Types of Executive Compensation


Types of Executive Compensation

Company executives are compensated in many different ways. They receive a base salary that also includes pension contributions and perquisites (such as a company car, club memberships, etc.). In addition, top executives may receive a bonus that is usually linked to accounting-based performance measures. Lastly, executives may receive additional wealth through long-term incentive programs. These incentives programs are commonly in the form of stock options, which reward managers for an increasing stock price. Stock grants are also a common form of long- term award.

Base Salary and Bonus

The base salary of a company's CEO is often determined through the "benchmarking" method. [2] This method surveys salaries of the CEO's peers for comparison. Salaries that are less than the 50th percentile are considered under market, while salaries in the 50th to 75th percentile are "competitive." Since CEOs always argue for competitive salaries, CEO base pay has continuously drifted upward. Interestingly, this base pay is based more on characteristics of the firm (industry, size, etc.) than on characteristics of the CEO (age, experience, etc.). In recent years , the average base salary has been around $500,000. Pay at large companies can be much higher. Benchmarking also occurs for bonus and option programs.

At the end of every year, the CEO is given a cash bonus payment. The size of the payment is based on the performance of the firm over the past year. The most common ways to examine firm performance are the accounting profit measurements of earnings and earnings before interest and taxes (EBIT). Measures of economic value added (EVA) are also common. These value-added measures are usually a variant on earnings minus the cost of capital. The idea is to measure how much value was added to the firm in relation to the firm's costs of using the different sources of money to conduct the business activities. Whether EBIT or EVA is used, a low threshold needs to be reached in order to qualify the CEO for a bonus. A higher bonus is awarded for higher levels of firm performance up to a specific maximum, or cap.

The use of accounting profits to measure performance has several drawbacks. First, to boost accounting profits, a CEO has an incentive to forego costly research and development that might make the firm more profitable in the future. Second, accounting profits may be manipulated (see the next chapter). Third, a bonus plan is developed each year. Therefore, if the threshold cannot be met one year, the CEO has an incentive to move earnings from the present year to the future. This would lower the expectations during the time next year's bonus plan is created and artificially increase the chance of receiving that bonus. In short, CEOs may place too much focus on manipulating short-term earnings instead of focusing on long-term shareholder wealth. The average bonus payment has been around $250,000 in recent years.

Though not frequent, the annual bonus has been abused. For example, Tyco International paid a $20 million executive bonus in conjunction with its acquisition of CIT Group in 2001. [3] One year later, Tyco was trying to sell CIT Group for half of the $9.5 billion price it paid. Apparently, the purchase wasn't that good after all ” certainly not worth a $20 million bonus! Or, consider that Enron's board awarded executives a total bonus of $750 million in 2000 ”a year in which the firm reported net income of $975 million. [4] That is, executives took three quarters of the firm's profits!

Stock Options

Executive stock options are the most common form of market-oriented incentive pay. Stock options are contracts that allow the executive to buy shares of stock at a fixed price, called the exercise or strike price. Therefore, if the price of the stock rises above the strike price, the executive will capture the difference as a profit. For example, if the stock of a company is trading at $50 per share, the CEO may be given options with a strike price at $50. Over the next few years, if the stock price increases to $75 per share, then shareholders would receive a 50 percent return on their stockholdings. The CEO could buy stock for $50 per share with the option and sell it for $75 per share, thus making a $25 profit on each option owned. If the executive has options for one million shares, then he or she could pocket $25 million. If the stock price goes to $100 per share, the executive could cash in for $50 million. If the stock price were to drop to less than $50 per share, the options have no exercisable value and are said to be "underwater." Executives treat stock options as compensation. In other words, they nearly always exercise the options to buy the stock and then sell the stock for the cash. Only rarely will an executive keep the stock.

Stock options give the executives of a firm the incentive to manage the firm in such a way that the stock prices increase. This is also precisely what the stockholders want! Therefore, stock options are believed to align managers' goals with shareholders' goals. This alignment helps to overcome some of the problems with the separation of ownership and control discussed in the previous chapter. The typical executive option contract assigns the strike price of the options to the prevailing stock price at issue. The most common length of the contract is ten years. That is, the CEO has ten years to increase the price of the stock and exercise the options. After ten years, the options expire. Executives cannot sell or transfer the options and are discouraged from hedging the stock price risk. Average incentive awards realized ”mostly stock options ”jumped from $500,000 in 2000 to more than $800,000 in 2001. Indeed, executive stock options were not common prior to 1980.

Options and Accounting

The popularity of stock options as incentive compensation in the United States partly comes from its very favorable tax treatment for both the executive and company. When options are granted, the company only has to report an accounting cost when the strike price is less than the current stock price. This means that the cost is amortized over the life of the option. Since most options are granted with the strike price equal to the current stock price, the firm never has to report an accounting cost. Of course, there is an economic cost to the firm, but that is not reported in the SEC-required reports that adhere to a set of standards, known as generally accepted accounting principles (GAAP), for public companies. Also, managers are allowed to pick the year in which they will exercise the options, and they can thus determine the year in which the tax liability occurs. In addition, the compensation is treated as a capital gain, not as income. This is an advantage to the CEO because capital gains taxes are lower.

The current use of options and reporting of standards of GAAP usually make the cost of options non-reportable in the income statement. That is, if an executive cashes in his or her shares for $100 million, this cost is not reported on the firm's income statement. The firm does not have to report an accounting cost, but the economic cost to the firm is real. Consider this simple example. A firm has 100 million shares outstanding and has given the executives options for 10 million shares. The firm currently has earnings of $100 million, or $1 per share. If the executives were to exercise their options, they would buy 10 million shares from the firm at the strike price and sell them into the stock market. At that point, there would be 110 million shares outstanding. This means that the $100 million in earnings becomes only $0.91 per share. The earnings per share have fallen by 9 percent! The firm has become less profitable.

The economic cost to shareholders is real. The question being debated recently is whether to change the standards for reporting options, and if so, how. Coca-Cola and the Washington Post have not waited. Pushed by board member Warren Buffett, they have decided to report the cost of the options as an expense of the company. This method immediately recognizes the economic cost of executive options, but it could have a dramatic impact on company earnings. For example, a study by Merrill Lynch concludes that expensing options would decrease the earnings of the largest 500 companies by 21 percent. [5] For companies that use options to a larger degree, like technology firms, the drop could be much higher. However, this was a pretty good strategy for Coke. While its earnings may decline a bit, it is signaling to investors that it uses conservative and trustworthy accounting methods . Several more companies decided that they would also expense stock options after the announcements made by Coke and the Washington Post . Investors want to see more of these types of signals.

Stock Options and (Mis)Alignment

Despite the tremendous growth in the use of stock options as incentive compensation for executives, very little direct evidence exists that it works. That is, does awarding managers stock options cause the firm and its stock to perform better on average? Financial economists have studied this question for at least two decades. The evidence is mixed. One study identifies a positive relationship between executive stock incentives and firm performance. Another study takes into account other corporate monitoring mechanisms (like capital structure, board structure, and institutional owners ) in a different way and finds no relation between stock-based incentives and firm performance. [6] In this way, the academic debate continues. Overall, there remains little direct evidence that a company can expect higher stock returns by introducing aggressive incentive-based compensation programs.

Stock options may not be as effective in aligning managerial incentives with shareholder goals as once thought. Following is a short list of improperly aligned incentives involving options:

  1. Shareholder returns are a combination of both stock price appreciation and dividends. The stock option is only affected by price appreciation . Therefore, the CEO might forego increasing dividends in favor of using the cash to try to increase the stock price.

  2. The stock price has a better chance of increasing when the CEO accepts risky projects. So, when a firm uses options to compensate the CEO, he or she has a tendency to pick a higher-risk business strategy.

  3. Stock options lose some incentive for the CEO if the stock price falls too far below the strike price. In this case, the options would be too far underwater to effectively motivate the CEO and other executives.

  4. Stock analysts and investors focus a great deal on a firm's accounting profits. The firm often has some ability to manipulate earnings (see Chapter 5). As a result, the CEO may have an incentive to manipulate earnings to maximize profits in one target year so that the stock price will be high for the option exercising. This manipulation can have the effect of reducing earnings (and consequently lowering the stock price) after the target year.

The very advantage that stock options use to align manager incentives with stockholder goals is also a major problem. Stock options are tied to a firm's stock price, and that helps align incentives. But executives only have partial influence on stock prices. Stock prices are affected by the performance of the company. However, many other factors that executives have no control over influence prices. Stock prices are mostly affected by the strength or weakness of the economy. Consider the graphs from the first chapter that relate the economy and the level of the stock market. When the economy thrives, stock prices rise. Stock prices can also rise and fall with the exuberance or pessimism of investors. The stock of a poorly run company may still rise. It would not rise as far as more successful competitors, but it can still go up. This may richly reward executives through their options when they do not deserve rewards. Alternatively, the stock market may fall because of poor economic conditions or investor pessimism. A company with managers who are able to outperform their competitors may still suffer from falling stock prices. Managers who should be rewarded for such good performance are not because their options become underwater when the overall market falls.

Options lose their effectiveness when the stock price falls far below the strike price. The stock price fall could be either related to a poor performance by the company or to a general stock market decline. To reestablish motivation for the executives, boards sometimes reprice the options. (Repricing is lowering the strike price on previously issued options.) Consider the incentives listed above and how they create interesting dynamics for CEO behavior. CEOs choose risky projects that have a chance of dramatically increasing the stock price. If the projects succeed, the CEO becomes rich and the stockholders experience increased wealth. However, if the projects fail, the stockholders lose wealth. After such a failure, the CEO simply asks the board to reprice the options and he or she can then repeat the strategy. Is this the type of strategy stockholders want the managers of a firm implementing? Proponents of option repricing claim that it is necessary in order to keep executives at the firm. This argument has some truth, but that doesn't change the skewed incentives it causes.

Consider the case of Kmart. Kmart's stock price started 1990 at $17 per share. In 1992, the stock climbed to more than $25 per share. However, the stock price steadily declined over the next three and a half years to nearly $7 per share. In March 1996, Kmart's board repriced the executives' stock options. [7] This seemed to have worked since the stock price slowly climbed to more than $15 per share. This was not to last. The firm's business strategy failed and it experienced financial difficulties. Its stock price deteriorated. The company filed for bankruptcy protection in 2002, and the stock price fell to less than $1 per share.

A similar move is to simply give the executives new options. In 2000, Apple Computer gave Steve Jobs 20 million options with a strike price of $43.59 as a reward for coming back to Apple and turning around the firm. However, one year later, the stock price had fallen substantially. So the board gave him 7.5 million more options with a strike price of $18.30. [8]

Who Gets Options?

The executives of most firms receive options. However, in the past, stock options have been a form of compensation that smaller, newer firms use the most. Small, fast-growing firms typically have less access to cash and prefer to pay executives through options, which does not require the firm to give up any cash. Indeed, in the 1990s, the era of the technology and dot-com firms, young companies offered nearly every employee stock or stock options as compensation. The stock market drop starting in 2000 hurt Silicon Valley, whose firms use stock options as an essential part of employee compensation. Many large companies use options to motivate and compensate employees. For example, 24,000 employees (out of 57,000) have stock options at Qwest Communications International. But for most companies, it is the executives of the firm ” especially the CEO ”who receive stock options.

Some executives should not need stock options to motivate them. Larry Ellison, CEO and founder of Oracle, owns 1.4 billion shares of stock, which represents 24 percent of the company. [9] At $10 per share, that is $14 billion of wealth. Therefore, if the stock rises only 10 percent, he receives $1.4 billion in increased wealth. If the stock price falls 10 percent, he loses $1.4 billion. Shouldn't the potential to make such gains be incentive enough to work hard for the company? Why does he need options to purchase another 104 million shares to motivate him? Other super-rich executives who possess material ownership in their firm, such as Ross Perot, Bill Gates, and Warren Buffet, do not accept options.