ExecutivesExecutives CompensationCompensation

• Tereza BůžkováTereza Bůžková• Veronika HoláVeronika Holá

• Jakub MikolášekJakub Mikolášek

IntroductionIntroduction

• Historic DevelopmentHistoric Development

• Optimal contracting x Managerial Optimal contracting x Managerial PowerPower

• Types of CompensationTypes of Compensation

• CamouflageCamouflage

• Optimal compensation packagesOptimal compensation packages

Historic DevelopmentHistoric DevelopmentExecutive pay relative to average wages in Executive pay relative to average wages in

the USthe US

The Economist 01/2007

0

50

100

150

200

250

300

350

median

mean

Widening gap-reasons Widening gap-reasons (1)(1)

• Share OptionsShare Options

–– to make managers think like to make managers think like owners owners

–– rising bull market increased share rising bull market increased share valuevalue

Widening gap-reasonsWidening gap-reasons (2)(2)

• Share optionsShare options

• Higher Fluctuation of CEOsHigher Fluctuation of CEOs

–– Tendency to search executives Tendency to search executives outside theoutside the

companycompany

–– underbiddingunderbidding

Widening gap-reasons Widening gap-reasons (3)(3)

• Share optionsShare options

• Higher fluctuation of CEOsHigher fluctuation of CEOs

• Increase of average firm’s sizeIncrease of average firm’s size

–– higher responsibility resulting in higher responsibility resulting in higher wageshigher wages

Widening gap-reasons Widening gap-reasons (4)(4)

• Share optionsShare options

• Higher fluctuation of CEOsHigher fluctuation of CEOs

• Increase of average firm’s sizeIncrease of average firm’s size

• Consultancy servicesConsultancy services–– consultants create compensations packagesconsultants create compensations packages

–– companies want to pay their managers at companies want to pay their managers at oror

above averageabove average

Theoretical BackgroundTheoretical Background

• Separation of ownership and controlSeparation of ownership and control→ agency problemagency problem

Owners

Maximize shareholder value

Managers

–– extract high rents

–– ensure stable income

–– gain prestige Need for incentives Compensation Packages

Managerial PowerManagerial Power

Compensation may be influenced by Compensation may be influenced by managersmanagers

Reasons:Reasons:•BOD electionBOD election•Directors lack the independent Directors lack the independent

informationinformation•Superior insider informationSuperior insider information•Interpersonal connectionsInterpersonal connections

Managerial Power Managerial Power (continued)(continued)

When it is likely to be high?When it is likely to be high?

• Weak or inefficient BODWeak or inefficient BOD–– BOD is too largeBOD is too large

–– CEO = chairman of the boardCEO = chairman of the board

• No big outside shareholderNo big outside shareholder → → No enhanced monitoring or No enhanced monitoring or

external powerexternal power

• AntiAnti--takeover provisionstakeover provisions→→ The manager’s position more secureThe manager’s position more secure

Market-based incentivesMarket-based incentives

• Threat of Takeover Threat of Takeover

– – in case of substantialin case of substantial

underperformanceunderperformance

Market-based incentivesMarket-based incentives

• Threat of TakeoverThreat of Takeover –– Generally very Generally very costlycostly

– – in case of substantialin case of substantial

underperformanceunderperformance

• EntrenchmentEntrenchment– – staggered boardstaggered board

– – poison pills etc…poison pills etc…

– – golden parachutesgolden parachutes

FAILURE

Equity-based IncentivesEquity-based Incentives

Links compensation to performance ≈ Links compensation to performance ≈ stock pricestock price

• Target equity ownership levelTarget equity ownership level

• OptionsOptions

Equity-based IncentivesEquity-based IncentivesFAILURE

Links compensation to performance ≈ stock priceLinks compensation to performance ≈ stock price

–– Stock price linked rather with market developmentStock price linked rather with market development• Target equity ownership levelTarget equity ownership level

–– Usually very low requirementsUsually very low requirements

–– No punishment if breachedNo punishment if breached

• OptionsOptions

–– No appropriate decrease in cash compensationNo appropriate decrease in cash compensation

–– Option whirOption whirllpoolpool

Careful ManagerCareful Manager• Outrage costs

–– EmbarrassmentEmbarrassment (negative media coverage etc.) (negative media coverage etc.)

–– Shareholder disappointmentShareholder disappointment→ → reduction of salary or firing out or reduction of salary or firing out or

takeovertakeover

• Compensation Consultants

–– underbidding

Preferred CompensationPreferred Compensation• Direct (cash) compensationDirect (cash) compensation

→ → ? ? Outrage costs Outrage costs ??

• Other benefitsOther benefits

–– (e.g. in UK about 30% of total (e.g. in UK about 30% of total compensation)compensation)

• OptionsOptions

–– convenient for both s-holders and COEconvenient for both s-holders and COE

PreferPreferrred Compensation ed Compensation (continued)(continued)

Camouflage (Stealth Compensation)Camouflage (Stealth Compensation)• Retirement rentsRetirement rents

• Loans (Loans (since 2002 prohibited in US by since 2002 prohibited in US by SOASOA))– – Often forgiven (at least in part)Often forgiven (at least in part)

• Goodbye paymentsGoodbye payments–– Sometimes beneficial even for s-Sometimes beneficial even for s-

holdersholders

„„OptimalOptimal“ Compensation“ CompensationOptionsOptions• Exercise price indexationExercise price indexation• Limited cashing-outLimited cashing-out

EquityEquity• Target ownership plansTarget ownership plans

Performance targetsPerformance targets• Compensation linked to adj. Stock price, Compensation linked to adj. Stock price,

EPS,…EPS,…

Sources:Sources:Literature:Literature:• Bebchuck, L. A., Fried, J. M., (Bebchuck, L. A., Fried, J. M., (2003):2003): Executive Executive

compensation as an Agency problem, The journal of compensation as an Agency problem, The journal of Economic Perspectives, Vol 17, No 3Economic Perspectives, Vol 17, No 3

• Barlett, L.R., Grant, J.H., Miller, T.I., Barlett, L.R., Grant, J.H., Miller, T.I., (1999): (1999): Personality Differences and Executive Compensation, Personality Differences and Executive Compensation, Eastern Economic Journal, Volume XVI, No. 3, July-Eastern Economic Journal, Volume XVI, No. 3, July-September 1999September 1999

• Bolton, P., Scheinkman, J., Xiong, W.Bolton, P., Scheinkman, J., Xiong, W.:: Pay for Short Pay for Short Term Performance: Executive Compensation in Term Performance: Executive Compensation in Speculative Markets, NBER Working Paper Series, Speculative Markets, NBER Working Paper Series, Working Paper 12107 Working Paper 12107

• Kubo, K., Kubo, K., (2002): The Determinants ot Executive (2002): The Determinants ot Executive Compensation in Japan and the UK: Agency Hypothesis or Compensation in Japan and the UK: Agency Hypothesis or Joint Determination Hypothesis?, CEI Working Paper Joint Determination Hypothesis?, CEI Working Paper Series, No. 2001-2Series, No. 2001-2

• The EconomistThe Economist, January 20th 2007, January 20th 2007

Still awake?Still awake?

Thank you for Thank you for attention attention