Chapter 10

Executive Compensation

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Overview• Concept of executive compensation plan (10.1)• Is it necessary? (10.2)• Compensation plan – a real world case (10.3)• Theories (10.4) and empirical evidence (10.5)

supporting efficient contracting on compensation– 10.4.1 Sensitivity vs. Precision – 10.4.3 Controlling compensation risk

• Theories and empirical evidence not supporting efficient contracting on compensation– Politics of executive compensation (10.6)– Power theory (10.7)

• Conclusion (10.8; 10.9) 2

Review of Efficient Contracting Theory

• Agent-Principle Conflict – Managers, like investors, are rational

• Act toward self-interest, risk-averse, effort-averse=> May not have same goals as owners and investors – Describes moral hazard problem of information

asymmetry • Principal wants agent to work hard, but • Principal cannot observe agent effort• Agent may shirk on effort

– If no exams, how hard will students work?– What would owner do in fear of manager shirk? (note

manager efforts and ability are not directly observable)

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What Would Owner Do In Fear of Manager Shirk?

• Not hire the manager• Hire the manager and let it be• Owner rents firm to manager• Monitoring manager effort

– Direct monitoring– Indirect monitoring

• e.g. executive compensation plan

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10.1 Executive Compensation Plan• An executive compensation plan is

– an agency contract between the firm and its manager

– that attempts to align the interests of owners and managers

• to achieve efficient contracting between the two– by basing the manager’s compensation on one

or more measures of the manager’s performance in operating the firm

– Also called incentive contracts

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10.2 Are Incentive Contracts Necessary?

• No: Fama (1980)– Forces of reputation on managerial labour market

enough to motivate manager to work hard– Assumes managerial labour market works well (i.e.

efficient)• Yes: Wolfson (1985)

– Provide empirical evidence that forces of reputation help reduce but do not eliminate manager shirking

• Thus compensation contracts are still needed

– Suggests that managerial labour markets do not work fully well

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10.3 RBC Compensation Plan (2009)- Group Discussion (p.407-408)

1) What consists of compensation in RBC’s plan before proposed change in 2009?

a) For each component of compensation in RBC’s plan, what performance measures and relative performance measures are used? Assess the appropriateness of each performance measure

b) Discuss merits and limitations of the plan

2) What are proposed changes in 2009 to the plan? Why such changes?

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Performance and Relative Performance Measures

• Performance measures– Generally multiple measures– Must be jointly observable – Can be categorized into

• Financial measures– Annual net income growth, ROE, etc.

• Non-financial measures– Internal peer/executive evaluations; personal goals;

management initiatives; etc.

• Relative performance measures– Relative to industry, segment, peer, and

individual performance8

1) Components of Compensation• Salary• Short-term incentives

– Cash – Or if elected, deferred share units

• Provide flexibility to executives to convert short-term incentives to mid-term incentives

• Mid-term incentives– 3-year deferred share units

• Long-term incentives – 10-year ESO, vesting at 25% per year for first 4 years– Must hold specific amount of shares (e.g. shares worth

8 times salary, for the president and CEO) 9

1a) Performance Measures• Short-term

– Business segment• Net income growth, return on equity (ROE)

– Individual bonus• Overall bank and segment performance, relative to targets and

peer group• Non-financial performance measures (personal goals, etc.)

• Mid-term– Share price performance over the previous 3 years,

relative to peer group– Conditioned on achievement of target ROE (20%)

• Long-term– Set share price on the ESO award date (i.e. price at year

0) as exercise price10

Relative Performance Measures

• Adjustable in relative to industry, segment, peer, and individual performance– Median value of a peer group in similar firms– Top third (15% increase) – Bottom third (15% decrease)– etc.

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Discussion: how to decide if a compensation plan is good or bad? Note a compensation contract is a mix of incentive, risk and labor market efficiency considerations, and is subject to mutual agreement Also note a contract may be rigid and incomplete A good plan should consider

– Tradeoff btw precision vs. sensitivity (10.4.1)– Controlling compensation risk (10.4.3)

1b) Merits and Limitations of the Plan

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Limitations of the Plan (Theory in Practice 10.1)

• Share prices do not fully reflect the risk inherent in the firm– Hence may not be an objective performance measure

• Most important firm decisions are made at the top– Lower-level managers who do not make such decisions

suffer form the decline in share value• Competent managers may leave the firm

– If the incentive contract does not or lower its expected utility

• etc.13

• Proposed changes to existing plan– Increase the deferral of bonus payments– Greater weight on individual non-financial

performance measures– Increase required executive stock holdings– Claw back bonus if fraud or misconduct

• Why the changes?– Effect on manager decision horizon

• To have managers focus more on long term

– Effect on manager compensation risk• To better align risk of managers with the firm

2) Proposed Changes to the Plan

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10.4.1 Sensitivity vs. Precision • Share price (as a performance measure)

– High in sensitivity, low in precision• Net income ((as a performance measure)

– Low in sensitivity, high in precision• Sensitivity

– The closer the measure to true manager efforts, the more sensitive the measure is

• Precision– The less noise contained in the measure, the

more precise the measure is15

10.4.1 Sensitivity vs. Precision • How to decide the relative proportion of

net income and stock price in a compensation plan?

• Depends on various factors– Short-term vs. long-term horizon? – Investment opportunities? – etc.

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10.4.1 Sensitivity vs. Precision • How to increase sensitivity of net income

– Reduce recognition lag• Net income “waits” until many aspects of

manager effort are realized– R&D, advertising, environment liabilities

• Current value accounting reduces recognition lag– At the cost of precision

– Full disclosure • More difficult for manager to disguise shirking by

earnings management• Enables compensation committee to better

evaluate earnings persistence17

10.4.3 Controlling Compensation Risk

• Managers are rational– The more risk managers bear on a project, the higher

compensation they expect• Compensation risk

– The risk that the compensation is more or less than expected

– Either way will result in lower manager effort• How to control compensation risk?

– Compensation should be aligned with the actions taken by managers

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Controlling compensation risk• Relative performance evaluation (RPE)

– Whether the manager performance beats industry/peer performance

– Sounds fair but may be sometimes problematic• Bogey/Cap of compensation plan• Role of conservative accounting• Role of Compensation Committee

– Too biased toward managers?• Stock options (ESO)

– No downside risk• Earnings management? 19

10.5 Empirical Compensation Research

• A number of studies provide evidence of efficient contracting– Efficient contracting

• The compensation contract is efficient, i.e. correctly reflects managers’ efforts and controls compensation risks

– Lambert & Larcker (1987), Hemmer and Labro (2009), Banker et al. (2013), etc.

• Counter evidence exist (Section 10.6; 10.7)– e.g. golden parachute; power theory

– 20

10.6 Politics of Executive Compensation

• Is executive compensation too high?• If so, suggests inefficient contracting

– Ignore extraordinary losses (Jensen & Murphy 1990)• Managers do not bear enough risk

– Solution: have managers hold more stock• What about extraordinary gains?

– Golden parachutes• Excessive retirement package

– Power theory (10.7)• Counter-evidence (next slide)

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Is Executive Compensation Too High?

• Counter evidence: Gayle & Miller 2009- Suggests managers are not overpaid- The increased manager compensation is due to

increased firm size and increased compensation risk

• Managers are risk averse, but they cannot diversify share holdings

• Managers’ ability to sell shares and ESOs usually restricted

• Therefore, shares and ESOs worth less to manager than their expense to firm

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10.7 The Power Theory• Power theory disputes efficient contracting

version of PAT– Manager has excessive power in the firm and

uses such power opportunistically, to earn more than reservation utility

– The source of manager power is the ability of the CEO to influence the BODs

• Core, Holthausen and Larcker (1999): the weaker the corporate governance, the more excessive the executive compensation is.

– Devices to camouflage excessive compensation and outrage

• Compensation consultants, peer groups, etc.23

Power Theory (Cont’d)• How to control excessive manager power

over compensation?– Good corporate governance – Full disclosure– Regulation

• Compensation discussion and analysis• Increased disclosures of risk management• Limit tax deductibility of compensation

– Say on pay

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10.8 Managerial Labor Markets

• The social significance of managerial labor markets that work well – Quality of manager effort important to

social welfare• Motivation of effort requires informative

performance measures– Encourages efficient tradeoff between

sensitivity and precision– Encouraged by full disclosure

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10.9 Conclusions• Financial reporting plays two important roles in

motivating manager effort– Provides a performance measure input into

compensation contracts• helps compensation committees tie pay to

performance, control manager power, and increase contract efficiency

– Improves working of managerial labor markets • Full disclosure helps labour market evaluate

manager performance and establish reputation• Motivating manager performance and improving

the working of managerial labor market equally important to social welfare as improving operation of capital market

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