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Executive Compensation Definition
Executive compensation is the incentive offered to executives to attract and retain them and to encourage them to work in the best interest of shareholders. Executive compensation may be offered in cash on non-cash forms. It is often reported that executives who are not offered any from of executive compensation are more likely to underperform, to quit the company, and to not perform in the best interest of shareholders to achieve corporate objectives.
Types of Executive Compensation
Executive compensation has many types:
- Cash compensation – The company may offer monetary rewards to its executive employees to keep them motivate and committed to the company goals. Cash compensation generally comes in the form of salaries and performance bonuses.
- Option grants – A company may also compensate its executive members by offering non-cash incentives, such as the employee stock option. A stock option is the right to buy a specific number of shares of stock at at specific price (the “strike price”) for a given time period. The executive will exercise the stock option if the stock prices goes up. This will result in gains, as the company will pay them the difference between the strike price and market value of share. This method of compensation is more tax-friendly to the executive than cash compensation.
- Long-term incentive plans (LTIPs) – An LTIP is an incentive reward system that is offered to improve employee performance in long term. Generally, employees are required to meet some conditions to show they maximize shareholder’s value with their performance. This could be a cash or stock award based upon achieving performance milestones or improving upon existing metrics.
- Retirement packages – A company may offer retirement benefits to executive employees to motivate them and keep them committed to corporate goals. The executives may pensions, deferred compensation, health benefits, earn-outs, and other perks upon retirement.
Executive Perks – Executive may enjoy many privileges given to them by the company. Executive perks may include a company car, accommodations, private planes, travel compensation, dining reimbursements, and many more.
Resources for Executive Compensation
Academic Research on Executive Compensation
- ● Pay without performance: The unfulfilled promise of executive compensation, Coco, M., & Christian, A. (2006). The article reviews the book “Pay Without Performance: The Unfulfilled Promise of Executive Compensation,” by Lucian Bebchuk and Jesse Fried.
- ● Executive compensation, Murphy, K. J. (1999). Handbook of labor economics, 3, 2485-2563. This chapter summarizes the empirical and theoretical research on executive compensation and provides a comprehensive and up-to-date description of pay practices (and trends in pay practices) for chief executive officers (CEOs).
- ● Executive compensation structure, ownership, and firm performance, Mehran, H. (1995). Journal of financial economics, 38(2), 163-184. This paper analyses the factors which motivate managers to increase firm value. Samples collected from a survey of 153 randomly selected firm from the period of 1979 to 1980 is used as evidence to support this claim.
- ● Institutional investors and executive compensation, Hartzell, J. C., & Starks, L. T. (2003). The journal of finance, 58(6), 2351-2374. This paper suggests that the institutions serve a monitoring role in mitigating the agency problem between shareholders and managers. It goes on to show that clientele effects exist among institutions for firms with certain compensation structures, suggesting that institutions also influence compensation structures through their preferences.
- ● Executive compensation, management turnover, and firm performance: An empirical investigation, Coughlan, A. T., & Schmidt, R. M. (1985). Journal of accounting and economics, 7(1-3), 43-66. This paper investigates the internal managerial control mechanisms at the disposal of a corporation’s compensation-setting board or committee. The objective is to show that firm’s board creates managerial incentives consistent with those of the firm’s owners, both by setting compensation and following management change policies which benefit shareholders.
- ● Executive compensation as an agency problem, Bebchuk, L. A., & Fried, J. M. (2003). Journal of economic perspectives, 17(3), 71-92. This paper provides an overview of the main theoretical elements and empirical underpinnings of a managerial power’ approach to executive compensation. It further explains how managerial influence might lead to substantially inefficient arrangements that produce weak or even perverse incentives.
- ● Executive compensation and executive incentive problems: An empirical analysis, Lewellen, W., Loderer, C., & Martin, K. (1987). Journal of accounting and economics, 9(3), 287-310. This paper addresses the question of whether the design of the corporate executive pay package reflects an attempt to reduce agency costs between shareholders and managers. The components of senior executive pay are found to vary systematically across firms in a manner that cannot easily be explained by tax effects, and which would indicate that individual elements of pay are aimed at controlling for limited horizon and risk exposure problems. Managerial decisions and the structure of managerial pay therefore appear to be interrelated.
- ● Managerial power and rent extraction in the design of executive compensation, Bebchuk, L. A., Fried, J. M., & Walker, D. I. (2002). Managerial power and rent extraction in the design of executive compensation (No. w9068). National bureau of economic research. This paper develops an account of the role and significance of managerial power and rent extraction in executive compensation. The authors show that the processes that produce compensation arrangements, and the various market forces and constraints that act on these processes, leave managers with considerable power to shape their own pay arrangements. This leads to the conclusion that the role managerial power plays in the design of executive compensation is significant and should be taken into account in any examination of executive pay arrangements or of corporate governance generally.
- ● Chief executive compensation: A study of the intersection of markets and political processes, Finkelstein, S., & Hambrick, D. C. (1989). Strategic Management Journal, 10(2), 121-134. This study analyses sample from a leisure company to aid the development of a model for the determinants of chief executive officer (CEO) compensations. This study finds that CEO’s pay has complex relations to different factors. This paper also includes a separate examination of CEO salary and bonus as well as a test of pay determination across McEachern’s (1975) ownership categories.
- ● Portfolio considerations in valuing executive compensation, Lambert, R. A., Larcker, D. F., & Verrecchia, R. E. (1991). Journal of Accounting Research, 129-149. This paper analyses the value to a poorly diversified risk-averse executive of acompensation package consisting of a risk free asset, restricted stock and stock options. The Lambert, Larcker and Verrecchia (1991) model is extended to include leverage and this facilitates comparison of cost to the firm and benefits to the executive of restricted stock and stock options.
- ● Executive compensation and principal-agent theory, Garen, J. E. (1994). Journal of political economy, 102(6), 1175-1199. This paper analyses the shortcomings of the empirical literature on executive compensation, where this literature is unable to base and test hypotheses regarding its determinant. This paper analyses a simple principal-agent model to determine how well it explains variations in CEO incentive pay and salary.
- ● Accounting earnings and top executive compensation, Sloan, R. G. (1993). Journal of accounting and Economics, 16(1-3), 55-100. This paper investigates the role of accounting earnings in top executive compensation contracts. It provides evidence in support of the hypothesis that earnings-based incentives help shield executives from market-wide factors in stock prices. The paper demonstrates that earnings reflect firm-specific changes in value, but are less sensitive to market-wide movements in equity values.