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Transcript of Executive Compensation
however assessments of equity are subjective
Reactions to perceived inequality:
COMPENSATION Warren Buffett on Executive Psychology Why is executive compensation so important?
It motivates and attracts talent in a highly competitive and thin market. Simply put, it is the means by which many executives measure the value of their contributions and moreover, how they measure themselves against others.
How are executives paid?
Usually through a diverse bundle: base salary, bonuses, perquisites, benefits, equity and a handsome severance package; however managerial opportunism is a real threat that arises from asymmetric information.
How is compensation set?
By a team comprised of both external and internal specialists who are susceptible to conflicts of interest and engage in an unscientific process so compensation can easily be ratcheted up. Executive Compensation Walster, Berscheid, Walster (1973)
Our own OUTCOMES/INPUTS=
Outcomes: what we receive
Inputs: what we contribute Foundations in Psychology Free Falling in the Age of Golden Parachutes How else are executives paid? How are executives paid? How is compensation set? How is compensation set? In 2012, Lloyd Blankfein (CEO of Goldman Sachs) earned the following:
$2 million in base salary
$5.7 million in bonuses
$323,514 in "benefits" such as $115,894 for security services and $47,467 for car service
$13.3 million in equity How are executives paid?
Equity compensation comes in many flavors, but restricted stock and stock options are perhaps the most common:
Extends right to buy stock in the company at an agreed-upon exercise price within a certain period of time or specific date
Objective: maximize (S-K), S being the spot price, K being the exercise price
Incentive Issue: Encourages managerial opportunism (i.e. artificially inflating the share price w/o adding underlying value)
Vested ownership: retains intrinsic value
Objective: maximize underlying value
Supposedly better aligns executive and company objectives
This is equity/voting power that is only offered to the company. Recap: Executive Compensation Fundamentals 62% of Mr. Blankfein's earnings came from equity, more specifically restricted stock. The Team
Human resources executives
Compensation consultants The unscientific process:
Consultant assesses executive compensation in company's peer group (e.g. JP Morgan Chase's Jamie Dimon: $18.7 million in 2012)
Compensation committee chooses a target percentile, usually 50th, 75th or 90th to set against market standard
HR executives then work to formulate a package which combines the countervailing forces of attracting/retaining the best talent with the oversight provided by the committee/shareholders "Executives don't suggest compensation consultants who are Dobermans; you make sure that they are Cocker Spaniels and that their tails are wagging." Potential Conflicts of Interest:
Fees as a % of total firm revenue and/or stock owned
Close business or personal relationship
Limited legal binding Severance Packages:
Usually specified only as a result of merger or takeover
Monetary compensation and/or stock options
No specification: firing, restructuring or even scheduled retirement
Provides monetary compensation and/or stock options as well as retirement benefits Moral hazard problem: if too meager, executives are too resistant to potentially profitable mergers; if too strong, eager to close deals for potential personal windfall (engage in excessive risk taking) Executives also consider how they will be "treated" on their way out. INCREASES IN EXECUTIVE COMPENSATION Rises in compensation piques our interest But the increased disparity is what warrants investigation WHAT IS THE DIFFERENCE? Are CEO's directly being paid by an increasing margin compared to their labor force?
Or are there other benefits that make the difference? INCREASE IN EQUITY COMPENSATION Equity compensation for CEO and other C-O's has seen a steady proportional increase
American Phenomenon TRACK THE MARKET Over time, executive compensation closely follows the performance of the stock markets Recap: Recent Trends in Executive Compensation Growing disparity between compensation for executives and labor force
Cash/Bonus pay has increased but the major cause has been the increase in equity compensation
Follow the market
Outrage costs may inhibit future increases in disparity between workers and executives Proposed by Gabaix and Edmans (2009)
Two major issues with current pay scheme:
Short vesting periods of stock options allow executives to “cash out” early
Executives may have incentives to behave differently depending on the company’s performance Reforming Executive Compensation
Schemes: Incentive Accounts Shareholders either vote in person at board meetings or using by using proxy materials:
Shareholders fill out a proxy card, then board of directors votes on their behalf based on information provided
Say-on-pay votes, frequency votes, golden parachute votes How does “Say on Pay” work? U.S. Securities and Exchange Commission:
“NOTE: The decision by a company regarding the amount and type of compensation to give an executive officer is a business decision and is not within the jurisdiction of the Commission. Rather, the Commission's jurisdiction extends to disclosure - making sure that the investing public is provided with full and fair disclosure of material information on which to base informed investment and voting decisions.”
Resolves one issue: shareholders now have information that was once private to executives
No guarantee that shareholders will seek or correctly interpret the given information
Disclosure does not mean that shareholders have any decision-making power Issues with Disclosure Requirements Modified in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Section 953
Companies required to disclose:
"relation between realized compensation and the firm’s financial performance, including stock-price performance
company policies regarding hedging by employees to protect against reductions in company stock prices
company policies and practices on why the company chooses either to separate the Chairman and CEO positions, or combine both roles
the ratio of CEO compensation to the median pay for all other company employees" (Murphy 2011) Disclosure Requirements Too much regulation: say on pay disrupts the inner workings of a company
Too little regulation: Gabaix and Edmans claim that “say on pay” will not deter the rising trend of compensation
Short term solution for a long term problem Issues with Say On Pay POSSIBLE MANIPULATIONS Board might misprice options
Call price too low
Board follow direction of the CEO
Perhaps both... He walked away with a cool
$21 million Fills in some of the gaps unaddressed by disclosure requirements
Section 951 of Dodd-Frank Act
Shareholders have a non-binding vote on executive compensation packages and golden parachutes Say On Pay Incentive Accounts Cont’d Two principles to address the two issues:
“Long-Horizon Principle”: compensation scheme must incentivize executives to boost company’s long-term value—achieved through gradual vesting
“Constant Percentage Principle”: a constant percentage, about 60%, of a CEO’s pay should be in the form of stock—achieved through rebalancing
Aligns management’s incentives with the objectives of the company Naomi Senbet
Zachary Javitt Recap: The Role of Regulation in Executive Compensation Most of the existing regulation: too narrow
Restructuring compensation packages may provide a solution to some of the controversial issues—Incentive Accounts
Compensation schemes such as incentive accounts do not interfere with the market for talented executives Pay for Performance?
In 1990, two economists looked at how $1,000 created in shareholder wealth corresponded to an increase in executive compensation:
In large firms like Goldman Sachs, the average increase in 1990 was $1.85. If you aggregate this across all of the $1,000 portions, it is easy to see how Mr. Blankfein ended up somewhere in the neighborhood of $21 million. In spite of this, a discrepancy still exists between the final figure and an executive’s actual contribution. What exactly are we paying executives for?