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Compensating Executives: Short and Long Term Incentives

Compensating Executives: Short and Long Term Incentives. Jayendra Rimal. Introduction.

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Compensating Executives: Short and Long Term Incentives

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  1. Compensating Executives: Short and Long Term Incentives Jayendra Rimal

  2. Introduction • In the wake of financial scandals involving major companies like Enron and WorldCom (especially their inflated accounting) there has been discussion about the compensation received by senior executives as much of the pay was tied to stock options. The American executive has been infamous for receiving compensation that are rather high by other standards. • On the other hand the proponents of high compensation packages state that these are needed and useful to attract and retain top management personnel of outstanding ability and to encourage excellence in the performance of individual responsibilities. It is claimed that these highly paid executives are responsible to the continuing rise and in the success and worth of US companies.

  3. Who are the Executives? Although executives in the US have been defined by the IRS for tax purposes, they seem to hold positions of substantial responsibilities. There are two types: • Key Employees: These are employees who at any time during the current year are: • Having an annual compensation greater than $130,000 • A 5% owner of the company or • A 1% owner having an annual compensation from the employer of more than $150,000. • Highly compensated employees: If during the current year or preceding year, the employee was: • A 5% owner at any time • For the preceding year had compensation from the employer in excess of $80,000 and • Was in the top-paid group of employees for the preceeding year

  4. Executive Compensation Packages Executive compensation has both core and fringe compensation elements. Different from other pay packages, these emphasize long-term or deferred rewards over short-term rewards. Main components are: • Current or annual core compensation • Deferred core compensation: stock compensation • Deferred core compensation: golden parachute • Fringe compensation: enhanced protection programme benefits and perquisites

  5. Components of Current Core Compensation Normally core compensation packages contain two components – annual base pay and bonuses. In the US the top 20 paid CEOs received an approximate average pay of $5.6 million, the level of which has dropped in recent years. • Base pay: This is the fixed element of the annual cash compensation. These may have specific pay grades and pay ranges. Larger range spreads to highly paid grades as the specialized skills associated with higher pay grades are considered valuable. But the CEOs do not fall under formal pay structure as their work is highly unpredictable and complex . • Bonuses: These represent single pay-for-performance payments companies use to reward employees. Some types: • Discretionary bonus • Performance-contingent bonus • Predetermined allocation bonus • Target plan bonus

  6. Components of Deferred Core Compensation • Stock Compensation: This refers to an agreement between an employee and a company to render payments to an employee as a future date. This is supposed to create a sense of ownership aligning the interests of the executive to that of the owners or shareholders. Different types of Company stocks shares are usually provided. • Golden Parachutes: This provided pay and benefits after a termination resulting from a change in ownership or a corporate takeover. This limits the executives risks in the event of unforeseen events and promotes recruitment and retention of talented executives.

  7. Fringe Compensation: Enhanced Protection Programmes Benefits and Perquisites Unlike other employees, compensation protection programmes for executives includes enhanced benefit levels and this component contains benefits exclusively for executives. • Enhanced protection programme benefits: Supplemental life insurance and supplemental executive retirement plans are programs that are different from other employees. • Perquisites: These are integral part of executive compensation and cover benefits from free lunches to free use of corporate jets. These recognize attained status and using perks for personal comfort or as a business tool.

  8. Principles and Processes for Setting Exec Compensation Theoretical Explanations for Setting Executive Compensation: • Agency Theory: Shareholders delegate control to top executives to represent their ownership interests. However executives usually do not own majority shares as a result executives work on behalf of their self-interests for short-term gains at the expense of long-term gains: agency problems • Tournament Theory: This provides lucrative executive compensation as the prize in a series of tournaments or contests among middle and top level managers who aspire to become CEO. Each promotion is a win. • Social Comparison Theory: Individuals need to evaluate their accomplishments and do so by comparing themselves to similar individuals. Demographic characteristics and occupation are common comparative bases.

  9. Any questions?

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