Comprehensive Guide to Executive Compensation: Theories, Factors, and Models

1. Executive Compensation Professor Srividya Iyengar

2. Coverage • Classification of Executive Compensation • Calibration of Exec. Compensation to Performance • Theories of Exec.Compensation • Principles of Executive Compensation • Factors affecting Executive Compensation • Models of Executive Compensation • Different Criteria for Exec. Compensation • Process of Setting Executive Compensation • Legal Environment for Exec. Comp in India

3. Performance Linked Compensation Base Compensation Classification of Executive Compensation Perquisites Terminal Benefits

4. Calibration of Exec. Compensation to Performance High Pay Low Performance High Low

5. Theories of Executive Compensation • Agency theory, Actions and Model • Tournament theory • Social comparison theory • Balance sheet approach • HQ-based pay • Golden handcuffs • Competency based pay • Golden Parachutes • Cafeteria plan

6. Agency Theory • Principals (shareholder)s are risk neutral or risk averse • Agents (Executives) are risk-averse or risk neutral • Material incentives are necessary and sufficient to motivate executives to work • Higher sum of monetary compensation causes higher executive effort; • The efforts put in by an executive is sometimes difficult to observe i.e., it is not tangible. And intangible efforts are difficult to quantify and reward

7. Sequence of actions Shareholders create a contract having or not the condition of awarding incentives Executives acceptance or non acceptance Shareholders pay for work provided including incentives Executives decide on quantity and quality of work they want Shareholders (through the BOD) evaluate results Executives handle a work

8. ORGANIZATIONAL OUTCOMES AGENCY PROBLEM AGENCY COST • Conflict arising out of separation of Ownership & Management • Interest Divergence: • Shareholder’s self-interest • Executive’s self-interest • Information asymmetry • Moral Hazard • Adverse Selection • Empire Building tendencies • Collusive agreement b/w executive and supervisor / employees • Performance • Risk • Diversification • Acquisition • Sale of Firm • Executive Compensation CONTROL STRUCTURES UPON THE AGENT • Shareholder’s Remedies • Monitoring Incentives • Bonding Writing of contracts Model of Agency Theory

9. Principles of Executive Compensation • Attracting and retaining executive talent • Upholding shareholders interest • Performance based compensation • Effective compensation committee • Executives to shareholders • Compliance of law • Transparent disclosure

10. Factors affecting Executive Compensation Governance Factors Affecting ExecutiveCompensation Changing nature of work Attracting & retaining high performing executives Investors confidence Fostering right executive behaviours Effective benchmarking

11. Models of Executive Compensation • Optimal Contracting Model • EC is designed to reduce agency cost • Market for managerial talent, capital, product and corporate control-preclude executives from earning excessive compensation • Arms length bargaining

12. Contd… • Managerial Power Model • Executive’s ability to manipulate the compensation • Set their compensation as shareholders are diffused and uninterested in corporate governance, generally preferring liquidity to control • Executive have considerable influence including • The power of the CEO over appointment of directors • The ability of the CEO to reward cooperative directors • Social and psychological influences • Cognitive biases of directors tat come from being CEO’s • Time and information barriers most directors face to making an informed and reasoned decision about compensation • Not negotiated at arm’s length

13. Different criteria Exec. Compensation • Strategy • Role or Position • Individual characteristics • Performance • Behaviour • Size • Market • Peer compensation

14. Process of Setting Executive Compensation Board of Directors Shareholders decide EC Setting ExecutiveCompensation Corporate Governance Mechanism to scrutinize EC Pay for Performance To Link EC with organizational performance Government Regulations U/S 198 of The Companies Act 1956 Market for Managerial Talent Engagement of compensation consultants

15. Legal Environment for Exe. Comp in India • Boothalingam Committee • Compensation differential between lowest and highest salary was in the range of 1:10 • Suggested for setting up National Pay Commission for fixing executive compensation • Sachar Committee • Role of government in regulating executive compensation should be reduced • Universal norms to be prescribed for everyone to follow • Shareholders should be taking a decision on executive compensation