Compensation Committee – Definition

Cite this article as:"Compensation Committee – Definition," in The Business Professor, updated September 14, 2019, last accessed October 20, 2020, https://thebusinessprofessor.com/lesson/compensation-committee-definition/.

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Compensation Committee Definition

This refers to a board of independent directors who set the level of compensation and decide the payment rate for managers at the senior level. The committee also helps in the choosing of other compensation like profit sharing, bonuses, and stocks. The creation of corporate objectives, goals, and grants is sometimes the work of the committee.

A Little More on What is the Compensation Committee 

Generally, the compensation committee serves as advisors, strategists, and administrators for the organization. As advisors, they should demonstrate best practices, and know the trends regarding compensation. In addition, they should come up with targets and performance measures, and also evaluate the performance of the executives.

Also, in their role as strategists, the committee should show the board and stakeholders how they are going to achieve corporate goals. In their capacity as administrators, the compensation committee is required to research on the most appropriate ways to plan for compensation.

However, the plans should meet the set ground rules and regulations. The committee must ensure that their plans reap the desired results.

Compensation Committee Components

Compensation committee members choose what to include in compensation packages, together with the amount to allocate. The compensation plan mostly consists of the components below.

  • The basic salary for the chief executive officer
  • Pluses that comprise of short-term goals with incentives which are on a cash-basis.
  • Long-term bonuses for creating value for the organization
  • General benefits such as; eye and dental insurance, life insurance, time for holidays and vacations, plans for investments, and savings plan.
  • Privileges that constitute usage of office phones, allocation of company cars, and use of other properties owned by the organization.

Generally, the committee does have the upper hand when deciding these compensations for senior management. However, the pressure from investors is a lot, and it forces the committee to come up with clear targets for measuring the executives’ performances. A benchmark is set to measure this.

The people who serve in the compensation committee

The organization’s board members are the ones who sit and select compensation committee members. The nature of the work of the committee requires the board to choose members who are directors independently.

Appointed members should have a level of industry expertise, and also have business skills to run the committee. The committee needs to understand that skills and independence are vital. The board generates the job description for the committee and highlights their roles and responsibilities.

Roles and responsibilities of the compensation committee

The board has assigned the following duties to the compensation committee;

  • Create the philosophy of compensation for the organization based on the organization’s values and mission. It includes the proportion of base salary to benefits, which drives an increase in salary, and the ways in which the philosophy affects the confidence of employees.
  • The committee comprises of independent executives. Therefore, they need to approve all the compensation plans that the directors and the Chief Executive Officer will take part in. It is an overwhelming task for the committee as both the board and stakeholders vote on it to decide if they are appropriate.
  • The committee, as board advisors, gives errors, recommends, and gives the go-ahead for the stock option awards. They may also be needed to approve incentive, benefits, and employment contracts with approvals from the board and shareholders.
  • The compensation committee serves as a link between the Chief Executive Officer and the board on issues related to human resources and administration.
  • Approves and recommends compensation for the reports that the CEO submits directly, as well as other packages that the CEO receives.
  • Ensure there is enough money available to cater to the organization’s compensation plan. They sit with the finance and audit team to evaluate the budget and approve the plan for compensations.
  • Make changes, if need be, to the compensation packages for the CEO and the board members. The changes need to be approved by the board.
  • Employ any external professional assistance that they require to assist them in achieving their goals. The support team includes the legal team, accountants, and consultants.
  • Recommend performance evaluation metrics, and approve them concerning their set targets for establishing the awards for compensation.
  • Identify the faults in compensation matters and discuss it with the board to find timely solutions to the oversights.

The compensation committee need not be too involved in the daily compensation plan that includes approving compensation for non-managerial positions.  It is wrong for the committee members to engage in such processes.

They should concentrate on forming the philosophical, and budgetary niche, and other executive plans. The committee must be transparent in all the matters they handle and ensure they carry out matters professionally and ethically.

Conclusion

The committee members should aim to carry out all their roles and responsibilities and help the board members identify errors in the plans. They should, however, be careful while undertaking these roles so that they do not micromanage the compensation plans of the executives.

In today’s market, the recruitment of compensation committee members is a task the board members, and shareholders take seriously. To ensure that they implement the compensation plans carefully, the committee members need to be ethical, accountable, transparent, and professional.

References for Compensation Committee

http://www.businessdictionary.com/definition/compensation-committee.html

https://www.compensationresources.com/compensation-committee-what-does-it-do-2/

https://www.investopedia.com/articles/stocks/07/executive_compensation.asp

Academic Research on Compensation Committee

Compensation committee composition as a determinant of CEO compensation, Daily, C. M., Johnson, J. L., Ellstrand, A. E., & Dalton, D. R. (1998). Compensation committee composition as a determinant of CEO compensation. Academy of Management Journal, 41(2), 209-220. Extant research examining the relationship between a firm’s board and its CEO’s compensation has focused primarily on the composition of the board-at-large. However, it may be the nature of the compensation committee, not the board as a whole, that is at issue. This study was a longitudinal assessment of the relationship between the composition of a firm’s compensation committee and multiple measurements of CEO compensation. We found no evidence that “captured” directors led to greater levels of, or changes in, CEO compensation. These findings may suggest the consideration of theories other than agency theory as explanations for the continued focus on board independence.

An empirical examination of the role of the CEO and the compensation committee in structuring executive pay, Anderson, R. C., & Bizjak, J. M. (2003). An empirical examination of the role of the CEO and the compensation committee in structuring executive pay. Journal of Banking & Finance, 27(7), 1323-1348. Motivated by the potential for opportunistic behavior in pay decisions, recent SEC and IRS regulations essentially preclude inside directors from serving on a firm’s compensation committee (CC). We examine whether greater CC independence promotes shareholder interests and whether the CEO’s presence on the CC leads to opportunistic pay structure. We find little evidence that greater committee independence affects executive pay. Moreover, committees consisting of insiders or the CEO do not award excessive pay or lower overall incentives. For example, we find no evidence that pay decreases or total incentives increase when CEOs come off the CC. Our results suggest that regulations governing committee structure may not reduce levels of pay or achieve efficiencies in incentive contracts.

Does the composition of the compensation committee influence CEO compensation practices?, Newman, H. A., & Mozes, H. A. (1999). Does the composition of the compensation committee influence CEO compensation practices?. Financial management, 41-53. This paper examines whether compensation committee composition affects CEO compensation practices. We find that CEOs receive preferential treatment (at shareholders’ expense) when insiders are members of the compensation committee. We do not find that CEO compensation is greater in firms that have insiders on the compensation committee than it is in firms that do not. However, we show that the relation between CEO compensation and performance is more favorable toward the CEO (i.e., biased in the CEO’s favor at shareholder expense) among the firms that have insiders on the compensation committee.

Further evidence on compensation committee composition as a determinant of CEO compensation, Vafeas, N. (2003). Further evidence on compensation committee composition as a determinant of CEO compensation. Financial Management, 53-70. I use more than 1,500 firm-year observations for 271 US firms between 1991-1997 to examine the relation between insider membership in compensation committees and CEO pay. I find a steady decline in the number of committees with insider participation during the sample period, and uncover some opportunism by insiders in setting pay prior to the compensation disclosure and tax reforms. Finally, I document changes in pay practices that would be consistent with the intent of these reforms. Based on this evidence, however, I cannot definitively conclude whether the reforms were efficient.

The effect of compensation committee quality on the association between CEO cash compensation and accounting performance, Sun, J., & Cahan, S. (2009). The effect of compensation committee quality on the association between CEO cash compensation and accounting performance. Corporate Governance: An International Review, 17(2), 193-207. Our findings imply that shareholders and directors should be concerned about the composition of compensation committees as we find that compensation committee quality varies depending on compensation committee size and other characteristics of the committee members. Our findings also imply that for compensation committee members, there are greater challenges in monitoring CEO compensation contracts for firms with high growth or that incur losses. Further, our findings imply that even when all compensation committees are regulated to be fully independent, there are still quality differences among these independent compensation committees.We contribute to the agency-based research on CEO compensation by: 1) directly examining the impact of compensation committee quality on the sensitivity of CEO cash compensation to accounting earnings; 2) examining whether the role of compensation committee quality varies across firms; and 3) developing a broader and richer measure of compensation committee quality.Using a sample of 812 US firms, we find that CEO cash compensation is more positively associated with accounting earnings when firms have high compensation committee quality. We also find that the positive effect of compensation committee quality on the association between CEO cash compensation and accounting earnings is less for high growth firms or loss-making firms.We examine the effect of compensation committee quality on the association between CEO cash compensation and accounting earnings and the moderating effects of growth opportunities and earnings status.EmpiricalWe examine the effect of compensation committee quality on the association between CEO cash compensation and accounting earnings and the moderating effects of growth opportunities and earnings status.Using a sample of 812 US firms, we find that CEO cash compensation is more positively associated with accounting earnings when firms have high compensation committee quality. We also find that the positive effect of compensation committee quality on the association between CEO cash compensation and accounting earnings is less for high growth firms or loss-making firms.We contribute to the agency-based research on CEO compensation by: 1) directly examining the impact of compensation committee quality on the sensitivity of CEO cash compensation to accounting earnings; 2) examining whether the role of compensation committee quality varies across firms; and 3) developing a broader and richer measure of compensation committee quality.Our findings imply that shareholders and directors should be concerned about the composition of compensation committees as we find that compensation committee quality varies depending on compensation committee size and other characteristics of the committee members. Our findings also imply that for compensation committee members, there are greater challenges in monitoring CEO compensation contracts for firms with high growth or that incur losses. Further, our findings imply that even when all compensation committees are regulated to be fully independent, there are still quality differences among these independent compensation committees.

Compensation committee governance quality, chief executive officer stock option grants, and future firm performance, Sun, J., Cahan, S. F., & Emanuel, D. (2009). Compensation committee governance quality, chief executive officer stock option grants, and future firm performance. Journal of Banking & Finance, 33(8), 1507-1519. This paper examines whether the relationship between future firm performance and chief executive officer (CEO) stock option grants is affected by the quality of the compensation committee. Compensation committee quality is measured using six committee characteristics – the proportion of directors appointed during the tenure of the incumbent CEO, the proportion of directors with at least ten years’ board service, the proportion of directors who are CEOs at other companies, the aggregate shareholding of directors on the compensation committee, the proportion of directors with three or more additional board seats, and compensation committee size. We find that future firm performance is more positively associated with stock option grants as compensation committee quality increases.

The compensation committee process, Hermanson, D. R., Tompkins, J. G., Veliyath, R., & Ye, Z. (2012). The compensation committee process. Contemporary Accounting Research, 29(3), 666-709.

Evaluating and monitoring CEO performance: evidence from US compensation committee reports, Epstein, M. J., & Roy, M. J. (2005). Evaluating and monitoring CEO performance: evidence from US compensation committee reports. Corporate Governance: The international journal of business in society, 5(4), 75-87.

The determinants of compensation committee membership, Vafeas, N. (2000). The determinants of compensation committee membership. Corporate Governance: An International Review, 8(4), 356-366. This study extends the work of Kesner (1988) and Bilimoria and Piderit (1994) in examining the determinants of compensation committee composition. Consistent with their findings, my results suggest that the likelihood of compensation committee membership is significantly related to director type (i.e., outside vs. inside), length of board tenure, and the number of other directorships held. In addition, my results suggest that committee membership also depends on director age, and the number of other committee memberships served. Importantly, in contrast to the predictions of agency theory, I find that committee membership is only marginally related to director affiliation, and unrelated to outside director stock ownership. Together, these results provide mixed, somewhat weak evidence that firms staff their compensation committees with directors that are likely to protect shareholder interests.

The effect of restructuring charges on executives’ cash compensation, Dechow, P. M., Huson, M. R., & Sloan, R. G. (1994). The effect of restructuring charges on executives’ cash compensation. Accounting Review, 138-156.  Top executives’ compensation contracts typically provide for annual incentive awards that link executives’ cash compensation and reported earnings. This link has been confirmed empirically by Lambert and Larcker (1987), who document a positive association between the cash compensation of chief executive officers (CEOs) and their firms’ contemporaneous earnings performance. The widespread use of earnings-based incentives has prompted concerns that executives may select real decisions and accounting procedures to maximize their earnings-based compensation, irrespective of the impact on the economic well-being of the firm (Kaplan and Atkinson 1989, 724; Watts and Zimmerman 1986, 204). These concerns presume that the earnings-based performance measures specified in compensation contracts are strictly adhered to in setting executive compensation. In practice, however, these plans are administered by compensation committees, who could adjust compensation to prevent executives from engaging in opportunistic behavior. Existing research provides mixed evidence as to whether compensation committees adjust earnings-based compensation. For example, Abdel-khalik (1985) finds evidence that CEO compensation is adjusted in response to accounting procedure changes. In contrast, Healy et al. (1987) find no evidence that CEO compensation is adjusted for the effects of accounting procedure changes on reported earnings. This study provides evidence suggesting that compensation committees do adjust earnings-based incentive compensation. It documents reliable and systematic evidence that CEOs’ cash compensation is adjusted for restructuring charges. We investigate a sample of 182 restructuring charges taken by 91 Fortune 500 firms between 1982 and 1989. The short-term incentive plans of the sample firms do not include explicit provisions for restructuring charges to be excluded from the definition of earnings used to determine executives’ incentive compensation. The empirical analysis, however, indicates that CEO cash compensation is shielded from restructuring charges relative to other components of earnings. The results also suggest that the degree to which executive compensation is adjusted for a restructuring charge depends on the characteristics of the restructuring. Our evidence is consistent with the hypothesis that compensation committees systematically override the provisions of incentive plans to avoid providing executives with incentives to behave opportunistically. Restructurings typically require a large charge to earnings but can have a positive impact on the economic well-being of a firm. By adjusting executive compensation for restructuring charges, the compensation committee ensures that executives are not deterred from undertaking value-enhancing restructurings.

The economic determinants of compensation committee quality, Sun, J., & Cahan, S. F. (2012). The economic determinants of compensation committee quality. Managerial finance, 38(2), 188-205.

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