Ch 09.ppt

Copyright © 2009, Tapomoy Deb

Excel Books9– 1 Compensation Management text & Cases Tapomoy Deb

CH-9

Part- E Executive Compensation

Nature of Executive Compensation

Chapter 9

Nature of

Executive Compensation



CH-9



MEANING OF EXECUTIVE COMPENSATIONExecutive Compensation means any reward given to top ranking executives such as Chairman, Vice Chairman, Executive Chairman, Managing Director, Joint Managing Director, Dy. Managing Director, Directors, Chief Technology Officer, Chief Financial Officer, Chief Operating Officer, etc., for services and expertise rendered to an organization.

Executive compensation can be broadly classified as: Base compensation: This usually consists of salaries, allowances, medical and insurance benefits. Performance linked compensation: This usually consists of bonuses, incentive payments, deferred compensation plans, and stock options. Perquisites: This usually consists of personal staff, personal transportation, company leased or provided house, club membership, exclusive car parking, and paid vacations. Terminal benefits: This usually consists of severance pay, retirement benefits, etc.



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DEFINITION OF EXECUTIVE COMPENSATION

Robert W. Kolb (2006) defines Executive Compensation as follows:

“Executive Compensation refers to the total reward provided by the firms to

the top level of executives in a corporation, such as the CEO, COO, CFO, and a

handful of other executives who occupy the very highest level of management”.

Author defines Executive Compensation as:

Executive Compensation refers to short-term and long-term financial and non-financial rewards given to top ranking executives under a contractual, legal and contractual mandate.

Executive Compensation refers to short-term and long-term financial and non-financial rewards given to top ranking executives under a contractual, legal and contractual mandate.



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Cont….

AGENCY THEORY AND EXECUTIVE COMPENSATIONThe association between shareholders and executives is an example of agency relationship. This relationship was defined by Jensen and Meckling (1976) as “a contract under which one or more persons (the principal/s) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making”. The underlying assumptions and sequence of action involved in agency theory/model are as follows:

Assumptions

Principals (shareholders) are risk neutral or risk averse;

Agents (executives) are risk-averse or risk neutral;

Material incentives are necessary and sufficient to motivate executives to work;

Higher sum of monetary compensation causes higher executive effort; and

The effort of an executive is difficult to observe.



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Cont….

The sequence of actions

Stage 1: Shareholders create a contract having or not the condition of

awarding premiums;

Stage 2: Executives sign or not;

Stage 3: Executives decide on quantity and quality of work they want;

Stage 4: Executives handle a work;

Stage 5: Shareholders (through board of directors) evaluate the results; and

Stage 6: Shareholders pay for work provided including premiums.



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Information asymmetry Moral Hazard Adverse Selection Empire building

tendencies Collusive agreement

between executive & supervisor/employee

Performance Risk Diversification Acquisition Sale of firm Executive

compensation

Shareholder’s Remedies

Monitoring Incentives Bonding Writing of contracts

AGENCY COST AGENCY PROBLEM

Conflict arising out of separation of Ownership & Management

Interest Divergence: Shareholder’s

self -interest Executive’s self -

interest

CONTROL STRUCTURES UPON THE AGENT

ORGANIZATIONAL OUTCOMES

Model of Agency Theory



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PRINCIPLES OF EXECUTIVE COMPENSATION

Executive compensation is critical to the long-term interest of shareholders and

attainment of organizational goals and objectives successfully. Therefore,

executive compensation must be based on certain sound principles as under:

1. Attracting and retaining executive talents

2. Upholding shareholder interests

3. Performance based compensation

4. Effective compensation committee

5. Executives to shareholders

6. Compliance of law

7. Transparent disclosure



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FACTORS AFFECTING EXECUTIVE COMPENSATIONMilkovich and Rabin (1991) argue that executive compensation is more complex than meets the eye and that a strategic perspective on compensation needs a look beyond how much executives earn. The dichotomy of attraction, motivation and retention of good executives versus tough corporate governance and media spotlights, places compensation decision-makers in a difficult position (Merchant, 1989).

The factors affecting executive compensation are as follows:

1. Changing nature of work

2. Investor confidence

3. Effective benchmarking

4. Governance

5. Attracting and retaining high performance executives

6. Fostering right executive behaviours

Ch 09.ppt

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