Management Compensation in Relation to Thesis

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The statement regulating accounting for stock-based compensations defines a fair value-based method of accounting for an employee stock option or similar equity instrument and encourages all entities to adopt that method of accounting for all of their employee stock compensation plans. However, it also allows an entity to continue to measure compensation cost for those plans using the intrinsic value-based method of accounting prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees. The fair value-based method is preferable to the Opinion 25 method for purposes of justifying a change in accounting principle under APB Opinion No. 20, Accounting Changes. Entities electing to remain with the accounting in Opinion 25 must make pro forma disclosures of net income and, if presented, earnings per share, as if the fair value-based method of accounting defined in this statement had been applied.

Stock options are the most frequently used method in executive long-term incentive grants among top 250 companies. However, other methods are popular as well for executive compensation (see fig. 1 & 2).

FIG. 1 - EXECUTIVE LONG-TERM INCENTIVE GRANT - TYPE USAGE % of TOP 250 COMPANIES

FIG. 2 - EXECUTIVE STOCK OPTION VARIATIONS % of TOP 250 COMPANIES

What are the implications for Managers?

The global discussion around executive compensation had a major impact on the way this is done nowadays compared to threee decades ago. Major changes have been adopted by major corporations which focused on increased corporate responsibility, encapsulating here the responsibility to immediate stakeholders, but also towards the society. Executives and the board of directors were exposed to increased transparency and held accountable easier now than in the past. The current trend aims to reduce the compensation gaps between executive compensation and that of the shareholders, to increase shareholder value and increase corporate performance compared to industry peers. More specifically, the executive compensation packages are a mix of long-term incentives (LTI), which tends to include more and more performance-based packages.

Firstly, executive compensation needs to be incentive enough to attract the right person to lead the company and since the average compensation is high, corporations can't afford to lower it significatly for the simple fact that they would lose valuable leaders to the competition. Secondly, poor performance can't justify a high executive compensation no matter what the perception on the leader's abilities is. Finally, a pure performance-based compensation package can be discouraging for any executives especially in economic recession circumstances. Thus, corporations, executives included need to design a mix of executive compensations that is aligned with everyone's objectives: the shareholders', the executives', the corporation itself and why not the public.

Table 1 displays the pros and cons of three long-term incentive plans including: stock options, restricted stock and performance awards.

TABLE 1 - LONG-TERM INCENTIVES

Stock Options

Restricted Stock

Performance Awards

PROs

Pay-for-performance

Align with shareholders

PROs attraction and retention

Efficient

PROs

Combines pay-for-performance with attraction and retention

Linked to corporate goals

CONs of shares outstanding

Perceived value and the cost attached to it

CONs

No link to pay-for-performance

CONs

Pressure on corporate goals

Too streched goals may reduce attraction and retention

How can this be resolved?

Linking CEO remuneration to company performance is quite a controversial topic and has been building up in the last 30 years. A study made by the Corporate Library (2007) highlights twelve of the largest corporations in U.S., which are characterized by high executive compensation and poor performance over a five-years period. During this whole period, the corporations paid out $865 million to their CEOs who in turn lost about $640 billion in shareholder value. The corporations mentioned in this study include: AT&T, BellSouth, Hewlett-Packard, Home Depot, Lucent Technologies, Merck, Pfizer, Safeway, Time Warner, Verizon Communications and Wal-Mart Stores.

Each of these companies paid its CEO at least $15 million in the two fiscal years available, had a poor performance compared to their competition and had a negative return on stockholders over the studied period.

There has been more concern over the past few years about the link between pay and performance," claims Paul Hodgson, senior research associate at the Corporate Library.

In the past few years, Hodgson says, companies replaced more and more often-controversial stock option programs with restricted stock within their compensation plans. "The problem is that many of the restricted share schemes being used are not designed well. There are too many companies out there that are adopting off-the-shelf versions of the plans without considering what they might do to adapt to their own company's circumstances.

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Hodgson also adds that the most common metric based on which compensation packages should be designed is total stockholder return. Even though that does not take into account how well the company is doing compared to the competition, these don't incur the risk of rewarding executives for losing shareholder value as some companies that base their payouts totally on performance relative their competition, which is also losing shareholder value.

Hodgson also adds that performance-based packages might be more effective if they were based on a mix of relative standard compensation methods and other methods that focus on absolute target.

Wharton accounting proffessor, Wayne Guay agrees that it is worth paying a lot for the best person possible to manage a global company and since the demand is very high that drives up CEO compensation: "Finding an individual to run these companies is extremely difficult," Guay says. "When you are talking about a $50 billion company, if the difference between the best CEO and the second-best CEO changes the value by half a percentage point, the [best CEO] will have justified his pay for his entire career."

SEC accounting rules will come to add more transparency to the value of total compensation packages, option grants in particular, which are a critical element in performance-based pay and bring disclosure to retirement pay.

Performance-linked compensation is also essential for corporate managers, who are in charge of setting the CEO's pay. For example, in 2006 Coca-Cola company said it would cancel managers' pay if the company wouldn't hit its financial targets. The beverage producer would stop paying its current managers in cash, switching to the issuing of $175,000 "equity-share units." The managers would later on be able to trade in those shares for cash in 2009, provided that the company achieves compounded annual growth of 8% in earnings per share between 2006 and 2008.

After all the focus on executive compensations, cutting edge approaches have been adopted by many companies, including caps to several compensation methods and limitations in executive pay.

After United Healthcare's McGuire's options package exceeding the $1 billion mark the SEC started investigating his timing of stock option grants to establish if they were priced on dips in the share price, dips that would inflate his holdings' value. UnitedHealth managers have voted against awarding new stock options to McGuire and other senior executives since that moment. In addition, some companies have adopted a cap for severance payouts, in most cases at shareholders' request. To set an example of corporate responsability, Coca Cola adopted a new policy that states that its stockholders have to approve any executive severance agreements amounting to at least 2.99 times the recipient's annual salary plus bonus. Hewlett-Packard also placed a cap on executive compensation. Nevertheless, the union pension funds sustained that the company violated its own policy when awarding former CEO Carly Fiorina a $42 million retirement package. This Fortune 500 company has a bad history of making high severance payments.

Shirley Westcott, managing director of policy at Proxy Governance, an independent proxy advisory firm in Vienna, Va reckons that another tricky area for executive compensation is 'change-of-control' provisions, which enable the latter to reap significant profits if their company is acquired. Company takeovers can be a profitable business for top officers, regardless if they stay or go. In the last two decades, it has been a common practice for change-of-control provisions known as "golden parachutes" to be contained in executive contracts. These provisions promise to return the CEO, and other top people, three times their pay if the company is subject to a takeover. Some recent cutting edge methods of dealing with increasing executive compensation issues include allowing shareholders to vote on director compensation and compensation committee reports, which apparently is common practice in the U.K. And Australia. Despite the outrage around executive compensation, whopping payouts are often in large corporations as these don't weigh that much to their bottom lines. An example in this direction is Former Exxon CEO Lee Raymond's $400 million package which was awarded by a company with a $400 billion market value.

Finally, one last potential restraint for outrageously outsized CEO compensation may come from the CEOs themselves as one of the reasons generating their value is CEOs comparing their compensations to industry peers and reaching the conclusing that they deserve similar pay. A good example of self-restraint CEO is.....

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