Executive Compensation

Business, Legal & Accounting Glossary

Definition: Executive Compensation




Full Definition of Executive Compensation


Executive compensation is how top executives of business corporations are paid.

Compensation System

The compensation of every employee is decided by the company owners through the board of directors (in the case of the most highly compensated executive positions) and the management team (or “management committee”) (for everyone else). The board of directors may have a personnel and compensation committee that deals specifically with labour compensation.

Workers Union

In some countries, employee compensation may be negotiated with a workers union. The workers union will in many cases deal with for example a minimum wage limit and will not deal with the management team compensation but instead leave that to the company.

Means Of Compensation

There are five basic tools to compensation (or reward) in US organizations. These are: base salary, short-term incentives, long-term incentives (LTIP), employee benefits and perquisites. In a typical modern US corporation, the CEO and other top executives are paid a salary plus short-term incentives or bonuses. This combination is referred to as Total Cash Compensation (TCC). Short-term incentives usually are formula-driven and have some performance criteria attached depending on the role of the executive. For example, the Sales Director’s performance-related bonus may be based on incremental revenue growth turnover; a CEO’s could be based on incremental profitability and revenue growth. Bonuses are after-the-fact (not formula-driven) and often discretionary. Executives may also be compensated with a mixture of cash and shares of the company which are almost always subject to vesting restrictions (a long-term incentive). To be considered a long-term incentive the measurement period must be in excess of one year (3-5 years is common). The vesting term refers to the period of time before the recipient has the right to transfer shares and realize value. Vesting can be based on time, performance or both. For example, a highly paid CEO would get 1 million in cash, and 1 million in company shares (and share buy options used).

Perquisites (“perks”)

Other components of an executive compensation package may include such perks as generous retirement plans, health insurance, a chauffeured limousine, an executive jet[1], interest-free loans for the purchase of housing, etc.

Fortune 500 Compensation

During 2003, about half of Fortune 500 CEO compensation was in cash pay and bonuses, and the other half in vested restricted stock, and gains from exercised stock options according to Forbes magazine. Forbes magazine counted the 500 CEOs compensation to $3.3 billion during 2003 (which makes $6.6 million apiece). Notice that this figure includes gains from stock call options used; the options may have been rewarded many years before the option to buy is used.

Forbes Categories Of Compensation

The categories that Forbes use are (1) salary (cash), (2) bonus (cash), (3) other (market value of the restricted stock received), and (4) stock gains from option exercise (the gains being the difference between the price paid for the stock when the option was exercised and that days market price of the stock). If you see someone “making” $100 million or $200 million during the year, chances are 90% of that is coming from options (earned during many years) being exercised.

Typical Compensation

The typical salary in the top of the list is $1 million – $3 million (Immelt). The typical top cash bonus is $10 million – $15 million (Henry R. Silverman). The highest stock bonus is $20 million (Fuld). The highest option exercise has been in the range of $100 million – $200 million (Reuben Mark).

Stock Options

Supporters of stock options say they align the interests of CEOs to those of shareholders since options are valuable only if the stock price remains above the option’s strike price. Stock options are now counted as a corporate expense (non-cash), which impacts a company’s income statement and makes the distribution of options more transparent to shareholders. Critics of stock options charge that they are granted excessively and that they invite management abuses such as the options backdating of such grants. Stock options also pose a conflict of interest in which a CEO can artificially raise the stock price to cash in stock options at the expense of the company’s long-term health, although this is a problem for any type of incentive compensation that goes unmonitored by directors. Indeed, “reload” stock options allow executives to exercise options and then replace them in part (and sometimes in whole), essentially selling the company stock short (i.e., profiting from the stock’s decline). For various reasons, including the accounting charge, concerns about dilution and negative publicity related to stock options, companies have reduced the size of grants to executives.

Restricted Stock

Executives are also compensated with restricted stock, which is stock given to an executive that cannot be sold until certain conditions are met and have the same value as the market price of the stock at the time of grant. As the size of stock option grants has been reduced, the number of companies granting restricted stock either with stock options or instead of has increased. Restricted stock has its detractors, too, as it has value even when the stock price falls. As an alternative to straight time vested restricted stock, companies have been adding performance type features to their grants. These grants, which could be called performance shares, do not vest or are not granted until these conditions are met. These performance conditions could be earnings per share or internal financial targets.

Tax Issues

Cash compensation is taxable to an individual at a high individual rate. If part of that income can be converted to long-term capital gain, for example by granting stock options instead of cash to an executive, more advantageous tax treatment may be obtained by the executive.

Criticism

There are many controversies about executive compensation:

Charges that CEOs are overpaid

The popular newsreels say people believe that CEOs are paid too much for the services they provide, while others believe that a good CEO can have a positive effect on the company’s performance and, therefore, that high compensation is needed to attract the best talent. Some argue that since the CEO’s pay is set by the board of directors, with the CEO determining the selection, tenure, and committee assignments of directors and most often selecting the compensation consultants as well, an unhealthy conflict of interest occurs and prevents effective price competition. In Searching for a Corporate Savior: The Irrational Quest for Charismatic CEOs, Harvard Business School professor Rakesh Khurana documents the problem of excessive CEO compensation, showing that the return on investment from these pay packages is very poor compared to other outlays of corporate resources.

Judging which CEO’s are overpaid is a complex issue. Many articles focusing on high CEO pay simply survey the executives who received the most overall money in a particular year even though the vast majority of that might be from selling stock or exercising options that were obtained over many years and were never sold before (unlike other CEOs who might regularly sell stock or exercise options). In addition, many indirect corporate perquisites are possibly not included in these figures. Stock options, for example, allow the CEO to buy the stock at a certain value later down the road. If the CEO makes his company do well the going price down the road can be much higher and the CEO could buy shares for his option price. If this hurdle looks sufficient many critics are assuaged, but there is an additional, more hidden factor that the options may be “repriced”, that is the hurdled lowered halfway through the game. The bottom line eventually a CEO will be paid what they are worth to the company or be replaced.

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 per cent of the portfolio company, contingent on a successful tenure. Rather than signalling 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.

Critics

In 2005, the issue of executive compensation at American companies has been harshly criticized by columnist and Pulitzer Prize winner Gretchen Morgenson in her Market Watch column for the Sunday “Money & Business” section of the New York Times newspaper.

Unions have been very vocal in their opposition to high executive compensation. The AFL-CIO sponsors a website called Executive Paywatch which allows users to compare their salaries to the CEOs of the companies where they work.

Shareholders, often members of the Council of Institutional Investors or the Interfaith Center on Corporate Responsibility have often filed shareholder resolutions in protest. 21 such resolutions were filed in 2003. About a dozen were voted on in 2007, with two coming very close to passing (at Verizon, a recount is currently going on). The U.S. Congress is currently debating mandating shareholder approval of executive pay packages at publicly traded U.S. companies.

The U.S. Securities and Exchange Commission 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 to make it easier for investors to compare compensation amounts paid by different companies.


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Definition Sources


Definitions for Executive Compensation are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 23rd April, 2020 | 1 Views.