The world of executive compensation is a complex and often debated topic. It involves a mixture of salary, bonuses, equity compensation, benefits, and perquisites. Understanding how executives are compensated, and the impact of this compensation is crucial in today's corporate landscape.
The compensation awarded to executives of publicly-traded companies differs from that awarded to executives of privately held companies. Some types of their pay (gratuitous payments, post-retirement consulting contracts), are unique to their occupation. Other types are not, but generally make up a higher (e.g. stock options) or lower (e.g. Annual base salary in large publicly owned companies is commonly $1 million.
Salary paid in excess of $1 million is not tax-deductible for a firm, though that has not stopped some companies from going over the limit. In the other direction, "some of the largest and most successful corporation" in the US-Google, Capital One Financial, Apple Computer, Pixar-paid a CEO annual salary a token $1-i.e.
Employee Benefits and Executive Compensation Trends
Executive Compensation: An Overview
Executive compensation has outpaced corporate profits, economic growth and the average compensation of all workers. Lower-level executives also have fared well. The compensation is typically a mixture of salary, bonuses, equity compensation (stock options, etc.), benefits, and perquisites (perks).
The top CEO's compensation increased by 940.3% from 1978 to 2018 in the US. In 2018, the average CEO's compensation from the top 350 US firms was $17.2 million.
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Most of the private sector economy in the United States is made up of such firms where management and ownership are separate, and there are no controlling shareholders. This separation of those who run a company from those who directly benefit from its earnings, create what economists call a "principal-agent problem", where upper-management (the "agent") has different interests, and considerably more information to pursue those interests, than shareholders (the "principals"). This "problem" may interfere with the ideal of management pay set by "arm's length" negotiation between the executive attempting to get the best possible deal for him/her self, and the board of directors seeking a deal that best serves the shareholders, rewarding executive performance without costing too much.
Ratio of CEO to Worker Pay. Source: Economic Policy Institute, 2012.
The Role of Bonuses and Incentives
In 2010, 85.1 percent of CEOs at S&P 500 companies received an annual bonus payout. Use of some bonus formulas has been criticized for lacking effective incentives, and for abandoning the formula targets for easier criteria when the executives find them too difficult. According to one anonymous insider, "When you've got a formula, you've got to have goals-and it's the people who are the recipients of the money who are setting these.
Examples of resetting targets when executive performance falls short have been criticized at Coca-Cola and AT&T Wireless Services. For example, when executives failed to meet the annual earnings growth rate target of 15 per cent at Coca-Cola in 2002, the target was dropped to 11 per cent. In the sluggish economy following the 2007 recession the practice has become "more frequent". For example, in 2011 Alpha Natural Resources' CEO failed to meet the compensation formula set by the board, in large part because of his overseeing the "biggest annual loss" in the company's history.
Equity Compensation and Stock Options
Individual equity compensation may include: restricted stock and restricted stock units (rights to own the employer's stock, tracked as bookkeeping entries, lacking voting rights and paid in stock or cash), stock appreciation rights, phantom stock-but the most common form of equity pay has been stock options and shares of stock. Perhaps the largest dollar value of stock options granted to an employee was $1.6 billion worth amassed as of 2004 by UnitedHealth Group CEO William W.
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While the use of options may reassure stockholders and the public that management's pay is linked to increasing shareholder value-as well as earn an IRS tax deduction as incentive pay-critics charge options and other ways of tying managers' pay to stock prices are fraught with peril. In the late 1990s, investor Warren Buffett lamented that "there is no question in my mind that mediocre CEOs are getting incredibly overpaid.
Use of options has not guaranteed superior management performance. Setting a low strike price. (An estimated 95 per cent of corporations in America pay executives with "at-the-money" options-i.e. Following the housing bubble collapse, critics have also complained that stock options have "turned out to be incredible engines of risk-taking" since they offer "little downside if you bet wrong, but huge upside if you roll your number".
Executives' access to insider information affecting stock prices can be used in the timing of both the granting of options and sale of equities after the options are exercised. Studies of the timing of option grants to executives have found "a systematic connection" between when the option was granted and corporate disclosures to the public. That is, they found options are more likely to be granted after companies release bad news or just before they "release good news" when company insiders are likely to know the options will be most profitable because the stock price is relatively low.
Executives have also benefited from particularly auspicious timing of selling of equities, according to a number of studies, which found members of corporate upper management to have made "considerable abnormal profits" (i.e. higher than market returns). (Since executives have access to insider information on the best time to sell, this may seem in violation of SEC regulations on insider trading. It is not, however, if the insider knowledge used to time a sale is made up of many pieces and not just a single piece of "material" inside data.
Restricted stock is the stock that cannot be sold by the owner until certain conditions are met (usually a certain length of time passing (vesting period) or a certain goal achieved, such as reaching financial targets).
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Severance Packages and Retirement Benefits
CEOs, and sometimes other executives in large public firms, commonly receive large "separation packages" (aka "walk-away" packages) when leaving a firm, whether from being fired, retired, not rehired, or replaced by new management after acquisition. Prior to a 2006 SEC overhaul of proxy disclosures of executive compensation, the packages were unique to executives because unlike salary, bonuses, and stock options, they had the advantage of not being required to be disclosed to the public in annual filings, indicating the dollar value of compensation of the CEO and the four other most highly paid executives. easily accessible to the prying eyes of investment analysts and the business media.
Because the 401(k) plans-widely provided to corporate employees-are limited in the amount that is tax-deductible to the employer and employee ($17,000 in annual contributions as of 2012, a small sum to top executives), executives are commonly provided with Supplemental Executive Retirement Plans (aka SERPs) (which are defined benefit pension plans) and Deferred Compensation (aka non-Qualifying Deferred Compensation or NQDF). This compensation can be considerable.
An example of how pensions have been used as "stealthy" compensation mentioned above was a change in the formula for determining the pension that one retiring CEO (Terrence Murray of FleetBoston Financial) made shortly before his departure. While his original contract based his pension on his average annual salary and bonus over the five years before retirement, that was changed to his average taxable compensation over the three years he received the most compensation. This change of a few words more than doubled the pension payout from $2.7 million to an estimated $5.8 million, but these numbers did not appear on the SEC-required executive compensation tables or in the annual report footnotes. The numbers were revealed only because a newspaper covering the story hired an actuary to calculate the new basis.
Severance packages for the top-five executives at a large firm, however, can go well beyond this. They differ from many lower-level packages not only in their size, but in their broad guarantee to be paid even in the face of poor performance. In 2013, Bloomberg calculated severance packages for CEOs at the largest corporations and found three-John Hammergren of McKesson, Leslie Moonves of CBS Corporation, and David Zaslav or Discovery Communications-that exceeded $224.7 million. Bloomberg quotes one corporate governance researcher as complaining, "If you have a safety net of this type of gargantuan size, it starts to undermine the CEO's desire to build long-term value for shareholders.
Critics complain that not only is this failure to punish poor performance a disincentive to increase stockholder value, but that the usual explanation offered for these payouts-to provide risk-averse execs with insurance against termination-doesn't make sense. The typical CEO is not anticipating many years of income stream since the usual executive contract is only three years. Furthermore, only 2 percent of firms in the S&P 500 reduce any part of the severance package once the executive finds another employer. And if employers are worried about coaxing risk-averse potential employees, why are executives the only ones provided with this treatment?
As part of their retirement, top executives have often been given in-kind benefits or "perks" (perquisites). Perks lack the flexibility of cash for the beneficiary. Consider retiree use of corporate jets, now a common perk. Although the marginal cost of allowing a retired executive to use the company jet may appear limited, it can run quite high. Consider the use of a company plane for a flight from New York to California and then back several days later. For the CEO of a large firm, such a contract might be worth $1 million a year or more. In 2005, AOL Time Warner was paying retired CEO Gerald M.
Chad Hallock and Undercover Boss
Chad Hallock, CEO and co-founder of Budget Blinds, gained widespread recognition for his appearance on Undercover Boss. The show follows corporate executives as they go undercover in their own companies to understand the business from the ground up.
As the seasons have progressed, so have the value of the rewards. The typical response from any long-deserving employee: “I never thought anything like this can happen to me.” And there was the deserving employee who was given a large sum of money from Budget Blinds CEO and co-founder Chad Hallock to build an extension on his home for his family.
“At the end of the day, when you give back, it makes it all worthwhile,” said Chad Hallock in a behind the scenes interview. “When you see people right in front of you get welled up in tears, when you actually see it close up and personal, it is very emotional and unbelievably rewarding.”
Undercover Boss offers an opportunity for branding, particularly as these overly generous CEOs shell out the big bucks for these worthy staff members. For the employees, the gifts and incentives makes this viewer - and you too, I am sure - a bit envious not to be on the receiving end. I mean, where was my “undercover boss” during the course of my career?
Factors Influencing Executive Pay
Cash compensation, such as salary, is funded from corporate income. Most equity compensation, such as stock options, does not impose a direct cost on the corporation dispensing it. It does, however, cost company stockholders by increasing the number of shares outstanding and thus, diluting the value of their shares. To work around the restrictions and the political outrage concerning executive pay practices, some corporations-banks in particular-have turned to funding bonuses, deferred pay, and pensions owed to executives by using life insurance policies.
The practice, sometimes called "janitor's insurance", involve a bank or corporation insuring large numbers of its employees under the life insurance policy and naming itself as the beneficiary of the policy, not the dependents of the people insured. The growth and complicated nature of executive compensation in America has come to the attention of economists, business researchers, and business journalists. Former SEC Chairman, William H. Donaldson, called executive compensation "and how it is determined ...
One factor that does not explain CEO pay growth is CEO productivity growth if the productivity is measured by earnings performance. Measuring average pay of CEOs from 1980 to 2004, Vanguard mutual fund founder John Bogle found it grew almost three times as fast as the corporations the CEOs ran-8.5 per cent/year compared to 2.9 per cent/year. Whether CEO pay has followed the stock market more closely is disputed. According to Fortune magazine, the unleashing of pay for professional athletes with free agency in the late 1970s ignited the jealousy of CEOs. As business "became glamorized in the 1980s, CEOs realized that being famous was more fun than being invisible".
The Role of Compensation Consultants
Compensation consultants have been called an important factor by John Bogle and others. Investor Warren Buffett has disparaged the proverbial "ever-accommodating firm of Ratchet, Ratchet and Bingo" for raising the pay of the "mediocre-or-worse CEO". John Bogle believes, "much of the responsibility for our flawed system of CEO compensation,
Why consultants would care about executives' opinions that they (the executives) should be paid more, is explained in part by their not being hired in the first place if they didn't, and by executives' ability to offer the consultants more lucrative fees for other consulting work with the firm, such as designing or managing the firm's employee-benefits system. In the words of journalist Clive Crook, the consultants "are giving advice on how much to pay the CEO at the same time that he or she is deciding how much other business to send their way.
Shareholders had been told the compensation was devised with the help of an "outside consultant" the company (Verizon) declined to name. Business columnist James Surowiecki has noted that "transparent pricing", which usually leads to lower costs, has not had the intended effect not only in executive pay but also in prices of medical procedures performed by hospitals-both situations "where the stakes are very high". He suggests the reasons are psychological-"Do you want the guy doing your neurosurgery, or running your company, to be offering discounts? Better, in the event that something goes wrong, to be able to tell yourself that you spent all you could.
The Influence of Shareholders
Management's desire to be paid more and to influence pay consultants and others who could raise their pay does not explain why they had the power to make it happen. Company owners-shareholders-and the directors elected by them could prevent this. Why was negotiation of the CEO pay package "like having labor negotiations where one side doesn't care ... lies partly in the changing pattern of shareholding.
Large shareholders in a company have both the means and the motive to remind managers whom they are working for and to insist that costs (including managers' pay) be contained and assets not squandered on reckless new ventures or vanity projects. Shareholders with small diversified holdings are unable to exercise such influence; they can only vote with their feet, choosing either to hold or to sell their shares, according to whether they think that managers are doing a good job overall. Crook points out that institutional investors (pension funds, mutual ...
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