Compensation Management

Unit 2
 Wage Theories that explain
Compensation
Economic theory Behavioual Theory

1.Labour Market Theory 1. Employee acceptance of a

Compensation Level

2.Subsistence Theory 2.Internal Compensation Structure

3.Wage Fund Theory 3.Wages & Motivators

4.Surplus Value Theory 4.Tournament Theory

5.Residual Claimant Theory

6. Marginal Productivity Theory

7. Bargaining Theory
1. Labor Market Theory -
• Here the compensation is determined by the forces of supply and demand of
labour.
• Based on the supply of employees , the employer decides how many and which
types of employees to employ at the compensation at which it can trade
profitability in its product market.
• For a given type of labour , the compensation is equal to their marginal product,
the additional added value gained by the organization from it’s least productive
employee.
• Neo-classical labour market theory predicts higher compensation for employees
who are more productive

2. Subsistence Theory – (supporting oneself, especially at a minimal level.)

• This is also known as “ Iron Law of Wages”
• It says that the employees are paid towards their labor in producing goods in
order to enable them to survive.
• The theory states that if the compensation increases beyond subsistence level,
then the number of employees would increase as they would procreate more
given that higher economic conditions would enable them to support more
number of family members.
• With increasing number of people available for employment and
with given number of employment available, compensation would
fall down due to increased supply of labor than demand.
• If compensation falls below the subsistence level, employees would
die of hunger, malnutrition, disease etc. therefore the number of
employees available for employment would push up compensation
level beyond subsistence level.

3. Wage Fund Theory –

• It was given by Adam Smith
• The theory states that compensation is paid from a pre-
determined fund of wealth which lay surplus with wealthy
persons such as employers as a result of savings from profits
earned by them.
• If the size of this surplus fund is large, compensation is high.
• Thus demand for employees and level of compensation depends on
the size of the fund.
4. The Surplus Value Theory -:
• Was founded by Karl Marx
• It says that labour is a commodity which can be purchased on payment
of subsistence price
• The pricing of a product is determined by the labour time required for
producing it.
• The employees are not paid in proportion to the time spent on work,
but much less
• The surplus goes to the Surplus Fund which is used for paying other
expenses.
5. Residual Claimant Theory –
• It was founded by Francis A. Walker
• The theory says that there are four factors of production – land, labour,
capital, and Entrepreneurship.
• Compensation represents the amount of value created in the
production which remains after payment has been made for all factors
of Production.
• Other costs associated with production have prominence over labour
payment.
• Thus Labour is the Residual Claimant.
6. Marginal Productivity Theory
• Was given by Philips Henry and John Clark.
• It says that compensation is based on an
Entrepreneur’s estimate of the value that will
probably be produced by the last or marginal
employee.
• Employees are paid according to their Economic
worth.
• As long as the additional employee contributes
more to the total value than the cost of
compensation, it is prudent for the Employer to
continue hiring.
7. Bargaining Theory
• It was given by John Davidson
• It says that compensation is determined by
the relative power to bargain by employees
• Compensation tends to be more subject to
the ability of the organization to pay.
• However , if the employers have more
bargaining power than employees the
compensation levels are low.
• Compensation is viewed as a bargainable
matter between Employees and Employers.
 Wage Theories
• Behavioral theories are divided into -:
• Content theories
• Process theories
 CONTENT THEORIES
• The content theories explain what inspires
manpower at their jobs.
• Maslow, Hergberg and Alderfer gives their
significant contribution to content theories.
These are as follows:-
 1.Herzberg’s Motivation-Hygiene
Theory
• Herzberg felt that job satisfaction and dissatisfaction
do not exist on the same continuum, but on dual
scales.
• In other words, certain things, which Herzberg called
Hygiene factors, could cause a person to become
unhappy with their job. These things, including pay, job
security, and physical work environment, could never
bring about job satisfaction.
• Motivating factors, on the other hand, can increase job
satisfaction. Giving employees things such as a sense of
recognition, responsibility, or achievement can bring
satisfaction about.
2. Maslow’s Hierarchy of Needs
 3.ERG theory

• ERG Theory is similar to the famous Maslow’s Hierarchy of

Needs.
• Existence, or physiological, needs are at the base. These
include the needs for things such as food, drink, shelter, and
safety.
• Next come Relatedness Needs, the need to feel connected to
other individuals or a group. These needs are fulfilled by
establishing and maintaining relationships.
• At the top of the hierarchy are Growth Needs, the needs for
personal achievement and self-actualization.
• If a person is continually frustrated in trying to satisfy growth
needs, relatedness needs will remerge. This phenomenon is
known as the frustration-regression process.
 Process Theories
• Process Theories deal with the “process” of
motivation and is concerned with “how”
motivation occurs.
• Vroom, Porter & Lawler, Adams and Locke
studied motivation from a “process”
perspective.
 1. Employee’s Acceptance of
Compensation Level
• Here compensation is viewed as more than providing for
livelihood
• Was given by March and Simon in 1958
• Main points of the Theory
 Lower the satisfaction of an individual, more the search for
alternatives
 More the search, higher the expected value of reward
 Higher the expected value of Reward , higher the level of
aspiration of Individual
 Higher the level of aspiration , the lower the satisfaction
 2. The Internal Compensation
Structure Theory
• The theory believes that compensation is an
Internal structural issue of the organization which
is influenced by market and social factors.
• Major factors
• Customs prevailing in the organization
• Ratio of maximum and minimum differential in
compensation
• Norms on span of control
• Demand for specialized labour
 3. Wage and Motivation Theory
• Every individual has some aspirations
depending on his life circumstances he wants
to achieve.
• These aspirations are motivators which
stimulate an individual to improve his
productivity and performance to achieve
those aspirations.
• Thus Performance-based rewards are required
to motivate employees.
 4. Tournament Theory
• Compares life in an organization to a sporting
match.
• Each round represents a competition for a
position at a higher job level.
• All the contestants are ranked based on their
performance.
• Winner will go on to the next round.
• It becomes easier to observe relative
performance than absolute performance.
• Compensation slots are fixed in advance
• Promotions are not awarded to employees
because they are good but because they
are better than other contestants
• Level of effort depends on the size of the
compensation increase caused by the
promotion
• The number of contestants is known in
advance and thus outside competitors are
not included.
Evolution of Modern Day Labor
Force
• In local terms, organized sector or formal sector in India refers to
licensed organizations, that is, those who are registered and pay
sales tax, income tax, etc.
These include
• the publicly traded companies,
• incorporated or formally registered entities,
• corporations, factories, shopping malls, hotels, and other large
businesses.
• Unorganized sector, also known as informal sector or own account
enterprises. It refers to all
• unlicensed,
• self-employed or unregistered
economic activity such as owner manned
• general stores,
• handicrafts and handloom workers,
• rural traders,
• farmers, etc.
• Also, the model offers the methodology for
evaluating a bonus compensation fund in relation
to the company's financial parameters.
• It is facilitated by an appropriately formulated
production function in additive form. The
calculated value of a bonus fund does not distort
the company's financial equilibrium.
• The applied methodology and concepts make it
possible to identify the right balance between the
four key functions of compensation: cost, income,
social and motivating functions.
• India's Ministry of Labour, in its 2008 report, classified the
unorganized labour in India into four groups.
• This classification categorized India's unorganized labour force by
• occupation,
• nature of employment, specially distressed categories and service
categories.
• The unorganized occupational groups include
• small and marginal farmers,
• landless agricultural labourers,
• share croppers,
• fishermen,
• those engaged in animal husbandry,
• Beedi rolling, labeling and packing, building and construction
workers, leather workers, weavers, artisans, salt workers, workers in
brick kilns and stone quarries, workers in saw mills, and workers in
oil mills.
• A separate category based on nature of employment
includes
• attached agricultural labourers,
• bonded labourers,
• migrant workers,
• contract and casual labourers.
• The last unorganized labour category includes service
workers such as
• domestic workers,
• barbers,
• vegetable and fruit vendors, newspaper vendors,
pavement vendors, hand cart operators, and the
unorganized retail.
• Some of lowest income jobs are in the rural
unorganized sectors.
• Poverty rates are reported to be significantly
higher in families where all working age
members have only worked the unorganized
sector throughout their lives.
 Labour laws in India
• The labour laws of India originated and express the socio-political views of
leaders such as Nehru from pre-1947 independence movement struggle.
• These laws were expanded in part after debates in Constituent Assemblies
and in part from international conventions and recommendations such as
of International Labour Organisation.
• The current mosaic of Indian laws on employment are thus a combination
of India's history during its colonial heritage, India's experiments with
socialism, important human rights and the conventions and standards that
have emerged from the United Nations.
• The laws cover the right to work of one's choice, right against
discrimination, prohibition of child labour, fair and humane conditions of
work, social security, protection of wages, redress of grievances, right to
organise and form trade unions, collective bargaining and participation in
management.[2]
• India is a federal form of government. Labour
is a subject in the concurrent list of the Indian
Constitution and therefore labour matters are
in the jurisdiction of both central and state
governments.
• Both central and state governments have
enacted laws on labour relations and
employment issues. Some of the major laws
relevant to India are as follows -:
Workmen's Compensation Act of 1923
• The Workmen's Compensation Act
compensates a workman for any injury
suffered during the course of his employment
or to his dependents in the case of his death.
• The Act provides for the rate at which
compensation shall be paid to an employee.
This is one of many social security laws in
India.
 Trade Unions Act of 1926
• This Act enacted the rules and protections
granted to Trade Unions in India. This law was
amended in 2001.
• It is an Act to provide for the registration of Trade
Unions and in certain respects to define the law
relating to registered Trade Unions
• Whereas it is expedient (useful) to provide for the
registration of Trade Unions and in certain
respects to define the law relating to registered
Trade Union
 Payment of Wages Act of 1936
• The Payment of Wages Act regulates by when
wages shall be distributed to employees by
the employers.
• The law also provides the tax withholdings the
employer must deduct and pay to the central
or state government before distributing the
wages.
 Industrial Employment (Standing
orders) Act of 1946
• This Act requires employers in industrial
establishments to define and post the conditions of
employment by issuing so-called standing orders.
• These standing orders must be approved by the
government and duly certified.
• These orders aim to remove flexibility from the
employer in terms of job, hours, timing, leave grant,
productivity measures and other matters.
• The standing orders mandate that the employer
classify its employees, state the shifts, payment of
wages, rules for vacation, rules for sick leave, holidays,
rules for termination amongst others.
 Industrial Disputes Act of 1947
• Industrial Disputes act 1947 regulates how employers may address
industrial disputes such as lockouts, layoffs, retrenchment etc. It controls
the lawful processes for reconciliation, adjudication of labour disputes.
• The Act also regulates what rules and conditions employers must comply
before the termination or layoff of a workman who has been in
continuous service for more than one year with the employer.
• The employer is required to give notice of termination to the employee
with a copy of the notice to appropriate government office seeking
government's permission, explain valid reasons for termination, and wait
for one month before the employment can be lawfully terminated.
• The employer may pay full compensation for one month in lieu of the
notice. Furthermore, employer must pay an equivalent to 15 days average
pay for each completed year of employees continuous service.
• Thus, an employee who has worked for 4 years in addition to various
notices and due process, must be paid a minimum of the employee's wage
equivalent to 60 days before retrenchment, if the government grants the
employer a permission to lay off.
 Minimum Wages Act of 1948
• The Minimum Wages Act prescribes minimum wages in
all enterprises, and in some cases those working at
home per the schedule of the Act.
• Central and State Governments can and do revise
minimum wages at their discretion.
• The minimum wage is further classified by nature of
work, location and numerous other factors at the
discretion of the government.
• The minimum wage ranges between 143 to 1120 per
day for work in the so-called central sphere.
• State governments have their own minimum wage
schedules.
• India has numerous labour laws such as those prohibiting discrimination and Child
labour, those that aim to guarantee fair and humane conditions of work, those
that provide social security, minimum wage, right to organise, form trade unions
and enforce collective bargaining. India also has numerous rigid regulations such
as maximum number of employees per company in certain sectors of economy,
and limitations on employers on retrenchment and layoffs, requirement of
paperwork, bureaucratic process and government approval for change in labour in
companies even if these are because of economic conditions.[2][42][43]
• Indian labour laws are considered to be very highly regulated and rigid as
compared to those of other countries in the world. The intensity of these laws
have been criticised as the cause of low employment growth, large unorganised
sectors, underground economy and low per capita income.[44][45][46] These have led
many to demand reforms for Labour market flexibility in India.[47][48][49] India has
over 50 major Acts and numerous laws that regulate employers in matters relating
to industrial relations, employee unions as well as who, how and when enterprises
can employ or terminate employment. Many of these laws survive from British
colonial times, while some have been enacted after India's independence from
Britain.[50][51]
Discrimination in Labour Market
Race and Gender in Labour Market
The Employment Decision of a Firm
that does not discriminate
Profits and Discrimination
 Human Capital Model ( tapomoy deb
pg 99)
• The methodology for achieving the objectives of work is based on
an alternative human capital model.
• This model facilitates explicit assessment of employees’ individual
human capital based on the achievements of accounting in the area
of valuations.
• The model identifies human capital as aggregated capital related to
the costs of living, education and professional experience.
• Recruiting an employee implies the use of human capital in a
business process, which makes employers responsible for offering
appropriate compensation – the product of human capital value
and the adopted rate of return.
• Fair base compensation requires the adoption of a rate of return at
the level of potential growth.
Incentive Plans
 Incentive Pay Programs
• Differ by
– payment method
– frequency of payout
– ways of measuring performance
– choice of which employees are covered
• Fitting program to situation depends on
– organizational structure
– management style
– type of work
 Incentive Plans

4 Types of Plans depending on

Different Payment Methods
 1.Stock Options
• A stock option is an incentive offered to
employees that want to invest their money into
the company by purchasing company stock
• According to HR Guide, employees that
participate in a stock option incentive plan are
able to defer paying income tax on the gains
realized by their stock purchases until the stock is
sold.
• The company itself does not get any kind of tax
break by offering a stock option incentive, but it
does reap the benefits of selling more stock.
 2.Profit Sharing
• Profit sharing is another incentive plan done with pre-tax
dollars. The company sets aside a portion of their pre-tax
profits and distributes that money to the employees.
• In most cases, an employee must qualify to receive profit
sharing by meeting company performance metrics, and by
having a predetermined amount of service with the
company.
• Some companies offer to place the pre-tax money into the
employees' company retirement plans, so it can add to
future fund growth.
• Companies may also develop a profit sharing percentage
based on the amount of time worked for the company, the
position held within the company or a combination of both
conditions.
 3.Performance Units
• Type of incentive plan for executives is known as
the performance unit.
• In the executive's agreement there is a schedule
of financial milestones that the company must
achieve for the executive to get awarded a pre-
determined amount of units.
• The amount of a performance unit varies by
company. Performance units are paid out based
on a schedule agreed to by the Executive and the
Company.
 4.Bonus Pay
• The bonus pay structure is common in
professions such as Sales, Marketing and
Production.
• When the employees reach a predetermined
goal, the company may create an Incentive Plan
that pays a bonus for going beyond that goal.
• For example, if a manufacturing plant has a goal
of 100 units in a month, the company may offer
to pay each employee a bonus for each unit
manufactured beyond 100 in that month.
Incentive Payment influences
Employees through
• Reinforcement theory
• Expectancy theory
 Reinforcement Theory
• Behavior that is rewarded will be repeated
• Reinforcement theory of motivation was
proposed by BF Skinner and his associates.
• It states that individual’s behavior is a function of
its consequences.
• It is based on “law of effect”, i.e. individual’s
behavior with positive consequences tends to be
repeated, but individual’s behavior with negative
consequences tends not to be repeated.
 Expectancy Theory of Motivation
• It explains the behavioral process of why individuals
choose one behavioral option over another and how they
make decisions to achieve the end they value.
• Three components of Expectancy theory: Expectancy,
Instrumentality, and Valence
• Motivational Force (MF) = Expectancy x Instrumentality x
Valence

1. Expectancy: Effort → Performance (E→P)

2. Instrumentality: Performance → Outcome (P→O)
3. Valence: V(R)
• Expectancy is the belief that one's effort (E) will
result in attainment of desired performance (P)
goals. Usually based on an individual's past
experience, self-confidence
• Instrumentality is the belief that a person will
receive a reward if the performance expectation
is met. This reward may come in the form of a
pay increase, promotion, recognition or sense of
accomplishment.
• Instrumentality is low when the reward is the
same for all performances given.
• Valence the value an individual places on the
rewards of an outcome, which is based on their
needs, goals, values and Sources of Motivation.
 Incentive Programs
• Differ by
– payment method
– frequency of payout
– ways of measuring performance
– choice of which employees are covered
• Fitting program to situation depends on
– organizational structure
– management style
– type of work
 Types of Incentive Plans
• Merit Pay
• Individual Incentives
• Profit Sharing
• Ownership
• Gainsharing
• Group Incentives
• Alternative Reward Systems
 Incentive Plans

Depending on Performance of the

Employee and Organization
 1.Merit Pay Programs Plan

• This plan links Performance Appraisal Ratings to

Annual pay increases
• Focus of the plan is to identifying Individual
differences in Performance
• Better performance results in higher reward
 Criticisms of Merit Pay
• merit pay systems focusing on individual performance
discourage teamwork
• if performance is not measured fairly and accurately,
the whole process will be contaminated
• apparent differences between people arise almost
entirely from the system that they work in, not the
people themselves
– coworkers, job materials, customers, management,
supervision
 2.Individual Incentives Plan
• These plans reward individual performance
• Payments are NOT rolled or included into Base
Pay meaning that extra payment is done as an
Incentive other than the Basic Salary
• Performance is usually measured as a physical
output (physical labour) rather than subjective
ratings which implies that there is direct payment
for the output achieved by the employee.
 3.Profit Sharing Incentive Plan
• payments are based on a measure of organizational
performance (profits)
• Payments do NOT become a part of Basic Pay
• Advantage: may encourage workers to think more
like owners
• Drawbacks:
– workers may perceive their performance has little to do
with profit
– deferred nature of payouts
 4.Ownership Incentive Plan
• These plans encourages employees to focus on
the success of the organization as a whole but
may not result in motivation for high individual
performance
• Gains in the form of Incentives ,are not realized
until stocks are sold
• Methods:
– stock options
– ESOPs (employee stock ownership plans)
 5.Gain sharing Plan
• This plan includes sharing productivity gains with
Employees
• Differs from profit sharing in that instead of using
an organization-level performance measure
(profits) these plans measure Group or Plant
Performance
• Better for Motivation of Employees
Conditions for effective Gainsharing
• management commitment
• need to change or a process of continuous improvement
• management acceptance & encouragement of employee input
• high levels of cooperation and interaction
• employment security
• information sharing on all productivity and costs
• goal setting
• commitment of all involved parties to change and improvement
• agreement on a performance standard
• calculation that is understandable, perceived as fair, closely related to
managerial objectives
 Conditions for Effective Incentive
Plans
• Plan is clearly communicated.
• Plan is understood by employees and management.
• Bonuses are easy to calculate.
• Employees participate in administrating the plan.
• Employees believe they are being treated fairly.
• Employees believe they can trust the company and that
they have security.
• Bonuses are awarded as soon as possible after the desired
performance.
 ESOP
EMPLOYEE STOCK OPTION SCHEME
Economic Value Addition

EVA Reward
Management in TNC’s
EVA Reward Management in TNC’s

• As defined by United Nations Commission

Transnational Corporations are 'enterprises
which own or control their Production or
Service Facilities outside the country in which
they are based.
 EVA (Economic Value Added)
• It is a single, value-based measure that was intended to
evaluate Business strategies, Capital projects and to
maximize long-term shareholders wealth.
• It accounts for Value that has been created or
destroyed by the firm during the period can be
measured by comparing profits with the cost of capital
used to produce them.
• Therefore, managers can decide to withdraw value-
destructive activities and invest in projects that are
critical to shareholder's wealth. This will lead to an
increase in the market value of the company.
 EVA
• EVA sets Managerial Performance Target and links
it to Reward Systems.
• The single goal of maximizing shareholder value
helps to overcome the traditional measure
problem, where different measures are used for
different purposes with inconsistent standards
and goal.
• Rewards are given to managers who are able to
turn investor's money and capital into profits
efficiently.
• Unlike simple traditional Budgeting, EVA
focuses on ends and not means as it does not
state how manager can increase company's
value as long as the shareholders wealth are
maximized.
• This allowed managers to have discretion and
free range creativity, avoiding any potential
dysfunctional short-term behavior.
• Rewards such as bonuses from the
attainment of EVA target level are usually
paid fully at the end of 3 years.

• This is because workers' performance is

monitored and will only be rewarded when
this target is maintained consistently.
Hence, leading to long-term shareholders'
wealth.
Compensation Strategy at
Micro Level
Company Level
 Compensation Strategy at
Micro (company) Level
• Industries and Corporations develop their
Compensation Models based on three building
blocks
1. Compensation Objectives
2. The strategic policies that form the foundation
of compensation system
3. The Techniques of Compensation

Source : Compensation Management, B.D.Singh,

Excel Books Chapter 4
 1.Compensation Objectives
• a)Efficiency
• b)Equity
• c)Compliance with laws and regulations
1.a) Efficiency objective can be stated
more specifically
1. Improving performance , quality , delighting
customers
2. Controlling Labour costs
 1.b) Equity
• Equity attempts to ensure fair pay treatment
for all participants in the employment
relationship
• Focuses on designing Pay System that
recognizes both Employee’s contribution and
Employee’s needs
 1.3) Compliance
• Involves conforming to the various central and
state wage legislations and regulations.
• As these laws and regulations change, a
system may need to be adjusted to ensure
continued compliance.
2.Strategic Compensation Policies
a) Internal consistency
b) External competitiveness
c) Employee contribution
d) Administration of Pay system
 2 a. Internal consistency

• Refers to the comparison amongst jobs or skill

levels inside a single organisation
• Jobs and skills are compared in terms of their
relative contributions to the organization’s
objectives
• Acts as a factor for determining the pay rates
both for employees doing equal work and for
those doing dissimilar work.
 2 b. External Competitiveness
• Refers to how an Employer positions it’s pay to
what competitors are paying
• Organizations claim that their pay systems are
market driven
• Some employers may set their levels higher than
their competitors hoping to attract the best
applicants.
• Other employers may offer lower base pay but
greater opportunity to work overtime
• Yet another option is better pay and benefits may
be lower but security may be higher.
2 c. Policy on Employee Contribution
• Refers to the relative emphasis placed on
Performance
• Degree of emphasis to be placed on
performance and seniority is an important
policy
• Employers with strong Pay for Performance
policies are more likely to place greater
emphasis on incentive and merit schemes as
part of their pay systems
 2 d. Administration of Pay Policy

Refers to the fact that Managers must

• plan the elements of pay included in the
system,
• communicate with employees and
• judge whether the system is achieving it’s
objectives
Internal Equity and External Equity
• Internal equity exists when an employer pays
wages commensurate with the relative
internal value of each job.
• This is established according to the employer's
perception of the importance of the work
performed.
 A Guide To

CEO Compensation
 A Guide To CEO Compensation
• Company boards, at least in principle, try to
use compensation contracts to align
Executives' actions with company success.
• The idea is that CEO performance provides
value to the organization.
• "Pay for performance" is the mantra most
companies use when they try to explain their
compensation plans
• While everyone can support the idea of paying
for performance, it implies that CEOs take on
risk: CEOs' fortunes should rise and fall with
companies' fortunes.
• When you are looking at a company's
compensation program, it's worth checking to
see how much stake executives have in
delivering the goods for investors.
• Let's take a look at how different forms of
compensation put a CEO's reward at risk if
performance is poor.
Model of Compensation
https://www.erieri.com/dlc/onlinetextbook/model-of-
compensation

Check this link for notes on Models

(Deferred – delayed )
Types of Compensation

for CEO
 1.Cash/Base Salaries
• These days, it's common for CEOs to receive
Base salaries in good amounts.
• In other words, the CEO gets a terrific reward
when the company does well, but still receives
the reward when the company does badly.
• On their own big Basic salaries offer little
Incentive for Executives to work harder and
make smart decisions.
 2.Bonuses
• Be careful about bonuses. In many cases, an
annual bonus is nothing more than a base
salary in disguise.
• A CEO with a $1 million salary may also
receive a $700,000 bonus. If any of that
bonus, say $500,000, does not vary with
performance, then the CEO's real salary is $1.5
million.
• Performance can be gauged by any number of things,
such as
• profits or revenue growth,
• Return on Equity, or share price appreciation.
• But using simple measures to determine appropriate
pay for performance can be tricky. Financial metrics
and annual share price gains are not always a fair
measure of how well an executive is doing his or her
job.
• Executives can get unfairly penalized for one-time
events and tough choices that might hurt performance
or cause negative reactions from the market. I
• It's up to the Board of Directors to create a balanced
set of measures for judging the CEO's effectiveness.
 3.Stock Options
• Companies trumpet stock options as the way to link
executives' financial interests with shareholders'
interests.
• But options are far from perfect. In fact, with options,
risk can get badly skewed.
• When shares go up in value, executives can make a
fortune from options - but when they fall, investors
lose out while executives are no worse off than before.
• Indeed, some companies let executives swap old
option shares for new, lower-priced shares when the
company's shares fall in value.
• Many companies use employee stock options plans to
retain and attract Employees, the objective being to
give employees an incentive to behave in ways that will
boost the company's stock price.
• If the company's stock market price rises above the call
price, the employee could exercise the option, pay the
exercise price and would be issued with ordinary
shares in the company.
• The employee would experience a direct financial
benefit of the difference between the market and the
exercise prices.
• If the market price falls below the stock exercise price
at the time near expiration, the employee is not
obligated to exercise the option, in which case the
option will lapse.
• Restrictions on the option, such as vesting and
non-transferring, attempt to align the holder's
interest with those of the business shareholders.
• Another substantial reason that companies issue
employee stock options as compensation is to
preserve and generate cash flow.
• The cash flow comes when the company issues
new shares and receives the exercise price and
receives a tax deduction equal to the "intrinsic
value" of the ESOs when exercised.
• Employee stock options are mostly offered to management as
part of their Executive Compensation package.
• They may also be offered to non-executive level staff, especially
by businesses that are not yet profitable, insofar as they may
have few other means of compensation.
• Alternatively, employee-type stock options can be offered to
non-employees: suppliers, consultants, lawyers and promoters
for services rendered.
• Employee stock options are similar to exchange traded call
options issued by a company with respect to its own stock.
• At any time before exercise, employee stock options can be said
to have two components: "time value" and "intrinsic value".
• Any remaining "time value" component is forfeited back to the
company when early exercises are made.
• Most top executives hold their ESOs until near expiration,
thereby minimizing the penalties of early exercise.
• Employee Stock Options are non standard contracts with
the employer whereby the employer has the liability of
delivering a certain number of shares of the employer
stock, when and if the employee stock options are
exercised by the employee.
• Traditional employee stock options have structural
problems, in that when exercised followed by an immediate
sale of stock, the alignment between
employee/shareholders is eliminated.
• Early exercises also have substantial penalties to the
exercising employee.
• Those penalties are
• a) part of the "fair value" of the options, called "time value"
is forfeited back to the company and
• b) an early tax liability occurs. These two penalties
overcome the merits of "diversifying" in most cases.
 4.Stock Ownership
• Stock ownership is the most important
performance driver. So, one way for CEOs to truly
have their interests tied with shareholders is for
them to own shares, not options.
• Ideally, that involves giving executives bonuses on
the condition they use the money to buy shares.
Face it: top executives act more like owners when
they have a stake in the business.
Different Components of

Compensation Package
 Component of Compensation
• Fixed Components
• Base pay
• Dearness Allowance
• House Rent Allowance
• Competency – Based Pay
• Fixed period employment contract
• Fringe benefits
• International compensation
• Performance Pay
• Retirement funds
• Total Package
• International Compensation – to any
remuneration that is received overseas. Eg
director’s fees, bonuses, retirement etc.
• Retirement funds – provident funds, pension
funds, deferred compensation.
• Total package – the concept includes all
remuneration grossed up and monetized , and
then the employee is given a choice of structuring
their own package within organizational
regulations.
• Variable components
• Long – term incentives (EVA)
• Share schemes
• Short- term incentives ( profit – sharing,
gain – sharing, commission & bonus
scheme.)
• Organization wide incentives- incentive
schemes devised for all the employees in
collectivity.
• Extend the vesting period of Executives' stock and
options.
• Current vesting periods can be as short as three
years, which encourages managers to inflate short-
term stock price at the expense of long-run value,
since they can sell their holdings before a decline
occurs.
• As passed in the Swiss referendum "against
corporate Rip-offs" of 2013, investors gain total
control over executive compensation, and the
executives of a board of directors.
• Institutional intermediaries must all vote in the
interests of their beneficiaries and banks are
prohibited from voting on behalf of investors.
• Disclosure of salaries is the first step, so that
company stakeholders can know and decide
whether or not they think remuneration is fair.
• In the UK, the Directors' Remuneration Report
Regulations 2002 introduced a requirement
into the old Companies Act 1985, the
requirement to release all details of pay in the
annual accounts.
• This is now codified in the Companies Act
2006. Similar requirements exist in most
countries, including the U.S., Germany, and
Canada.
• A say on pay - a non-binding vote of the general meeting to
approve director pay packages, is practised in a growing
number of countries. Some commentators have advocated
a mandatory binding vote for large amounts (e.g. over $5
million).
• The aim is that the vote will be a highly influential signal to
a board to not raise salaries beyond reasonable levels.
• The general meeting means shareholders in most countries.
In most European countries though, with two-tier board
structures, a supervisory board will represent employees
and shareholders alike.
• It is this supervisory board which votes on executive
compensation
• Another proposed reform is the bonus-malus system, where executives carry
down-side risk in addition to potential up-side reward.
• Progressive taxation is a more general strategy that affects executive
compensation, as well as other highly paid people. There has been a recent trend
to cutting the highest bracket tax payers, a notable example being the tax cuts in
the U.S.[citation needed] For example, the Baltic States have a flat tax system for
incomes.[citation needed] Executive compensation could be checked by taxing more
heavily the highest earners, for instance by taking a greater percentage of income
over $200,000.
• Maximum wage is an idea which has been enacted in early 2009 in the United
States, where they capped executive pay at $500,000 per year for companies
receiving extraordinary financial assistance from the U.S. taxpayers. The argument
is to place a cap on the amount that any person may legally make, in the same way
as there is a floor of a minimum wage so that people can not earn too little.[36]
• Debt Like Compensation - If an executive is compensated exclusively with equity,
he will take risks to benefit shareholders at the expense of debtholders. Thus,
there are several proposals to compensate executives with debt as well as equity,
to mitigate their risk-shifting tendencies
• Indexing Operating Performance is a way to make bonus targets business cycle
independent. Indexed bonus targets move with the business cycle and are
therefore fairer and valid for a longer period of time.
• Two strikes - In Australia an amendment to the Corporations
Amendment(Improving Accountability on Director and Executive Remuneration) Bill
2011[39] puts in place processes to trigger a re-election of a Board where a 25%
"no" vote by shareholders to the company's remuneration report has been
recorded in two consecutive annual general meetings. When the second "no" vote
is recorded at an AGM, the meeting will be suspended and shareholders will be
asked to vote on whether a spill meeting is to be held. This vote must be upheld by
at least a 50% majority for the spill (or re-election process) to be run. At a spill
meeting all directors current at the time the remuneration report was considered
are required to stand for re-election.[40]
• Independent non-executive director setting of compensation is widely
practised.[citation needed] An independent remuneration committee is an attempt to
have pay packages set at arms' length from the directors who are getting paid.