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Executive Compensation: Evolution, Impact & Strategies for Optimal Packages

Delve into the historic development and key factors shaping executives' compensation packages, from agency problems to market-based incentives and equity-linked rewards. Learn about managerial power dynamics, compensation camouflage, and the pursuit of optimal pay structures. Uncover the nuances of stock options, consultancy services, and preferred compensation methods. Explore the complexities of performance targets and the critical role of compensation consultants. This comprehensive overview is informed by academic research and expert insights from leading economists.

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Executive Compensation: Evolution, Impact & Strategies for Optimal Packages

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  1. Executives Compensation Tereza Bůžková Veronika Holá Jakub Mikolášek

  2. Introduction • Historic Development • Optimal contracting x Managerial Power • Types of Compensation • Camouflage • Optimal compensation packages

  3. Historic Development Executive pay relative to average wages in the US

  4. Widening gap-reasons (1) • Share Options – to make managers think like owners – rising bull market increased share value

  5. Widening gap-reasons(2) • Share options • Higher Fluctuation of CEOs – Tendency to search executives outside the company – underbidding

  6. Widening gap-reasons (3) • Share options • Higher fluctuation of CEOs • Increase of average firm’s size – higher responsibility resulting in higher wages

  7. Widening gap-reasons (4) • Share options • Higher fluctuation of CEOs • Increase of average firm’s size • Consultancy services – consultants create compensations packages – companies want to pay their managers at or above average

  8. Theoretical Background • Separation of ownership and control • agency problem Owners Maximize shareholder value Managers –extract high rents –ensure stable income –gain prestige Need for incentives Compensation Packages

  9. Managerial Power Compensation may be influenced by managers Reasons: • BOD election • Directors lack the independent information • Superior insider information • Interpersonal connections

  10. Managerial Power (continued) When it is likely to be high? • Weak or inefficient BOD – BOD is too large – CEO = chairman of the board • No big outside shareholder →No enhanced monitoring or external power • Anti-takeover provisions →The manager’s position more secure

  11. Market-based incentives • Threat of Takeover – in case of substantial underperformance

  12. Market-based incentives FAILURE • Threat of Takeover – Generally very costly – in case of substantial underperformance • Entrenchment – staggered board – poison pills etc… – golden parachutes

  13. Equity-based Incentives Links compensation to performance ≈ stock price • Target equity ownership level • Options

  14. Equity-based Incentives FAILURE Links compensation to performance ≈ stock price – Stock price linked rather with market development • Target equity ownership level – Usually very low requirements – No punishment if breached • Options – No appropriate decrease in cash compensation – Option whirlpool

  15. Careful Manager • Outrage costs –Embarrassment (negative media coverage etc.) –Shareholder disappointment → reduction of salary or firing out or takeover • Compensation Consultants • –underbidding

  16. Preferred Compensation • Direct (cash) compensation → ? Outrage costs ? • Other benefits –(e.g. in UK about 30% of total compensation) • Options – convenient for both s-holders and COE

  17. Preferred Compensation (continued) Camouflage (Stealth Compensation) • Retirement rents • Loans (since 2002 prohibited in US by SOA) – Often forgiven (at least in part) • Goodbye payments –Sometimes beneficial even for s-holders

  18. „Optimal“ Compensation Options • Exercise price indexation • Limited cashing-out Equity • Target ownership plans Performance targets • Compensation linked to adj. Stock price, EPS,…

  19. Sources: Literature: • Bebchuck, L. A., Fried, J. M., (2003):Executive compensation as an Agency problem, The journal of Economic Perspectives, Vol 17, No 3 • Barlett, L.R., Grant, J.H., Miller, T.I., (1999): Personality Differences and Executive Compensation, Eastern Economic Journal, Volume XVI, No. 3, July-September 1999 • Bolton, P., Scheinkman, J., Xiong, W.:Pay for Short Term Performance: Executive Compensation in Speculative Markets, NBER Working Paper Series, Working Paper 12107 • Kubo, K., (2002): The Determinants ot Executive Compensation in Japan and the UK: Agency Hypothesis or Joint Determination Hypothesis?, CEI Working Paper Series, No. 2001-2 • The Economist, January 20th 2007

  20. Still awake? Thank you for attention 

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