Management Compensation

JEM100 - Corporate Governance

Doc. MPhil. Ondej Schneider, Ph.D., McKinsey Chair Prof. Ing. Michal Mejstk, CSc

12/11/2007

Jana Prochzkov
Julia Neue Robert Warren

Tony Mikes
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Outline

Introduction to Management Compensation Comparison between Managerial and Executive Compensation

Chevron case example

Principal Agent Problem

Mitigating Principal Agent problems

Concluding remarks

Introduction to Management Compensation

Specifications of managerial work
very difficult to describe various types of task on day to day bases

internal role directing an organizational unit (leadership) external role

developing relationships outside the organization

Levels of management

Managerial compensation follows the hierarchical structure of an organization

Top management

1-5 % of the organizations workforce Developing goals and strategies to keep the organization effective Concerned with the problems extending years in the future

Responsible for the total operation (CEO and executive VPs)

the owners through the board of directors see them as the trustees of their sources their compensation is connected with the success of the organization as a whole as well as their own indeed, it has been found that managerial system which did not focus on critical organization outcomes were ineffective (Schuster, Management Compensation)

Levels of management

Lower management

first line mangers = supervise the work of non-managerial employees compensated as a percentage of wage of the people they supervise

Middle management

a larger number of managers information channel between top managers and supervisors specific function in the organization and coordinate other functions in the organization compensation related to the function being managed, managerial surveys decrease over the past years in order to reduce bureaucracy

Difference between 'Management' and 'Executive'

Management group Executive group

exists within the management group top, president, vise-president, chief differentiated position within the organization

In many international locations and within small to medium-sized North American firms, the terms managers and executives are used interchangeably

However

Difference between 'Management' and 'Executive'

in U.S large publicly traded corporations two separate spheres

Executive body Management Body

Components of managerial compensation

base pay, bonuses (short term incentives),

capital appreciation plans (long term incentives),

deferred compensation and benefits (including perquisites/perks).

Aspects of compensation plans

commitment

managers associate themselves with the organization

difficult to turn off the job even in their leisure time

decision making

core of managerial work

particularly broad framework of decision-making under uncertainty

primarily conceptual decision-making

orientation

focus on getting the job done in the organization

power needs

enjoy controlling a situation and having a strong influence on the outcome of events

the idea of status

managers spend an enormous amount of time at work have heavy responsibility

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Other ways to determine the level of pay

Management by objective

based on individual definition of performance

measurable standards are developed by the manager himself and his supervisor
performance is evaluated towards the objectives at the end of a period by both parties jointly

drawbacks
hold managers to the objective that are out of date in case the world is too dynamic

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Other ways to determine the level of pay

Pay for performance

It has been found that the perception would lead to higher pay is more important than the fact

Generally, there is nearly no relation between pay and performance with managers measured from a sample of 600 middle- and lower-level managers. However, those who were the most highly motivated felt that pay was important to them and that good performance would lead to higher wage

In many cases it is hard for the managers to see the connection between performance and pay

rewards are deferred the goals are not clearly expressed

It cannot be taken for granted that paying for performance is worth doing

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Bonus standards short term incentives

a manager receives a bonus because some standard was met in the past period

organizational (productivity, cost saving)

job related (job outcomes, performance of particular activities) usually paid in cash

based upon the base pay of the managers

e.g. assume that the organization wished to maintain a minimum return on assets of 10 percent. The managers may receive 20 percent of base pay if the organization achieves a 10 percent return on assets and an additional 5 percent of base pay for each 5 percent increase in return on assets over 10 percent.

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Long term incentives stock options

Is used to tie the managers to the long term success of the organization

primarily motivates top management

granting managers the right to become a part of shareholders

ownership and control come closer together

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Stock Option Possibilities

Stock Option Plan

managers are offered stock at a set price

Stock Appreciation Rights (SAR)

work like stock options but the managers do not have to buy the stock

the manager receives from the organization the difference between the current market value of the stock and the stated option value of the stock
however, the amount of possible gain is limited

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Stock Option Possibilities

Restricted stock plans

the manager is granted a certain number of shares of stock as a bonus but may not sell those shares until certain conditions have been met (such as certain performance, employment for certain years)

Phantom Stock plans

In these plans the manager is awarded units that represent shares of stock. These units typically mature at some time, ordinarily four to six years. At maturity the manager is paid the then-current value of the stock or the difference between the original value and current value.

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Stock Option Possibilities

Performance share plans

the manager is granted performance units that represent shares of common stock. He or she earns these shares through the performance of the organization.

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Issues with stock options

Managers may be inclined to inflate the value of the company so as to inflate the value of their stocks options.

Enron Apple Computer

WorldCom
Global Crossing

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Deferred compensation

Retirement benefits Golden parachutes

provides pay and benefits to an executive after being terminated due to a merger or acquisition

reasons for doing so

limit the risk of unforeseen events business expenses

Perks

designed to satisfy special needs of the managers, especially top managers

may include a car, entertainment expenses, and club memberships. services such as free medical examinations, low-cost loans, and financial or legal counseling
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Comparison between management and Executive Compensation

Annual salary comparison table Data in national currencies: County Position Low

Average 239 778 133 848 469 665 262 185 5 017 514 2 801 071

High 479 557 440 238 939 331 862 351 10 035 028 9 213 003

Bonus % 37,3 22,4 37,7 22,4 37,3 22,4

Great Britain Germany

CEO CFO CEO CFO CFO

187 603 93 359 367 466 182 874 3 925 703 1 953 747

Czech Republic CEO

Source of data: www.salaryexpert.com - salary calculator

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Comparison between management and Executive Compensation

Annual salary comparison table Data in EURO: County Position Low

Average 338 806 189 127 469 665 262 185 184 528 103 015

High 677 614 622 056 939 331 862 351 369 057 338 825

Bonus % 37,3 22,4 37,7 22,4 37,3 22,4

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Great Britain Germany

CEO CFO CEO CFO CFO

265 083 131 916 367 466 182 874 144 375 71 853

Czech Republic CEO

Source of data: www.salaryexpert.com - salary calculator

Interesting note: Pay rises in all circumstances

The CEO is truly underpaid. The consultant reports this to the Compensation Committee, and the executive's salary is increased.

The CEO is not underpaid and the company is doing well. The consultant is asked to compare the executive's salary to a set of companies who are known to pay highly. The result is a recommendation to raise the executive's pay. The CEO is not underpaid and the company is not doing well. The consultant finds management lamenting that with these low wages, turnover is inevitable. The consultant then suggests a raise to prevent turnover.

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Examples Former CEO Chuck Conaway filed the country's

largest retail bankruptcy, after which he (and other Kmart executives) still received bonuses. Kmart While Kmart laid off 22,000 workers without severance pay, Conaway walked away with $9 million. George Shaheen left the online grocery company a few months before it closed its doors, taking a Webvan severance package of $375,000 per year for life. (If he dies, his wife still receives the compensation.) While Jill Barad was at the reigns of Matel, the Mattel Inc. stock price dropped 70%, but she still walked away with over $10 million.
Source: Jennifer Dixon, "Departure of Kmart Chief Ra ises Questions about Severance Package," March 12, 2002. Detroit Free Press,

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Executive pay compared to blue-collar workers in the U.S.A.

Year CEO salary compared to blue-collar worker 1980 42 times 1990 85 times 2000 531 times

Source: Business Week

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Differences in the pay of managers and blue collar workers explained

5 Motivational models:
1. The equity model

if the manager is earning such high salary, his contribution should be equally great
contradictions

2. The performance-motivation model

questions whether it is the manager or other environmental factors that lead to results of the company

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Differences in the pay of managers and blue collar workers explained

3. Agency theory

managers agents of the stockholders

in the general assumption, interest of the shareholders and managers are the same, but in practice not. Shareholders thus attempt to align the interest of top management with their own by designing attractive compensation packages

4. Tournament theory

promotion is viewed as tournament and the high pay is the price of winning

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Differences in the pay of managers and blue collar workers explained

5. Social comparison theory

people need to evaluate themselves in comparison to others thus managers of one company must be paid similarly to managers of another

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How is pay established?

Board of Directors = Compensation Committee

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Executive compensation

The compensation of every employee is decided by the company owners through the board of directors and the management team (or "management committee"). There may be a 'personnel and compensation committee' that deals specifically with labour compensation. Employee compensation may be negotiated with a workers union. Management team compensation is often left to the company.
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Executive compensation

Five tools of compensation:

base salary

short-term incentives
long-term incentives (LTIP) employee benefits

Perquisites

In a typical modern US corporation, the CEO and other top executives are paid salary plus short-term incentives or bonuses.

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Management compensation
Chevron management committee example:

The purpose of the Management Compensation Committee of the Board of Directors of Chevron Corporation is:

1. To discharge the responsibilities of the Board of Directors of the Corporation relating to compensation of the Corporations executives; 2. To assist the Board of Directors in establishing the appropriate incentive compensation and equity-based plans and to administer such plans;

3. To produce an annual report on executive compensation for inclusion in the Corporations annual proxy statement; and
4. To perform such other duties and responsibilities enumerated in and consistent with this Charter.
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Mitigating the Principal-Agent problem

Managers have strong incentives to gamble on risky projects that impose potentially large losses on the firm's fixed claim holders. Moral hazard :

investment-risk choices made by management are not readily observable by depositors and regulators

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Firms response to threat by:

Altering top-management compensation as a way of influencing managerial return and risk-taking incentive Bank lenders may impose measures (such as imposing more restrictive loan covenants) to protect their investments in troubled firms. Senior managers' compensation may be tied to the successful resolution of the firm's bankruptcy or debt restructuring, or is based on the value of payoffs to creditors.
From CEO Compensation in Financially Distressed Firms: An Empirical Analysis pg 456

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Firms response to threat by:

Replacing top managers:

One-third of top management may be replaced in a given year around default, and those who remain often take substantial cuts in their salary and bonus.

Average inside replacement CEO earned 35% less than his or her predecessor. Average outside replacement CEO earned 36% more than the CEO he or she replaced.

Outside replacement CEOs, who represent almost 60% of new CEO hires, also typically receive large grants of stock options as part of their compensation (to turn the company around).

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Firms response to threat by:

Deferred compensation:

Deferring part of the managements compensation until the firm's financial restructuring was completed.

reduces legal fees and other costs that increase directly with the amount of time that firms spend renegotiating their debt contracts.

firms respond to financial distress by

basing more of senior managers' compensation on longterm stock-based performance measures,

cuts in their cash compensation (including bonuses).

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Concluding remarks

The components of managerial compensation are:

base pay,

bonuses (short term incentives),

capital appreciation plans (long term incentives), deferred compensation and benefits (including perquisites/perks).

Principal Agent Problems can be mitigated through a variety of methods

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Sources:

http://www.eridlc.com/onlinetextbook/chpt20/text_main.htm Schuster, Management Compensation www.salaryexpert.com Jennifer Dixon, "Departure of Kmart Chief Raises Questions about Severance Package," Detroit Free Press, March 12, 2002 Business Week http://www.cnb.cz/www.cnb.cz/cz/financni_trhy/devizovy_trh/kurzy_devizoveho_trhu/prumerne_mena.j sp?mena=USD http://www.x-rates.com/

PLEASE PROVIDE FULL CITATIONS

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Hall, Brian J., Murphy,Kevin J. The Trouble with Stock Options Journal of Economic Perspectives. Vol. 17(3), Summer 2003

"A Theory of Bank Regulation and Management Compensation." The Review of financial studies Spring 2000 Vol. 13, No. 1,

Chang, Chun. "Payout Policy, Capital Structure, and Compensation Contracts when Managers Value Control" The Review of Financial Studies, Vol. 6, No. 4. (Winter, 1993)
Gilson, Stuart C., Vetsuypens, Michael R. "CEO Compensation in Financially Distressed Firms: An Empirical Analysis." The Journal of Finance, Vol. 48, No. 2. (Jun., 1993) Hadlock, Charles J., Lumer, Gerald B. "Compensation, Turnover, and Top Management Incentives: Historical Evidence" The Journal of Business, Vol. 70, No. 2. (Apr., 1997) http://news.bbc.co.uk/1/hi/business/5131990.stm

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