Structure Of Ceo Compensation

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02 Nov 2017

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Falato, Antonio, and Dalida Kadyrzhanova. "Optimal CEO incentives and industry dynamics." (2012). http://ssrn.com/abstract=2197495

In this paper, the authors discussed the inverse relationship between CEOs-pay-sensitivity and, (a) across industries, the level of complexity of industry structure; and (b) within industries. According to previous studies and calculation, the authors used some graphs and formulas derived from computing industry equilibrium under various data of key parameters to show the result 1 that "industry leaders had lower pay-performance sensitivity than laggards". Additionally, they found the result 2 with the positive and significant coefficient on the interaction of industry complexity and performance that similar industries tended to have higher than heterogeneous industries. And, pay-performance sensitivity in growing industries would be greater than in declining industries. Another result 3 was derived from turbulence effect and interaction. With positive and high significant coefficient on the interaction of turnover and firm performance, it was proved that greater pay-performance sensitivity appeared in higher turnover industries. Through this article, it supplemented the agency model of CEOs compensation due to its lack of information about connection of economic regulations and CEO incentives.

Milkovich, George T., Jerry M. Newman, and Carolyn Milkovich. Compensation. Part V. Ed. Times Mirror. Burr Ridge, Ill.: Irwin/McGraw-Hill, 2004.

A CEO compensation package includes five most basic elements: base salary, short-term incentives in the form of bonuses, long-term incentives, executive benefits (included a supplemental executive retirement plan – SERP) and perquisites. However the important role of these elements has been changing over time. Before, a compensation package could include only base salary and annual bonus. Short-term incentives were used to create a motivation for both CEOs and employees in companies. From 1960s, the long‐term incentives began to be noticed in this package which was often paid out over several years, again with payment in either cash or stock. Stock option compensation was used to increase shareholder value that was a right to buy a number of stocks at strike price following with some requirements. Also, in Ellig, Bruce R. "The complete guide of executive compensation." Part I, the author listed some types of stock options that were involved in long-term incentives for CEOs:

Nonqualified stock option: was a stock option not conforming to Internal Revenue Code. It was used to deduct company’s expenses.

Phantom stock plan: was cash or stock award settled by increase in stock price at a specific date in future and was taxed as an ordinary income.

Stock appreciation right: was cash or stock award settled by increase in stock price at any time in future and was taxed as an ordinary income.

Performance share: was cash or stock award earned by achieving a goal and was taxed as an ordinary income.

For the executive benefits, besides life insurance or pension plan CEOs can receive deductibles for health insurance or additional pension income under Employment retirement income security Act (ERISA) guidelines. The last element is perquisite which is designed as internal and inside the company such as a luxury office or reserved parking. Another type of perquisite is membership in clubs, resorts or hotels paid by company.

Bouwman, Christa. "The geography of executive compensation." Available at SSRN 2023870 (2012). http://ssrn.com/abstract=2023870

In this article, the author suggested that CEOs compensation could be affect by the geography. There were four main conjectural reasons: (a) competition for CEOs at local labor market; (b) local hiring of similar CEOs; (c) "leading firms" in the neighborhood and (d) envy among geographically-close CEOs.

(a) Local labor competition for CEOs: the author examined a sample but excluded global or national companies which were part of S&P 500. He calculated the average compensation of geographically-close CEOs by using the previous year’s CEO compensation at central firms within a 100-kilometer radius. However, the coefficients on the average compensation of geographically-close CEOs seemed to be greater and positive. It meant that geography affected CEO compensation for not only outstanding but also local companies. Therefore, geographically local labor market competition did not have impact on CEOs compensation.

(b) Local hiring of similar CEOs: he ran the same regression model as testing the first suggestion with the variables: CEO age, tenure, risk aversion and education. He found out that the standard deviations of CEO age, tenure or education for both local hiring and overall sample were similar. In a result of that, local hiring of similar CEOs did not affect on CEOs compensation.

(c) Leading firm effect: the author ran two tests to calculate the average compensation of CEOs of within-100-kilometer-radius companies. Both two tests showed the results that did not support the reason "leading firm effect".

(d) Envy among geographically-close CEOs: Since he got the consistent results: the coefficient on the compensation gap between geographically-close CEOs and the CEOs were positive and significant and it was asymmetric effect, he concluded that geography affected CEO compensation through envy. More interestingly, he used evidence from sports players to prove it.

Core, John E., Wayne R. Guay, and Randall S. Thomas. "Is US CEO compensation broken?" Journal of Applied Corporate Finance 17.4 (2005). http://ssrn.com/abstract=859204

Core, Wayne and Randall pointed out four important reasons retrieved from observation in U.S to imply that CEOs compensation was defected and needed to reform:

Executive compensation in dollar-nominated market was too high and had a tendency to increase every year.

Lack of strong incentives from CEO contracts to increase shareholder’s value.

Options and other equity-based incentives offered large payoffs did not reflect any good performance.

CEOs have too many rights to unbend their incentives.

Since almost observation concentrated on annual income of CEOs – base salary, bonuses, stock option, it leaded to misconceptions and skipped the amount CEO’s holdings of firm equity. Actually, the relationship between CEOs compensation and firm performance was stronger and has been increasing year by year. There was always relative risk associated with the growing degree of CEOs incentives; therefore, increase in executive compensation was essentially happened. Moreover, CEOs should spend incentives on exercising options and selling stocks for portfolio rebalance purposes instead of wealth of company. The authors also showed two methods to help increasing firm value when offering executive pay. Firstly, it was to differ the annual incentives from some measurement of operating or stock price performance. Secondly, it was necessary to require CEOs to hold company stock and options with the value of them varying directly with stock price performance.

Sigler, Kevin J. "CEO Compensation and Company Performance." Business and Economic Journal 2011 (2011): 1-8.

Through sample of 280 firms listed on the New York Stock Exchange from 2006 to 2009, Sigler wanted to examine the relationship of CEO compensation and company performance. Sigler chose the period 2006 – 2009 which was after the implement of the Sarbanes Oxley Act and the SEC approval of the corporate governance rules affecting CEOs compensation for New York Stock Exchange firms. Both the SOX and NYSE governance rules had corresponding influences on executive pay. The percentage of each component in a compensation package changed dramatically. Approximately 70 percent of the companies used stock options in 2009 proved that long-term incentives were the most important element at that time. In contrast, most of types of perquisites declined in 2009 when compared to 2008. Therefore, a long-term incentive plan was more favorable and helped to encourage top management to reach the target of the company. However, due to the combination of various components of executive pay, it was not surprising when the strength of one component would be offset by the shortcoming of another. The author used the function CEO Pay = f (Tenure, Beta, Employees, ROE) to examine the relationship between CEOs compensation and firm performance. It was consistently proved that there was a positive relationship between executive compensation and the firm size. The bigger the firm the more complicated and higher skills needed for the management to operate smoothly.

Frydman, Carola, and Dirk Jenter. CEO compensation. No. w16585. National Bureau of Economic Research, 2010. http://ssrn.com/abstract=1582232

This paper surveyed the recent literature on CEO compensation in US rather than foreign evidence, and public instead of private firms. The authors suggested power of management and competitive market forces affected significantly on CEO pay. The data in the article was that the median ratio of CEO pay was stable before 1980 but had increased strikingly from 1.4 to 2.6 by 2000 – 2005. The executive pay was not similar for large-cap, mid-cap, and small-cap firms and its growth rate became steeper in larger firms. Especially, executive pay was larger for CEOs comparative to other top executives which helped to raise the compensation premium for CEOs. In this article, the five basic elements (salary, annual bonus, payouts from long-term incentive plans, restricted option grants, and restricted stock grants) of a compensation package and their relative importance were discussed. Option compensation was used frequently in order to tie remuneration directly to share prices and boost the shareholder value. However, if shareholders could not control managers’ self-interest, executives should follow up their own well-being at the expense of shareholder value. Moreover, the long-run evidence showed that compensation arrangements were utilized to link the wealth of managers to firm performance as well as re-classify interests of managers and shareholders for most of the twentieth century. Finally, this literature provided evidences that CEO compensation and portfolio incentives were correlated with a wide variety of corporate behaviors, from investment and financial policies to risk taking and manipulation.

Chhaochharia, Vidhi, and Yaniv Grinstein. "CEO compensation and board structure." The Journal of Finance 64.1 (2008). http://ssrn.com/abstract=901642

Through this paper, the authors raised the problem in complying new governance regulations in 2002 and the influence on CEO compensation. In 2002, after scandal that Enron declared bankruptcy, the Chairman of SEC wanted to adjust their governance listing standards. The NYSE and the subsidiary of National Association of Securities Dealers – the Nasdaq Stock Market proposed some changes. It was required firms to adopt new rules, such as: (a) "all firms must have a majority of independent directors"; (b) "independent director had no material relationship with the listed company, directly, or as a partner, shareholder, or officer of an organization"; (c) "the compensation committee, nominating committee, and audit committee shall consist of independent directors"; and (d) "the compensation committee and the nomination committee must have a written charter that defines the obligations of these committees. The committees should also have self-evaluation procedures". The new regulations had an important influence on both the structure and size of executive compensation. By using the difference-in-difference approach, they suggested that it was about 17.5% drop in compensation for firms who complied the new rules and it was primarily attributed to the drop in bonus compensation and stock-based compensation. Moreover, firm had to face stronger scrutiny of investors when it was not compliant and had low governance score that caused decrease in CEO compensation. When it existed a large amount of block holders on the board, it could lessen the efficiency of board structure and procedures on compensation decisions.

Cooper, Michael, Huseyin Gulen, and Raghavendra Rau. "Performance for pay? The relation between CEO incentive compensation and future stock price performance." (January 30, 2013) (2010). http://ssrn.com/abstract=1572085

The authors of this paper found evidence that industry and size adjusted CEO pay was negatively related to future shareholder wealth changes for periods up to five years. After testing the efficient market and optimal incentives hypotheses and using data of firms listed on CRSP, Compustat, and Execucomp, they concluded that the negative relation between incentive compensation and stock performance was not consistent; and it was not consistent with the risk-shifting hypothesis either. However, they concluded that firm size and stock performance were significant predictors of both cash and incentive compensation. The remaining variables were significant either for cash or for incentive compensation but not consistently across both types of compensation. When classifying firms into the lowest and highest compensation deciles, firms with lowest compensation deciles gained insignificant industry returns. In contrary, the firms with highest compensation deciles earned significant negative excess returns. Total cash compensation included salary and bonuses whereas total incentive compensation consisted of restricted stock grants, long term incentive payouts, value of option grants, and other annual non-cash compensation. Each element in a compensation package was affected differently. For instance, while the proportion of cash salary was significantly positively related to excess returns, options granted and long-term incentives were significantly negatively related. Finally, it was extracted from the results that components of managerial compensation such as restricted stock, options and long-term incentive payouts were used to adjust managerial interests and shareholder value but not to translate into higher future returns for shareholders.

De Franco, Gus, Ole-Kristian Hope, and Stephannie Larocque. "The effect of disclosure on the pay-performance relation." Available at SSRN 1428826 (2011).

http://ssrn.com/abstract=1428826

This research empirical investigated whether greater transparency leads to improved evaluation and rewarding of management. By using management guidance as the main proxy for disclosure they examined the effect of disclosure on the relationship between CEO pay and firm performance. The authors believed that managerial power would make compensation weaken managers’ incentives to increase firm value and that could even create incentives for managers to take actions that reduce long-term firm value. Firstly, they predicted that disclosure could improve transparency, which helped to control management and forced managers to work more for the interests of firms and shareholders. Secondly, increase in disclosure influenced external stakeholders on developing their independent and separated opinions on firms’ decisions. Thirdly, it could better the quality of boards’ information sets and reduced the bias of CEO compensation’s information. Generally, CEO did not have much incentive to public information that might affect board members to revise downward their assessment on the CEO’s talent or abilities. All of these above reasons helped to explain the importance of public disclosure for firm. It was essential to be checked and assessed by both external stakeholders and internal stakeholders and more care would be taken in the process of disseminating it. Moreover, they discovered higher sensitivity of cash compensation to firm performance – both accounting and stock return – for firms that issued management guidance. In a sub-sample of firms that issue guidance, they learned that the sensitiveness of compensation to performance was increasing in the frequency of management guidance events during the year and in the number of consecutive years that firms have issued management guidance.

Florin, Beth, Kevin F. Hallock, and Douglas Webber. "Executive pay and firm performance: methodological considerations and future directions." Research in Personnel and Human Resources Management 29 (2010).

This paper investigated the pay-for-performance link in executive compensation. It discussed the history of the debate CEO compensation and firm performance and reason it was not resolved due to the methodological issues. Although data on executive pay had been widely available since 1992, it was reported not entirely satisfying in terms of really understanding the way executives were paid at a point in time. In 2006, the SEC required publicly traded firms to disclose compensation for the CEO, Chief Financial Officer and three other most highly paid Named Executive Officers (NEOs). It helped to clarify and standardize the elements of compensation as well as the time period for reporting. Among the information firms were now asked to report were salary, bonus, non-equity incentive compensation, stock, stock options, changes in pension and non-qualified deferred compensation and other compensation. According to the paper, Hallock and Torok (2010) revealed that of 2,108 firms they studied, in only 81% was the CEO was the highest paid executive. There were three major commercial data sources on executive pay at the person-level were widely used: (a) ExecuComp (Executive Compensation data base) was produced by Standard and Poor’s Corporation and has been most widely used source of data for research on executive pay by academics; (b) Equilar and (c) Salary.com that provided many interface features for comparison groups easier and for presentation purposes.

It was necessary to control a firm's size when estimating an executive's pay. There were two most common methods to control for firm size were measurement of sales or assets and the total number of employees. Another factor to examine the effect of performance on pay was the variability of performance. Some industries naturally had very volatile performance indicators which could weaken the pay-(observed) performance relationship because a high (or low) value may not necessarily be a signal of the executive's ability. While Garen (1994) used the standard deviation of performance for control the volatility, Garvey and Milbourn (2003) used cumulative distribution function (CDF) of performance. Moreover, it was concluded that a one unit increase in performance was on average correspondent with an increase in compensation. The most common performance measure was a firm's return on assets, followed by the return on common stock. Other measures included the return on equity, shareholder wealth, or firm profits.

More importantly, this paper mentioned international issues which leaded to differences in CEO compensation due to methods of disclosure and across countries. CEOs in the United States were paid more than CEOs in any other country and firms in the United States were larger (in terms of annual revenue) than firms in any of the other countries. The authors retrieved from some other studies of Fattoruso, Skovoroda, Buck and Bruce (2007) for U.K or Edwards, Eggert, Weichenrieder (2009) for Germany to examine the CEO pay-to-performance relationship within countries. While bonuses were in essence "guaranteed" in U.K, in Germany firms with low concentrations of investor ownership had little connection between CEO pay and firm profits.

Matolcsy, Zoltan, and Anna Wright. "CEO compensation structure and firm performance." Accounting & Finance 51.3 (2007) http://ssrn.com/abstract=971300

In this article, the author used a data sample of 696 Australian firms during the period 1999 – 2001 to provide some significant insight into the relation between CEO compensation and firm performance. They found two important main points:

Firms with cash-based compensation only and those with both cash- and equity-based compensation did not affect much their own performance.

Firm performance would be lower when firm established inefficient compensation structure.

They suggested two hypotheses:

(1) H1 - There was no difference, on average, in firm performance across the different compensation groups. It was concluded that although the cash group had significantly higher ROA than the equity group, but it did not interpret into better market performance. There were no other significant differences in performance between the two groups across the individual years.

(2) H2 - Deviation from the efficient compensation structure had a negative impact on firm performance. From analysis, it was proved that cash constraints were considered to be a key element of compensation structure (Ittner, Lambert and Larcker, 2003; Core and Guay, 2001).

Moreover, depending on economic characteristics and environment of the firm, the compensation structure would be adjusted to be efficiently. Besides firm size and decentralization, they revealed that firms using the wrong compensation structure would have lower market performance compared to those firms making the correct choice. Generally, firm was advised to create a considerable structure of compensation package following with its environment, features and industry.

Gabaix, Xavier, and Augustin Landier. "Why has CEO pay increased so much?" The Quarterly Journal of Economics 123.1 (2008): 49-100. http://ssrn.com/abstract=901826

This article developed a simple competitive model of CEO pay. The model examined predictions about CEO pay across firms, across countries, and across time. Furthermore, it revealed much of the rise in CEO compensation since the 1980s. In the model’s view, it was explained that increase in pay was a result of rise in the market value of firms. It also tested that CEO compensation should increase one for one with the average market capitalization of large firms in the economy. Nowadays, CEO is one of the hottest jobs and has increasing dramatically and rigorously with its compensation. The suggested model explained that it is due to demand for top-talent. When stock market valuations were 6 times larger, CEO productivity was multiplied by 6, and pay increased by 6 as firms competed to attract talent. Furthermore, the paper argued whether firms would follow up when other firms increased compensation (for example because they believed talent impact has increased). It also mentioned that depending on specific industry the dynamics of compensation could cause large infective effects to the rest of the economy. And, other firms might be forced to re-balance their compensation policy to meet these new changes in criterion. Finally, they proposed a calibration of various quantities of interest in corporate finance and macroeconomics, the distribution and influence of CEO talent and CEO effort.

CEO compensation for other countries: Korea, India, China

Kato, Takao, Woochan Kim, and Ju Ho Lee. "Executive compensation, firm performance, and Chaebols in Korea: Evidence from new panel data." Pacific-Basin Finance Journal 15.1 (2007): 36-55. http://ssrn.com/abstract=548921

This paper discussed the estimates on the pay-performance relations for executives of Korean firms with and without Chaebol affiliation. Chaebol was used to define some Korean business groups which occupied most of stake in securities firms that issue analysts’ reports on their member companies. This structure was unique in Korean industrial companies and securities firms were affiliated and operated within the same group1. There were a lot of papers studying the Chaebol behavior such as Joh (2003) shows that firms affiliated to a Chaebol group experienced lower operational profits during the pre-crisis period.2 Gathering data from 246 firms included in KSE (Korea Stock Exchange) from 1998 to 2001, it was proved that Chaebol-affiliated firms were not independently operated, but to maximize the interest of the overall group or the controlling family’s interest. It was more observable in internal capital market studies. Most believed that Korean corporate governance and the structure of Korean executive compensation were not similar as in the Western style; yet, it was found that cash compensation of Korean executives had relation to stock market performance and was comparable to the U.S. and Japan methods. Especially, further research brought out that such overall significant executive pay-performance link was driven by non-Chaebol firms but not for Chaebol firms. They examined the robustness of the model basing on the pay-stock performance link by considering: (a) year effects; (b) the use of stock option; (c) proportion of stock owned by all directors; (d) lagged performance; (e) industry dummy variables; and (f) alternative performance measures (such as accounting profitability and sales). Next, top 30 Chaebol and non-Chaebol firms were categorized basing on the Korea Fair Trade Commission (KFTC) press to estimate relation of pay-performance for non-Chaebol and Chaebol firms. For non-Chaebol firms the estimated coefficient on stock returns was positive and statistically significant at 5 percent level while for Chaebol firms it was not significant, in fact negative. These results took part in supporting that executive compensation was more strongly related to firm performance (in particular stock returns) in non-Chaebol firms than in Chaebol firms. Besides, the firm size was tested whether affected the CEO compensation. Although Chaebol firms were larger than non-Chaebol firms, it showed no relationship between executive compensation and stock return for the Chaebol sample while it was a positive and statistically significant at 5 percent level for non-Chaebol firms.

Parthasarathy, Aditya, Debashish Bhattacherjee, and Krishnakumar Menon. "Executive compensation, firm performance and corporate governance: An empirical analysis." (January 2006). http://ssrn.com/abstract=881730

By using the current data on firm performance, managerial compensation and corporate governance of Indian firms, the authors established a linear regression model to verify explanations of total executive compensation and the proportion of each element of a compensation package. CEO compensation was a function of three separate sets of parameters: (a) firm performance and shareholder wealth; (b) firm specific characteristics and (c) corporate governance parameters. The result was that firm size was an important variable to explain both total CEO compensation and the proportion of variables or incentive pay that a CEO received. However, the authors want to focus on the firm performance in the future, which resulted from the present actions of managers. The "managerial power" approach helped to explain features of CEO compensation which was observed but hard to explain from a financial economics standpoint. Due to various cultures of corporate governance across countries, it leaded to difference in legal and institutional frameworks. The corporate governance systems of countries in North America and Western Europe were not similar as in Eastern Europe and Asia where the western style corporate governance practices was recently adapting. And, CEO who is also the owner earns a greater proportion in a compensation package. In conclusion, through measuring log (Sales) it was resulted that firm size had a positive and significant influence on total CEO compensation. Therefore, the larger the firm size, the greater amount for CEO compensation. Furthermore, it showed that a dual leadership structure, represented by the variable CEO Chairman, had a positive relationship but not statistically significant. CEO who also held the position of the Chairman obviously received a greater proportion of executive compensation comparative to a CEO who was not the Chairman of the board. Nevertheless, the ‘human capital’ approach towards managerial compensation like age, education, experience etc of the CEO had not been considered in this study.

Kato, Takao, and Cheryl Long. "Executive compensation, firm performance, and corporate governance in China: Evidence from firms listed in the Shanghai and Shenzhen Stock Exchanges." National Bureau of Economic Research (2005)

http://ssrn.com/abstract=2134208

The authors analyzed the quality of corporate governance and the success of Stated-Owned Enterprises Reform in China. They used not only economic theory but also empirical evidence to prove that an efficient compensation system was due to close relationships between firm performance and executive compensation and the existence that connection in China’s listed firms. In China, a compensation package included two parts: the base salary related to the average wage for ordinary employees and the size of the enterprise; and a variable component that was distributed at the end of the year basing to the base salary and financial performance of the firm. Using information from 1998 to 2002 the paper suggested finding that it was consistent for firms listed in China’s emerging stock market significant sensitivities of cash compensation for the highest-paid executives with respect to shareholder value although the size of this sensitivity was approximately greater than what was found in U.S or Korea. Furthermore, sale growth contributed to affect executive compensation. If Chinese CEOs made the company get loss, they were penalized though they were not rewarded for changes in positive profit. One of the most important things was that the government ownership of China’s listed firm could worsen pay-performance link for top executives and probably making them less effective in solving the agency problem.



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