(3) EXECUTIVE COMPENSATION

Core Reading:
• Larcker, D. and Tayan, B. (2011). Chapters 8 & 9 in “Corporate Governance Matters”.

Some Background Statistics

Equity & Efficiency

• Senior executives have a bigger impact on firm performance than junior employees
o Is it fair that executives get paid so much more than employees?
• Does executive pay motivate intended behaviour? Do senior executives earn their pay?

Optimal Contracting Perspective

• Need to create financial incentives to reduce moral hazard in a principal-agent relationship
• Compensation contracts are designed to satisfy a manager’s participation constraint and incentive
compatibility constraint
• Executive remuneration contracts:
o Attract talented individuals (satisfies participation constraint)
o Motivate managers to make decisions that maximise shareholder value (satisfies incentive
compatibility constraint)
o Reward managers for maximising shareholder value
• While perfect contracts are impossible, pay packages contain components that link rewards to
outcomes
o i.e., provide high-powered incentives

Managerial Power Perspective

• Senior executives use their power to influence how much they are paid and pay composition
• Executive compensation is:
o More than required to attract talented individuals to a post
o More than required to motivate managers
o Weakly related to firm value as a consequence
• Managers receive:
o Pay for non-performance factors
o Hidden pay
• Greater managerial power results in greater excess pay (i.e. rent extraction) as compensation
offered too high in order to attract talented managers for large firms

Pay-Performance Relationship
• Optimal contracting predicts a strong pay-performance relationship
o i.e. to reduce the agency problem manager’s pay depends on share value
• Managerial power predicts a weak pay-performance relationship
o i.e. managers extract rents that have no sensitivity to share value
• Empirical studies are concerned with determining and quantifying the pay-performance
relationship
 (3) EXECUTIVE COMPENSATION

Executive Compensation Packages

• Need for high-powered incentives linking pay to performance, but the manager must bear risk
• Stock performance is determined by:
(1) Firm-specific factors in managers’ control
(2) Industry & Market factors outside manager’s control (links pay to luck)
• Relative performance filters out factors beyond manager’s control

Golden Hello
Lump-sum cash payment upon signing the contract
• Used to attract talent and show commitment to the individual
• More likely the person will agree to give up rights to unvested stock or options
• Not performance related and provides no retention incentives
• Compensates the individual for leaving another job (where they may have RSUs)

Salary
• Fixed pay awarded over time
• Source of insurance as managers do not bear the risk associated with fluctuating firm
performance
• To induce effort, managers must bear risk and be compensated for bearing risk

Bonus
• Can be paid in cash or shares
• Linked to accounting performance (e.g. sales, profit, EPS)
o Or other metrics important to the firm (e.g. CSR, safety)
• Usually, a bonus hurdle & bonus cap with pay increase with performance between these levels
(incentive zone)
• If alignment is successful, value of bonus paid should be related to performance target
o Below bonus hurdle: incentive to increase performance to get a higher bonus
o Above bonus cap: incentive to slacken off or defer achievement to the next period

Executive stock options (ESOs)

• Option to buy the stock at a future date at a specified price (exercise price) and the time granted
• Normally a seven-year ‘exercise’ window.
Return = (Current market price - Exercise price) - Transaction costs of buying & selling
• Intended to link pay with performance
 (3) EXECUTIVE COMPENSATION

• If the share price drops below the exercise price, the manager won’t lose as they will not exercise
their option
Problems with ESOs
• Potential for exploitation (rent-seeking) by self-serving executives e.g. spring load
• No penalty for underperformance and incentive to take risks to increase share value
• Pump & Dump:
o Artificially inflating price before buying & selling
• When ‘strike price’ is ‘in-the-money’ or ‘out-of-the-money’, incentives could be distorted

Restricted stock
• Issuing stock with restrictions on trading (usually for 2-3 years)
• Sometimes linked to long-term performance targets:
o Vested when targets met
• Manager bears some downside risk

Long-Term Incentive Plans

• Deferred payment of stock and/or cash when relative performance targets are reached over a
specified period
o Relative to other similar company’s performance
• An incentive for executives to create longer-term performance gains
• Stock awards may be subject to short-term trading restrictions
• After shares are awarded, the manager is exposed to downside risk
Problems with LTIPs
• Complicated and less transparent than bonuses and ESOs as other companies may not disclose
performance
o Potential for executives to exert managerial power over pay
• Award of LTIPs is linked to relative stock performance so awards can be made even when the
stock price is falling as other company’s stock may be falling too

Golden Parachutes
• A severance pay-off
• ‘Reward for failure’
• Rewards executives that have taken risks, but the decisions have not paid off
• Encourages executives, whose firms are targets for a takeover, to leave

The Pay-Performance Relationship

Empirical models typically estimate variations:
∆ ln 𝑃𝑎𝑦!" = 𝛼 + 𝛽# ∆𝑃𝑒𝑟𝑓𝑜𝑟𝑚𝑎𝑛𝑐𝑒!" + 𝛽$ ∆𝑅𝑒𝑙𝑎𝑡𝑖𝑣𝑒𝑃𝑒𝑟𝑓𝑜𝑟𝑚𝑎𝑛𝑐𝑒!"
+ 𝛽% ∆ ln 𝑆𝑖𝑧𝑒!" + 𝜃𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒𝑠 + 𝜀!"
• 𝛽! : pay-performance relationship (% return)
• 𝛽" : pay-relative performance relationship (% return)
• 𝛽# : measures the pay-size relationship (elasticity) (usually between 0.3-0.5)
• Control variables can include person and firm characteristics
Key issues for estimating this model are how you are measuring pay and measuring performance
 (3) EXECUTIVE COMPENSATION

Performance: Salary
Early evidence on executive pay:
• Measured pay using salary + bonus only
• Weak pay-performance relationships are often reported
• The strong pay-to-firm-size relationship (larger firm, larger pay)
• Early studies found it difficult to obtain data on equity & options, impacting the sensitivity of
estimates

Performance: Bonuses
• Studies have found no link was found between bonuses (short-term rewards) and shareholder
return (Fattorusso, 2007)
o Consistent with managerial power perspective
• No link was found between transparency measures and the odds of a bonus pay-out
o Inconsistent with the managerial power perspective that managers are not transparent in
the pay-setting practices

Performance: ESOs
Studies show ESOs result in a strong pay-performance relationship:
• Found a 10% increase in shareholder wealth and a 7.2% increase in CEO’s total pay package
(Main, 1996)
• $1 of the ESO grant is associated with the generation of $3.71 of operating income over 5 years
after the ESO grant (Hanlon, 2003)
o Consistent with optimal contracting perspective (good relationship between pay-
performance)

Performance: LTIPs
• Studies have found that as LTIPs increase, so does total compensation (managers being
compensated for bearing more risk) (Buck, 2003)
• LTIPs reduce pay-performance sensitivity
o Excluding LTIPs: a £1,000 increase in shareholder wealth is associated with a £1.81p
increase in CEO pay
o Including LTIPs: this falls to £1.55p
• Consistent with managerial power, as LTIPs are part of the agency problem

Acquisitions
• Evidence that structure of pay package impacts acquisition behaviour (Sanders, 2001)
• Firms whose CEOs are compensated with ESOs are more likely to engage in acquisitions and
divestments
o These are risky strategies, and you bare less risk with ESOs
• Firms whose CEOs own shares are less likely to engage in acquisitions and divestments

Divestment
• Divestment is a way of reducing the scale and scope of a firm’s activities
o If it has grown beyond its optimal size or scope
• Evidence that CEOs are not directly rewarded for voluntarily downsizing their firms via divestment
due to the pay-size relationship (Haynes, Thompson & Wright, 2007)
o Also, little incentive for CEOs to voluntarily downsize