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Compensation

Management, 2e
Dipak Kumar
Bhattacharyya
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Chapter 11

Executive Compensation

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Introduction
Executive compensation correlates with organizational performance.
There are three main areas of focus in executive compensation:
Understanding the criteria

Understanding the consequences


Mechanism to determine executive compensation

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Components of Executive Compensation


Components of executive compensation are:

1.
2.
3.

Variable pay such as bonuses, commissions, and profit sharing


Base pay such as salary and perquisites
Employment status such as promotions and termination

Effective executive compensation packages typically comprises of the following


components:

base salary
annual incentives
long-term capital accumulation
deferred compensation arrangements
supplemental benefits and perquisites
special severance and retirement arrangements
employment and change of control agreements(golden parachutes)

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Emerging trends in executive compensation


Following are some emerging trends in executive compensation.

Increase in the number of corporate meltdowns is now dragging executive


pay and corporate governance into the public domain.
Business conditions are putting pressures on existing pay levels and
structures.
Corporate restraint and accountability make controlling executive
compensation a major issue in tough economic times.
Executive compensation movements at the median of the market are
getting subdued over the years.

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Executive compensation theories


Most executive compensation theories centre on the theories of firms. With profit
maximization as the core objective, firms rely heavily on their executives. This
syndrome encourages executives to expect above normal compensation.
Theories of executive compensation centres on following issues:

Organizations need to identify executive compensation options that help


them derive benefits of performance satisfaction and increased executive
retention.
Perquisites and supplementary benefits represent a very small fraction of
executive compensation due to tax burden.
Organizations need to design tax-efficient long-term incentive packages.
Organizations link executive compensation to sales maximization
hypothesis.

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Executive Compensation theories


Other important economic determinant of executive compensation is
the performance of the firm. Executives are accountable for the firms
performance. Hence, their compensation is linked to the results of
organizational performance.
Executive compensation can also vary with the type of industry. For
example, the compensation packages in the service sector are higher
than those of the manufacturing sector.
Another important economic variable is the difference in value of
human capital.
Political and social factors also influence executive compensation.
Important theories of executive compensation are as under:
Agency theory, which suggests designing of executive compensation based on the
mutual interests of the agents (executives) and shareholders (principals).
Tournament theory, which views executive compensation as the prize in a series of
tournaments or contests among middle and top-level managers.
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Executive compensation theories


Social comparison theory, which suggests designing executive compensation by
comparing it with similar individuals.
Balance sheet approach, which aims to provide expatriates compensation based
on the standard of living they normally enjoy in their own country.
Headquarters-based pay, which refers to executive compensation to all according
to the rate used at headquarters.
Golden handcuffs, which refers to payment of above market rate executive
compensation.
Competency-based pay, which refers to a pay directly related to the kinds and
levels of competencies required in the performance of the work or job

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Executive compensation theories


Golden parachutes, which refers to the practice of providing pay and benefits to
executives after their termination resulting from a change in ownership or a
corporate takeover.
Cafeteria plan, which gives executives the option to choose different types of
benefits, which is commonly known as the cafeteria plan.
Profit-sharing plan, which provides direct or indirect payments based on the
organizations profitability, apart from regular compensation.

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Executive Compensation Design


Executive compensation design process links compensation criteria such as
organizational performance or size to compensation consequences such as pay at
risk.
Such process or mechanism is categorized into two formsthe process that
centres on contract and the process that involves direct monitoring of the
executive.
Organizations that follow the contract process make it a time-bound employment
offer, which becomes a legal arrangement. Contracts specify criteria for
compensation, basis of compensation (in the form of schedules), and some
predictable conditions for linking compensation consequences to criteria.
Direct monitoring is a behavioural approach to monitor the performance of the
executive. It is a subjective evaluation. It is based on the principles of agency
theory.

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Typical executive compensation component

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Executive compensation and organizational


strategy
Organizations need to design executive compensation to reward the work, which will then
by default fulfill organizational strategy.
Designing executive compensation in the era of economic uncertainty, while rationalizing
expectations of the executives and fulfilling organizational strategy, is a very challenging
task.
Following are some action plans to meet this strategic intent, while retaining a trade-off
between executive compensation and organizational objectives:

Optimize the cost of compensation for health and welfare benefits, while identifying
vendors.
Rationalize the compensation budget by restructuring the deferral components of
compensation.
Optimize the cost of retirement benefits using funded pension assets through stock
build-up.
Identify wasteful HR costs by reviewing and restructuring the terms of contracts.

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Different criteria of executive compensation


Some important perspectives of executive compensation are:

Strategy criterion - The strategic dimension of executive compensation


focuses on the rising cost of compensation, which for many organizations is
their second biggest expense.
Role or position criterion This criterion links executive compensation
to job position as a strategy to stimulate others to achieve the same results.
Individual characteristics criterion This criterion argues that the
amount of human capital possessed by executives influences their
productivity and, thus, should influence their compensation.
Performance criterion This criterion emanates from the agency theory
approach, which suggests linkage of executive compensation to the firms
performance.
Behaviour criterion This criterion is associated with the monitoring
mechanism, and executives take strategic initiatives while making a
subjective analysis of business decisions. Therefore, executive
compensation design based on behaviour criterion makes sense.
Oxford University Press 2015. All rights reserved.

Different criteria of executive compensation


Size criterion As per this criterion, size of the organizations is the determinant
of executive compensation.
Market criterion This criterion argues that market forces (supply and demand
for executive talent) determine executive pay.
Peers compensation criterion This criterion suggests that the compensation
of selected peers may play a role in setting executive pay. It is based on the
principles of social comparison approach.

Oxford University Press 2015. All rights reserved.

Say on Pay and Executive Compensation


Excessive executive compensation even at the cost of stakeholders interest has
now become a global issue.
Increased compensation to those in the C-suite, even when the organization is
struggling to survive is common across the world.
Say on pay is a movement, which gives opportunity to companys shareholders to
oppose or approve executive compensation by voting against or for it.
Such shareholder endorsement on executive compensation has almost now
become essential in public limited companies. .
In India also say on pay movement is visible.

Oxford University Press 2015. All rights reserved.