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Executive Compensation

Managing Executive Compensation

Chapte r
Managing Executive Compensation
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Executive Compensation

Managing Executive Compensation

MODELS OF EXECUTIVE COMPENSATION

The executive compensation models can be classified as Optimal Contracting and Managerial Power. Organizations enter into employment contracts with executives to minimize agency costs with a view to maximize the net economic value to shareholders less transaction costs and payments to executives. The efficiency of any individual employment contract is difficult to measure and therefore judgments about the efficiency of executive compensation are based on theoretical models of the employment contracting process.

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Executive Compensation

Managing Executive Compensation

CONSIDERATIONS IN EXECUTIVE COMPENSATION

The considerations in executive compensation are as follows: 1. Moral hazard: Moral Hazard problems are common in labour contracting

issues. It is the condition under which the principal cannot be sure if the agent has put forth his best effort. Moral hazard problems can be presented, any time two parties come into a risk sharing agreement with one another, and where their privately taken actions affect the profitability of the total outcome.
2. Incentive contracts: An incentive contract is such that the compensation is structured on the basis of the agent meeting specific incentives targets in the accomplishment of his contract. The purpose of the incentive contracts is

to motivate the agents efforts and discourage the agents inefficiency and waste. A form of incentive contract is a fixed price contract. Cont.
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3.

Executive Compensation

Managing Executive Compensation Increased risk: According to Gray and Cannella (1997), risk is the extent to which there is uncertainty about outcomes. Shareholders manage risk through portfolio diversification while executives do not have that same possibility and therefore, their risk preferences are significantly different.

4.

Option pricing: Option pricing theory, also called Black-Scholes theory,

postulates that the cost of the option can be known in advance by

dynamically hedging the short option while making assumptions on constant volatility and risk neutrality. The risk neutrality assumption is the basis of option-pricing theory and is central to all option-pricing models, including

arbitrage pricing models and Monte Carlo method.

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Executive Compensation

Managing Executive Compensation

SETTING EXECUTIVE COMPENSATION

Adam Smith made a far reaching observation about the agency problem: The directors of such companies, however, being the managers of other peoples money than their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over them. Negligence and profusion, therefore, must always prevail more or less, in the management of the affairs of such a company. Therefore, setting executive compensation is a complex and challenging task. It cannot be set like employees in the organization by deciding upon compensation

level, structure and systems. This is because organizations compensation level,

structure and systems decisions are taken by these executives.
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Executive Compensation

Managing Executive Compensation

Process of Setting Executive Compensation

Board of Director
Shareholders decide compensation of executives

Corporate Governance
Mechanism to scrutinize executive compensation

Setting Executive Compensation

Pay for Performance
To link executive compensation with organizational performance

Market for Managerial Talent

Engagement of compensation consultants 10 6

Government Regulation
U/S 198 of The Companies Act, 1956
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Executive Compensation

Managing Executive Compensation

EXECUTIVE COMPENSATION SYSTEM AND POLICY

The compensation system and policy in respect of executive compensation are as follows: 1. 2. Legal compliance Market position policy

3.
4. 5. 6. 7. 8.
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My compensationmy way
Rand hedging of compensation Compensation committee Compensation governance Compensation mix Retention strategies
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Executive Compensation

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LEGAL ENVIRONMENT OF EXECUTIVE COMPENSATION IN INDIA

Given the nature of executive compensation, various committees have been set up by the government of India to suggest appropriate and effective measures for regulating executive compensation (or managerial remuneration, as mentioned in The Companies Act, 1965). Boothalingam Committee: Compensation differential between lowest and highest salary was in the range of 1:10. Suggested for setting up of 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.
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Executive Compensation

Managing Executive Compensation

Executive Compensation at Infosys Technologies

Particulars of remuneration and other benefits provided to key management personnel (Directors and Statutory Officers) during the year ended March 31, 2007 and 2006 are as follows: Name Salary Contributions to provident & other funds 0.02 0.03 Perquisites and incentives 0.21 0.26 Total remuneration (Rs. In crores) 0.28 0.42

Chairman & Chief Mentor N.R. Narayana Murthy*

0.05 0.13

CEO & MD Nandan M. Nilekani

President, COO & JMD S. Gopalakrishnan

0.14 0.13
0.14 0.13

0.04 0.03
0.04 0.03

0.33 0.25
0.34 0.26

0.51 0.41
0.52 0.42
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Executive Compensation

Managing Executive Compensation

Whole time director K. Dinesh Whole time director S.D. Shibulal Whole time director T.V. Mohandas Pai Whole time director Srinath Batni CFO V. Balakrishnan

0.14 0.13 0.13 0.70 0.24 0.19 0.21 0.17 0.17 0.13

0.04 0.03 0.04 0.01 0.08 0.04 0.06 0.04 0.05 0.03

0.33 0.25 0.29 0.31 0.60 0.53 0.51 0.47 0.56 0.38 0.78 0.54

0.51 0.41 0.46 1.02 0.92 0.76 0.78 0.68

* Whole-time director till August 20, 2006

Source: Infosys Annual Report 200607.

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Managing Executive Compensation

PROBLEMS WITH EXECUTIVE COMPENSATION

Total shareholder return (TSR) and earnings per share (EPS) can become disconnected from intrinsic company value for significant periods of time, are subject to manipulation, do not reflect return on invested capital and can encourage executives to focus on short-term factors at the expense of building long-term value. Stock options and time-vested restricted stock awards do not necessarily create alignment with long-term interests of shareholders and can incentivize executives to pursue risky, short-term strategies, reward them for industrywide or market wide trends unrelated to their own effectiveness and have often been used to merely inflate compensation levels. Executive compensation surveys often do not reflect market compensation levels because of comparability problems in selection of peers and variations in levels of work or executive capabilities between peer group organizations. Money is not necessarily the key driver for executive retention.
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