incremental revenue growth; a CEO's could be based on incremental profit margin and/or revenue growth. Bonuses are after-the-fact (not formula driven) and often discretionary. Short-term incentives can also take various other forms, namely, fringe benefits, employee benefits and paid expenses (perquisites). Common fringe benefits can vary from meal plans to health insurance cover, retirement plans, company cars and even interest-free loans for the purchase of housing. Fringe benefits are also often tax deductible for the employee. The level of STI relative to basic salary is typically a function of seniority eg. a junior executive may have an STI that is capped at 10% of basic salary whereas for a senior executive, it may rise to 50% or more.

### Medium-term incentives (MTIs)

Medium-term incentives are often associated with the delivery of corporate strategic goals and therefore extend beyond the scope of short-term incentives. The performance of the company in achieving the pre-determined targets is the basis for the benefit which is usually cash.[5] There is often no determination of an individual's contribution to achieving the targets - the performance is calculated purely at the corporate level. As with STIs, the weight of the MTIs relative to the basic salary is dependent on seniority. Because deployment of corporate strategies typically covers a 2-5 year period, the MTIs are only paid out when an assessment of the achievement is possible. This feature is therefore seen as supporting employee retention. MTIs are not common, most publicly listed companies disclose only STIs and LTIs, although purists may argue that one or both of these are more aligned to a medium term reward (e.g STIs are often deferred for a number of years, and LTIs are often measured over a period of only 3 years).

## Mathematical Formula

In a globalised world economy, all businesses compete with one another to hire their CEO from the same talent pool. In its most simple form, the talent of any individual CEO is determined by the percentage increase in profit margins the individual is expected to bring to the firm.[17] The desired outcome of this is that, in part due to efficient allocation of resources in the economy, the largest firm will be matched with similarly the best CEO, the second largest firm will be matched with the second best CEO and so forth. While there have been numerous methods for formulating executive compensation, some complex and some very basic, the method proposed by Xavier Gabaix[17] is a good reference point. It is worth noting that results vary significantly after share options, bonuses and benefits are taken into consideration.

The compensation of CEO number ${\displaystyle n}$  equates to:

${\displaystyle w(n)=D(n^{*})S(n)^{\gamma -b}S(n^{*})^{b}}$

where:

${\displaystyle w(n)}$  is the wages of the ${\displaystyle n}$ th best talented CEO,
${\displaystyle S(n)}$  is the size of that firm,
${\displaystyle S(n^{*})}$  is the size of the reference firm (e.g., the size of the median firm in the S&P 500),
${\displaystyle \gamma =1}$  for constant returns to scale,[18]
${\displaystyle \gamma -b}$  = the power law parameter in the distribution of CEO compensation, and
${\displaystyle D(n^{*})}$  denotes a constant, dependent on model parameters, such as the scarcity of talent, assuming the wages of the least talented CEO are zero. (Of course, few CEOs work for nothing. However, All models are wrong, but some are useful, and this may still be useful.[19]

Consider, for example, a firm that is 27 times bigger than the median firm and suppose that ${\displaystyle b}$  = 2/3. The CEO's remuneration would be 3 times larger than the median CEO's compensation. Should the size of all the firms increase 27 times, however, the compensation of the CEO for the company that is 27 times larger, will increase 27 times over. This formula exhibits a strong correlation between the rise in executive compensation and the rise in value of the S&P 500.

## Controversy

The explosion in executive pay has become controversial, criticized not only by those on the left,[20] but by proponents of shareholder capitalism such as Peter Drucker, John Bogle,[21][22] Warren Buffett[13] also.

The idea that stock options and other alleged pay-for-performance are driven by economics has also been questioned. According to economist Paul Krugman,

"Today the idea that huge paychecks are part of a beneficial system in which executives are given an incentive to perform well has become something of a sick joke. A 2001 article in Fortune, "The Great CEO Pay Heist" encapsulated the cynicism: You might have expected it to go like this: The stock isn't moving, so the CEO shouldn't be rewarded. But it was actually the opposite: The stock isn't moving, so we've got to find some other basis for rewarding the CEO. And the article quoted a somewhat repentant Michael Jensen [a theorist for stock option compensation]: I've generally worried these guys weren't getting paid enough. But now even I'm troubled.'"[23][24]

Recently, empirical evidence showed that compensation consultants only further exacerbated the controversy. A study of more than 1,000 US companies over six years finds "strong empirical evidence" that executive compensation consultants have been hired as a "justification device" for higher CEO pay.[25]

Defenders of high executive pay say that the global war for talent and the rise of private equity firms can explain much of the increase in executive pay. For example, while in conservative Japan a senior executive has few alternatives to his current employer, in the United States it is acceptable and even admirable for a senior executive to jump to a competitor, to a private equity firm, or to a private equity portfolio company. Portfolio company executives take a pay cut but are routinely granted stock options for the ownership of ten percent of the portfolio company, contingent on a successful tenure. Rather than signaling a conspiracy, defenders argue, the increase in executive pay is a mere byproduct of supply and demand for executive talent. However, U.S. executives make substantially more than their European and Asian counterparts.[13]

### United States

The U.S. Securities and Exchange Commission (SEC) has asked publicly traded companies to disclose more information explaining how their executives' compensation amounts are determined. The SEC has also posted compensation amounts on its website[26] to make it easier for investors to compare compensation amounts paid by different companies. It is interesting to juxtapose SEC regulations related to executive compensation with Congressional efforts to address such compensation.[27]

Since the 1990s, CEO compensation in the US has outpaced corporate profits, economic growth and the average compensation of all workers. Between 1980 and 2004, Mutual Fund founder John Bogle estimates total CEO compensation grew 8.5% year, compared to corporate profit growth of 2.9%/year and per capita income growth of 3.1%.[28][29] By 2006 CEOs made 400 times more than average workers—a gap 20 times bigger than it was in 1965.[13] As a general rule, the larger the corporation, the larger the CEO compensation package.[30]

The share of corporate income devoted to compensating the five highest paid executives of (each) public firms more than doubled from 4.8% in 1993–1995 to 10.3% in 2001–2003.[31] The pay for the five top-earning executives at each of the largest 1500 American companies for the ten years from 1994 to 2004 is estimated at approximately $500 billion in 2005 dollars.[32] As of late March 2012, USA Today's tally showed the median CEO pay of the S&P 500 for 2011 was$9.6 million.[33]

Lower level executives also have fared well. About 40% of the top 0.1% income earners in the United States are executives, managers, or supervisors (and this does not include the finance industry) — far out of proportion to less than 5% of the working population that management occupations make up.[34]

A study by University of Florida researchers found that highly paid CEOs improve company profitability as opposed to executives making less for similar jobs.[35] However, a review of the experimental and quasi-experimental research relevant to executive compensation, by Philippe Jacquart and J. Scott Armstrong, found opposing results. In particular, the authors conclude that "the notion that higher pay leads to the selection of better executives is undermined by the prevalence of poor recruiting methods. Moreover, higher pay fails to promote better performance. Instead, it undermines the intrinsic motivation of executives, inhibits their learning, leads them to ignore other stakeholders, and discourages them from considering the long-term effects of their decisions on stakeholders"[36] Another study by Professors Lynne M. Andersson and Thomas S. Batemann published in the Journal of Organizational Behavior found that highly paid executives are more likely to behave cynically and therefore show tendencies of unethical performance.[37]

### Australia

In Australia, shareholders can vote against the pay rises of board members, but the vote is non-binding. Instead the shareholders can sack some or all of the board members.[38] Australia's corporate watchdog, the Australian Securities and Investments Commission has called on companies to improve the disclosure of their remuneration arrangements for directors and executives.[39]

## Regulation

There are a number of strategies that could be employed as a response to the growth of executive compensation.

• Extend the vesting period of executives' stock and options.[51] Current vesting periods can be as short as three years, which encourages managers to inflate short-term stock price at the expense of long-run value, since they can sell their holdings before a decline occurs.[52]
• As passed in the Swiss referendum "against corporate Rip-offs" of 2013, investors gain total control over executive compensation, and the executives of a board of directors. Institutional intermediaries must all vote in the interests of their beneficiaries and banks are prohibited from voting on behalf of investors.
• Disclosure of salaries is the first step, so that company stakeholders can know and decide whether or not they think remuneration is fair. In the UK, the Directors' Remuneration Report Regulations 2002[53] introduced a requirement into the old Companies Act 1985, the requirement to release all details of pay in the annual accounts. This is now codified in the Companies Act 2006. Similar requirements exist in most countries, including the U.S., Germany, and Canada.[citation needed]
• A say on pay - a non-binding vote of the general meeting to approve director pay packages, is practised in a growing number of countries. Some commentators have advocated a mandatory binding vote for large amounts (e.g. over $5 million).[54] The aim is that the vote will be a highly influential signal to a board to not raise salaries beyond reasonable levels. The general meeting means shareholders in most countries. In most European countries though, with two-tier board structures, a supervisory board will represent employees and shareholders alike. It is this supervisory board which votes on executive compensation.[citation needed] • Another proposed reform is the bonus-malus system, where executives carry down-side risk in addition to potential up-side reward. • Progressive taxation is a more general strategy that affects executive compensation, as well as other highly paid people. There has been a recent trend to cutting the highest bracket tax payers, a notable example being the tax cuts in the U.S.[citation needed] For example, the Baltic States have a flat tax system for incomes.[citation needed] Executive compensation could be checked by taxing more heavily the highest earners, for instance by taking a greater percentage of income over$200,000.
• Maximum wage is an idea which has been enacted in early 2009 in the United States, where they capped executive pay at $500,000 per year for companies receiving extraordinary financial assistance from the U.S. taxpayers. The argument is to place a cap on the amount that any person may legally make, in the same way as there is a floor of a minimum wage so that people can not earn too little.[55] • Debt Like Compensation - If an executive is compensated exclusively with equity, he will take risks to benefit shareholders at the expense of debtholders. Thus, there are several proposals to compensate executives with debt as well as equity, to mitigate their risk-shifting tendencies.[56][57][58] • Indexing Operating Performance is a way to make bonus targets business cycle independent. Indexed bonus targets move with the business cycle and are therefore fairer and valid for a longer period of time. • Two strikes - In Australia an amendment to the Corporations Amendment (Improving Accountability on Director and Executive Remuneration) Bill 2011[59] puts in place processes to trigger a re-election of a Board where a 25% "no" vote by shareholders to the company's remuneration report has been recorded in two consecutive annual general meetings. When the second "no" vote is recorded at an AGM, the meeting will be suspended and shareholders will be asked to vote on whether a spill meeting is to be held. This vote must be upheld by at least a 50% majority for the spill (or re-election process) to be run. At a spill meeting all directors current at the time the remuneration report was considered are required to stand for re-election.[60] • Independent non-executive director setting of compensation is widely practised.[61] An independent remuneration committee is an attempt to have pay packages set at arms' length from the directors who are getting paid. • In March 2016, the Israeli Parliament set a unique law that effectively sets an upper bound to executive compensation in financial firms. According to the Law, an annual executive compensation greater than 2.5 million New Israeli Shekel (approximately US$650,000) cannot be granted by a financial corporation if it is more than 35 times the lowest salary paid by the corporation.[62]
• In the United States, clawback provisions may exist due to Dodd-Frank and the Sarbanes-Oxley Act.[63]

## References

• Xavier Gabaix (September 2008), Power Laws in Economics and Finance (PDF), National Bureau of Economic Research Working Paper Series, National Bureau of Economic Research, doi:10.3386/W14299, Wikidata Q105902569

## Notes

1. ^ a b c Ellig, Bruce R. (2002). The complete guide to executive compensation. ISBN 9780071399722.
2. ^ see, for one example, The Guardian, August 4, 2005, "US executive pay goes off the scale"
3. ^ Lucian Bebchuk and Jesse Fried, Pay Without Performance (2004)
4. ^ Krugman, Paul, The Conscience of a Liberal, W W Norton & Company, 2007, 143-148
5. ^ a b Rodgers, W.; Gago, S. (2003). "A model capturing ethics and executive compensation". Journal of Business Ethics. 48 (2): 189–202. doi:10.1023/B:BUSI.0000004589.34756.8a. hdl:10016/12260.
6. ^ J.M. Pearce and D. Denkenberger, “Aligning Executive Incentives with Global Public Health GoalsProgress in Health Sciences 5(2), 16-23 (2015).
7. ^ Tortoriello, Richard (28 October 2020). "In the Money: What Really Motivates Executive Performance?" (PDF). S&P Global Quantamental Research.
8. ^ Hall, Brian J.; Murphy, Kevin J. (2003). "The Trouble with Stock Options". The Journal of Economic Perspectives. 17 (3): 49–70. ISSN 0895-3309.
9. ^ "CEO compensation has grown 940% since 1978: Typical worker compensation has risen only 12% during that time". Economic Policy Institute. Retrieved 2020-10-28.
10. ^ Henriques, Diana B. (1992-09-21). "Business Fraud of the 90's: Falsifying Corporate Data (Published 1992)". The New York Times. ISSN 0362-4331. Retrieved 2020-10-29.
11. ^ O'Connor, Joseph P.; Priem, Richard L.; Coombs, Joseph E.; Gilley, K. Matthew (2006). "Do CEO Stock Options Prevent or Promote Fraudulent Financial Reporting?". The Academy of Management Journal. 49 (3): 483–500. doi:10.2307/20159777. ISSN 0001-4273.
12. ^ "CEO compensation has grown 940% since 1978: Typical worker compensation has risen only 12% during that time". Economic Policy Institute. Retrieved 2020-10-28.
13. ^ a b c d
14. ^ Melin, ers; Sam, Cedric. "These Are America's Highest Paid CEOs". Bloomberg.com. Retrieved 2020-10-28.
15. ^ Landy, Heather, "Behind the Big Paydays", The Washington Post, November 15, 2008
16. ^ "CEO compensation surged 14% in 2019 to \$21.3 million: CEOs now earn 320 times as much as a typical worker". Economic Policy Institute. Retrieved 2020-10-28.
17. ^ a b Gabaix (2008).
18. ^ Gabaix (2008, expression (28)).
19. ^ Gabaix (2008, expression (33)).
20. ^ "3 Bills to Rein in Executive Pay". Inequality.org. Retrieved 2020-10-28.
21. ^ The Executive Compensation System is Broken John C. Bogle| December 2005
22. ^ A Crisis of Ethic Proportions By JOHN C. BOGLE wsj.com April 21, 2009
23. ^ The Great CEO Pay Heist Executive 25 June 2001, Fortune
24. ^ Krugman, Paul, The Conscience of a Liberal, 2007, p.148
25. ^ "Compensation consultants lead to higher CEO pay". Retrieved 18 August 2016.
26. ^ The Securities and Exchange Commission website
27. ^ Kenneth Rosen, Who Killed Katie Couric? And Other Tales from the World of Executive Compensation Reform, 76 Fordham Law Review 2907 (2007)
28. ^ Reflections on CEO Compensation by John C. Bogle| Academy of Management| May 2008
29. ^ Pay Madness At Enron Dan Ackman, 03.22.2002
30. ^ Kevin Hallock, Dual Agency: Corporate Boards with Reciprocally Interlocking Relationships, in Executive Compensation and Shareholder Value: Theory and Evidence, ed. Jennifer Carpenter and David Yermack (Boston: Kluwer Academic Publishers, 1999) p.58
31. ^ Based on the ExecuComp database of 1500 companies. Bebchuk, Lucian; Grinstein, Yaniv (April 2005). "The Growth of Executive Pay" (PDF). Harvard University: John M. Olin Center for Law, Economics and Business.
32. ^ Based on the ExecuComp database , from Bebchuk and Fried, Pay Without Performance (2004), (p.9-10)
33. ^ CEO pay rises again in 2011, while workers struggle to find work By Matt Krantz and Barbara Hansen, USA TODAY. Updated 31 March 2012
34. ^ Jobs and Income Growth of Top Earners and the Causes of Changing Income Inequality: Evidence from U.S. Tax Return Data Jon Bakija, Adam Cole, Bradley T. Heim| March 2012
35. ^ Cathy Keen (2009-12-17). "Paying CEOs more than other CEOs results in stockholder dividends". University of Florida News. ufl.edu. Archived from the original on 2010-06-09.
36. ^ Jacquart, Philippe; Armstrong, J. Scott (2013). "Are Top Executives Paid Enough? An Evidence Based Review". Interfaces. 43. doi:10.2139/ssrn.2207600. S2CID 9545536.
37. ^ Batemann, Thomas. "Journal of Organizational Behavior". 18 (5). {{cite journal}}: Cite journal requires |journal= (help)
38. ^ "Shareholders told to oust directors". Business Day. The Age. 28 February 2009. Archived from the original on 8 July 2012. Retrieved 10 March 2014.
39. ^ "ASIC calls for better executive remuneration disclosure". Media Release: 12–34MR. ASIC. 29 February 2012. Archived from the original on 9 March 2014. Retrieved 10 March 2014.
40. ^ a b Highest-paid Canadian CEOs got 27 per cent pay hike Dana Flavelle| thestar.com 2| January 2012
41. ^ Executive pay in Europe| Jun 12th 2008
42. ^ "Barnier Targets Executive Pay After Banker Bonus Victory". Bloomberg.com. 2014-04-09. Retrieved 2020-10-28.
43. ^ "US executive pay goes off the scale" The Guardian, August 4, 2005
44. ^
45. ^ a b In Britain, Rising Outcry Over Executive Pay That Makes ‘People’s Blood Boil’ By JULIA WERDIGIER| nytimes.com 22 January 2012| accessed 2 April 2012
46. ^
47. ^ "Deliberating on the Best Executive Compensation Practices and Strategies in SEA: Kevin Ong Goes Candid". Retrieved 16 August 2016.
48. ^ "Executive Remuneration Disclosures in Asia" (PDF). Retrieved 16 August 2016.
49. ^ "Executive Compensation in China". Retrieved 29 July 2017.
50. ^ "Executive Compensation in China: An Overview". Retrieved 29 July 2017.
51. ^ How to Fix Executive Compensation by Alex Edmans, 27 February 2012
52. ^ When Bosses Take The Short-Term View by The Economist, 8 February 2014
53. ^ SI 2002/1986
54. ^ Failing Banks' Executive Pay May Face New Rules
55. ^ Dietl, H., Duschl, T. and Lang, M. (2010): "Executive Salary Caps: What Politicians, Regulators and Managers Can Learn from Major Sports Leagues", University of Zurich, ISU Working Paper Series No. 129.
56. ^ Alex Edmans and Qi Liu (2011): Inside Debt Review of Finance
57. ^ Why It Pays to Link Executive Compensation with Corporate Debt 7 July 2010 Knowledge@Wharton
58. ^ Alon Raviv and Elif Ciamarra Sisli (2010): Executive compensation, risk taking and the state of the economy Journal of Financial Stability
59. ^ Quest, Two strikes rule passed by Senate Accessed 30 December 2011
60. ^ Allion Legal, Remuneration Reform: How does the '2 strikes' rule affect your Company and your Board? Accessed 30 December 2011
61. ^ Choosing a Strategic Compensation Consultant By Brent Longnecker, Kevin Kuschel, & Josh Whittaker, June 21, 2016
62. ^ Do Executive Compensation Contracts Maximize Firm Value? Evidence from a Quasi-Natural Experiment By Menachem (Meni) Abudy, Dan Amiram, Oded Rozenbaum and Efrat Shust, 30 June 2017.
63. ^ Governance, Harvard Law School Forum on Corporate; Regulation, Financial. "The State of Play on Clawbacks and Forfeitures Based on Misconduct". corpgov.law.harvard.edu. Retrieved 2020-03-15.