Executive Pay and Performance, Term Paper Example

Executive pay and compensation packages are a hot topic in today’s world of business and public analysis. Many top executives in the United States are seen as more highly compensated than is necessary, while other Americans are struggling to make ends meet. Even so, the cost of executive compensation continues to increase despite efforts to curtail this type of company spending.

Despite the fact that the cost of compensation is steadily increasing, a company´s performance often depends on the performance of a good Chief Executive Officer (CEO). Therefore, it is often necessary for a company to pay its CEO handsomely, usually well above the market rate, in order to retain him or her as one of the company’s most prized assets.

This paper analyzes this notion and gives an in-depth look into the concept of pay for performance for senior executives such as CEOs. It is important to note that a company’s Board of Directors, shareholders and compensation committee are responsible for executive compensation package proposals presented to prospective CEOs, and they are charged with weighing possible risks against benefits for any particular package presented.

CEO Compensation

There is a consensus in America regarding executive compensation and it is the philosophy that it is better to align executive compensation with performance. It is reasonable, considering that it just makes sense that paying an executive more for better performance is motivational to the executives (Ferracone 2010).

As analyzed by Gomez-Mejia, Tosi & Hinkin (1987), compensation for CEOs is as follows:

Compensation has three distinct components: salary, bonuses, and long-term income. The last includes a wide array of deferred compensation benefits like pensions, profit sharing, stock options, IRAs, and bonus deferrals (60).

The above quote outlines the totality of the basic CEOs compensation package, not including any added benefits or perks the company deems is necessary to attract and retain their chosen CEO executive. However, the bottom line is whether or not the executive is capable of handling the responsibilities of being the top executive for the firm.

According to Lewellen, Loderer, Martin & Blum (1994), senior executives are responsible for their corporations’ sound investment and financing decisions and also to ensure that their firms’ shareholder and investor interests are well taken care of; however, there is concern by many shareholders and investors that their corporate executive may not do was is expected. This brings up the issue of whether there is a correlation between the size of senior executive compensation packages offered and the firm’s financial performance standing.

A positive correlation between the two can result in a reduction of overall costs for a large corporation (Lewellen, Loderer, Martin & Blum 1994). This is significant, given the fact that many smaller firms are competing in the marketplace with larger firms that can afford better executive compensation packages.

Similarly, Gomez-Mejia, Tosi & Hinkin (1987) suggests that economic theory concerning executive compensation is based on the human capital theory, and it relates to a company’s size as being associated with how difficult a top executive’s job is.

It is further noted that organizational size and the CEO’s compensation package should be closely related and based on the complexity of the job more so than how well the job is done. However, many experts and industry professionals disagree and feel that the CEO’s performance should definitely be taken into account. The obvious assumption is that a high compensation incentive would yield a high performance level and success for top executives.

More CEO Pay vs. CEO Exits

As illustrated by Ferracone (2010), a company’s Board of Directors may see the company in a position of risk by losing a strong-performing, qualified CEO, so they may opt to reward the CEO accordingly rather than risk losing the CEO to a competitor. They see it in their best interest to retain an already well-performing CEO who is experienced with the ins and outs of their firm and not have to deal with the possibility of ending up with a less desirable executive.

Morgenson (2012) reports, many corporations argue that if they do not pay high CEO compensation packages, then they will not have the most highly qualified CEO. Therefore, many corporations find it in their best interest to justify the high-valued executive rewards and compensation packages by saying that their focus is really on hiring the most competent executive instead of simply trying to scrimp on pay and end up losing a promising executive for the company.

Additionally, it is a fact that plenty of management teams in companies across America feel like they have to keep up with whatever the competition is doing, in this regard, based on what the market can stand. It’s a classic case of keeping up with the Jones’. However, a company’s compensation committee may choose to offer a compromise by presenting the CEO with a reasonable pay incentive that is contingent on company performance. This way, the company is protected from the possibility of the company’s financial collapse and also having to lose the CEO by forced resignation, along with paying out a hefty CEO severance package. With this in mind, questions often arise about whether or not pay-for-performance incentives for CEOs actually work and are a good idea.

In terms of pay-for-performance, it is a fact that high value incentives may not necessarily equate to good CEO performance, and good CEO performance may not necessarily mean better company performance.

As outlined by Barro & Barro (1990), the amount of CEO pay-for-performance increases as the CEOs relative experience increases. Additionally, as it relates to CEO turnover, CEO skill matching is directly related to compensation and the size of the corporation. It is also noted that CEO experience has an affect on pay-for-performance sensitivity. As it relates to CEOs jumping ship of a firm to join the competition, relative transferable knowledge, skills and talents is an issue.

Morgenson (2012) points out that most CEO skills are not easily transferrable from one firm to the next and that CEOs do not move often because of this fact. This means that perhaps all the hype about more money and incentives every year for CEOs is not necessary to keep them, because they will more than likely not move anyway. Many CEOs are comfortable and would rather not risk jumping ship to find greener pastures and end up in a worse situation than the one they think they are in at their present company. This is a valid assumption and it is crucial to the concept of aligning CEO pay with company performance. However, some highly compensated executives are raking in the dough even when their companies are not performing well, and this is seen as highly unacceptable.

Executive Compensation Overpayment

Some CEOs are overpaid, in spite of undesirable company performance trends. Highly compensated top executives often accept large compensation bonuses and incentives, even when they see their company is not doing so well. A case in point is outlined in an article in the Huffington Post reports that, in 2011, the CEO of Dean Foods, Gregg Engles, was given a 52 percent increase in salary and incentives from the previous year and made $8.5 million, even though the company had a $1.6 billion loss for the year (Kavoussi 2012). This seems out of context but it is evident that this CEO’s company places a high value on his presence without the organization.

Another example of a CEO cashing in when his company’s profits took a downturn is the case of the CEO of Omega Healthcare in Hunt Valley. His executive pay package value doubled to $7.8 million, in spite of it being criticized by a shareholder advisory firm and also in light of the fact that the company’s fallen stock price and decreased profits were on the books (Hopkins 2012). These are glaring examples of CEO overpayments and many people in the general public consider it an outrage.

As it relates to CEO overpayments, Popper (2012) reports that the median pay of the 200 most highly compensated CEOs in the United States was $14.5 million in 2011. This statistic comes from a study done by Equilar, a Redwood City, California compensation data firm.

Additionally, those same CEOs’ median pay raise equaled 5 percent. This is a standout social issue and it feeds the anger of ordinary Americans who often struggle with unemployment, pay cuts and decreasing wealth. It is seen as a case of the haves catering to greed while the have-nots are barely getting by. Ferracone (2010) states some people blame the recent financial collapse in America on overly high executive compensation.

CEO Pay Alignment to Performance

In light of the overpayment issue, company investors’ points of view are often in favor of aligning CEO pay with company performance, as well as having a trustworthy compensation committee that has the best interests of the investors and shareholders of the company in mind (Ferracone 2010). For instance, a Wall Street Journal report shows that 2011 CEO pay packages were more aligned with company performance. On average, CEOs received 0.6 percent increases for every extra 1 percent of returns to shareholders. This, at least, is a measurable component to the executive compensation package issue.

Shareholders often need justification of the significance of an executive compensation package before approving it. To meet approval, it is often not so much an issue about the amount of pay that is being considered for the CEO but more of whether or not the CEO is giving the corporation its money’s worth. It is a question of does the CEO meet goals and standards put in place to help the company advance. Bhatt (2012) states that companies justify executive pay to shareholders by implementing compromises such as eliminating perks, tying bonuses to corporate goals and putting policies in place that allows the company to take back bonuses and stock options from executives if the company gets into financial trouble. This is seen as a fair compromise. With this type of justification tied to compensation package proposals, shareholders can feel better about the executives worth and commitment, and therefore they can feel better about approving the executive’s compensation package.

Say on Pay Authority

In contrast to decades past, investors are heavily involved in the decisions of what to pay top executives in their companies. They have a say about pay for top executives, unlike in the past. The vehicle in which investors’ voices can be heard is called the “Say on Pay” law. The “Say on Pay” law mandates that public companies allow its shareholders and investors to cast votes, based on advisory decisions, regarding executive compensation (Bhatt 2012). This has shed light on pay practices and allows a check and balance approach to alert for any red flags that may arise. The “Say on Pay” law is also a way for investors to vote against compensation packages it deems is too much and not in the best interest of the company, its shareholders and investors. For example, Bhatt (2012) reports that a Portland-based bank had an executive-pay proposal rejected by its committee and it cut the CEO’s base salary by about 7 percent last year to a “paltry” $815,000. This example shows a move in the best interest of the shareholders, while still allowing for a hefty pay package for the CEO. It also shows that there can be a win-win situation with controlling executive compensation package amounts.

Shareholders, legislators, regulators and the media all put pressure on company Boards to appropriately balance the vested interests of investors and corporate management (Mercer 2009). This is not only true for companies in the United States, but other countries as well. For example, Mercer (2009) reports that Europe has imposed legislation giving shareholders a say on executive compensation matters. Also, firms in Span, Sweden, Australia, Norway and the Netherlands have voted to increase disclosure of executive pay programs. These types of corporate governance reforms have become popular, though the United States and Canada are the last to implement them. It is important that new disclosure regulations about executive pay programs are presented to shareholders of companies (Mercer 2009).

In addition to an increase in corporate disclosures about executive pay matters, there has also been an increase in compensation committee responsibilities in many firms. This is significant because it shows that more time is going into the decision-making process to approve CEO compensation packages and that the interest of the company’s shareholders and investors is taken into consideration on a larger scale. Regulations have been strict, so it is in a company’s best interest to ensure compliance to regulatory standards to avoid any possible corporate scandals (Mercer 2009). However, this presents a challenge for Board and compensation committee members to ensure an appropriate balance between executive pay with a necessity of attracting and retaining the best executive talent in the market.

Additionally, when it comes to the compensation of top executives, many in the industry believe that CEO pay scales should have restrictions.

CEO Pay Should Be Restricted

CEO pay is often a subject of controversy as it relates to unnecessary compensation of corporate executives at the expense of taxpayers. DeCarlo (2012) reports on a study done in 2011 that revealed top executives of the United States’ top 500 companies received $5.2 billion in pay raises, which represents 16% collectively. Comparatively, the average American worker only got an average of a 3% raise in pay. This is an in-balance that is seen as unfair to the general public. It’s the old adage, ‘the rich keep getting richer’ and it shows a need for more corporate governance in this regard.

In contrast, some CEOs are simply not as greedy or fortunate as others. An article by CNET News reports that the CEO of Amazon, Jeff Bezos, has passed on his pay raise and bonus for the last five years. To make up for this, though, he did exercise some very lucrative stock options (Kawamoto 2003). This is something that is seen by shareholders as a good move and is preferable. It helps the corporation but still takes care of the executive.

Additionally, in the case of Amazon, a proposal is on the table for more executive compensation plans to include linking stock option cash out to an industry performance index. This means that the company executives would only get paid the large dollar amounts if the company’s stock performed favorably (Kawamoto 2003). This is a compromising concept to executive pay restrictions.

Similarly, Hopkins (2012) states a recent study showed that six Baltimore CEOs received large pay cuts instead of large pay raises, due to low performing company issues. For example the CEO of Corporate Office Properties had his compensation cut in half the year before he retired. This was because the company had a loss in 2011 of approximately $134 million due to plummeting stock prices. The other five CEO pay reductions were also mostly related to bad company performance but there were other factors involved as well.

Another example of a CEO pay reduction instead of increase is the case of Armour’s CEO whose compensation package was cut last year by 14 percent to only $1.1 million, but this was in light of the fact that the company’s stock prices went up and they realized substantial profits. The company justified this by citing that the CEO did not reach all of his goals for the year (Hopkins 2012). This is an example of CEO pay restrictions in place.

According to Pearce, Stevenson & Perry (1985), some industry experts agree that CEO pay should have restrictions. This is based on the concept that high compensation merit pay may be an inappropriate way to enhance CEO performance and statistical analyses showed this to be likely. Additionally, it is noted that CEO performance motivation should be contingent on performance but many times it is not.

It is interesting to note that, according to Pearce, Stevenson & Perry (1985), a comprehensive study on performance-contingent pay programs for executives revealed that implementing these types of programs did not show significant effects on general CEO organizational performance. One reason for this is suggested that managers have limited direct control over the performance of an organization and focus should be more on environmental influences that the managers are responsible for manipulating.

It is important to note that even when CEOs are high-performing, they may not necessarily receive the highest pay for their performance. For example, the Society for Human Resource Management reports on a study done by a professional services firm that revealed that top CEOs of companies with the highest performance did not receive the highest pay raises. With this in mind, a question of whether or not it is even possible to successfully restrict CEO compensation and still benefit from the work of a quality CEO is appropriate. However, inefficiency in a product of interference should be taken into consideration as well as possible regulation of CEO compensation package ceilings.

CEO Compensation Packages Regulation

Many argue that it is unfair to have such an inequality in business as it relates to the astronomical salaries and compensation packages of CEOs in this country. However, others argue for its justification based on the fact that the CEO has the responsibility of final decisions that are made for a company and they have responsibility towards the company´s reputation and performance.

In light of this and the public attention from highly publicized, high profile corporation scandals such as the Enron situation, pay and performance of executives in the United States have come under some scrutiny (Jarque 2008). It is no wonder that the general public is skeptical and suspicious of how much money many executives make on a yearly basis. This is especially true because a lot of the money paid to these executives comes from taxpayer dollars, and the everyday American is aware of this and is not happy with it. An article from ABC News reports on a 2011 study that found tax loopholes, concerning executive compensation packages, which costs taxpayers more than $14 billion a year. This is due to CEOs receiving more in their compensation packages than was paid in taxes by their companies. Many see this as an unfair concept. It means that large corporations are taking advantage of these loopholes to lower their tax bills and the taxpayers end up subsidizing large CEO paydays. This is possible because, as it stands now, companies can take off executive pay as a deductible business expense on their taxes, so the trick is the companies pay the executives with stock options, which are exempt from taxation (Kim 2012). So, taxpayers get stuck with the bill and CEOs reap the rewards.

Regarding regulation of CEO compensation, however, there needs to be some. Jarque (2008) reports over the last 20 years, the average pay of CEOs working in the top 500 firms in the United States increased some six-fold. This compensation was mainly performance-based and was paid in stock options.

It is also reported that regulatory standards, imposed over the last 15 years, that affect executive compensation include changes in corporate capital gains taxes, limits on deducting CEO pay expenses unless they are performance-based, increased company disclosure requirements, and standards on option grants expenses (Jarque 2008).

Additionally, studies done following regulatory changes show a shift of compensation trends from salaries and bonuses to stocks and options (performance-based compensation). Jarque (2008) states, “This suggests that regulation efforts to improve corporate governance and transparency have been moving in the right direction, although it is difficult to evaluate the relative importance of regulation versus the market induced changes in governance practices” (267).

Conclusion

Executive compensation is a significant aspect of corporate governance and is often governed by a company’s Board of Directors, investors, shareholders and compensation committee members. Executive pay typically consists of salary, stock options, benefits, bonuses and other perks deemed appropriate, based on different company preferences. As noted above, executive compensation has disproportionately increased relative to the average American worker and this is often seen as a negative in the public eye, so it is a growing social issue.

To help change the view of executive compensation as a root to evil, measures have been put in place to gear executive compensation packages more toward pay-for-performance. This equates to more executives receiving their bonuses, rewards and incentives only when their company’s are doing well financially.

In today’s competitive business world, many companies are looking for new and better ways to attract and retain the highest qualified CEOs to help lead their businesses to financial success through growth and expansion. Therefore, many companies are prepared to offer and follow through with paying handsome compensation packages to existing and prospective CEOs. Many firms are prepared to justify paying CEOs compensation packages above the market rates in an attempt to retain the services of what they feel is their most prized asset – the CEO.

Works Cited

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