Chapter 10

Executive Compensation

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Chapter 10 Executive Compensation

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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

Yes: Wolfson (1985)

Forces of reputation help to motivate manager, but incentive contract still needed Suggests that managerial labour markets do not work fully well See Supp. slides for details

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10.3 The BCE Compensation Plan

Components of senior management compensation
Salary Short-term incentive awards
Cash bonus or deferred share units, based on attainment of financial targets (e.g., EPS ) & new business development, Individual contribution (based on a third performance measure: creativity & initiative)
More suitable for less senior managers?
Continued

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10.3 The BCE Compensation Plan

(continued)

Compensation components, contd.

Stock options, based on share price performance Executives required to hold BCE shares

All compensation components except salary increase alignment

Since investors and managers both want firm to do well

Continued

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10.3 The BCE Compensation Plan

(continued)

Revisions to compensation plan 2004

Mid-term incentive plan (2 year) Reduced stock option awards
Restricted share units instead

Reasons for revisions

To shorten manager decision horizon, but not too short Improve BCE corporate governance credibility

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10.4 Theory of Executive Compensation

Desirable properties of a performance measure
Sensitivity Precision Generally, these properties have to be traded off

Share price
High in sensitivity, low in precision

Net income
Low in sensitivity, high in precision

Continued

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10.4 Theory of Executive Compensation (continued)

How to increase sensitivity of net income
Reduce recognition lag
Net income waits until many aspects of manager effort are realized
R&D, advertising, legal & environmental liabilities Capital expenditure programs

Current value accounting reduces recognition lag

But decreases precision

Continued

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10.4 Theory of Executive Compensation (continued)

How to increase sensitivity of net income, contd.
Full disclosure
More difficult for manager to disguise shirking by earnings management Enables compensation committee to better evaluate earnings persistence

Continued

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10.4 Theory of Executive Compensation (continued)

Two types of manager effort
Short-run Long-run

If net income congruent to payoff, mix of short-run and long-run effort does not matter to investor
Each effort type equally effective in generating payoff

Continued

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10.4 Theory of Executive Compensation (continued)

If net income not congruent to payoff (more likely), effort mix does matter
Firm owner may wish to control managers effort mix (i.e., length of managers decision horizon)

Continued

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10.4 Theory of Executive Compensation (continued)

Controlling length of manager decision horizon
Greater proportion of performance based on share price relative to net income increases long-run effort relative to short-run effort, and vice versa Recall BCE 2004 compensation plan revisions
Why did BCE want to shorten decision horizon?

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10.4.3 The Role of Risk in Executive Compensation

Risk goes both ways
Downside risk: Compensation may be less than expected Upside risk: Compensation may be more than expected

Source of compensation risk

Lower performance measure precision higher risk

Manager must bear some risk to motivate effort

Continued

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10.4.3 The Role of Risk in Executive Compensation (continued)

Too little compensation risk
Reduces effort incentive

Too much compensation risk

Manager avoids risky projects Excessive hedging

Goal is to control compensation risk, not eliminate it

Continued

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10.4.3 The Role of Risk in Executive Compensation (continued)

Controlling compensation risk
Relative Performance Evaluation
Fine in theory, but hard to find in practice

Bogey of compensation plan

Controls downside risk

Cap of compensation plan

Controls upside risk

Role of Board, compensation committee Role of conservative accounting Golden parachutes

Eliminate too much risk?

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10.5 Empirical Compensation Research

Research suggesting efficient contracting
Lambert & Larcker (1987)
Cash compensation (salary + bonus) more highly correlated with ROE than with return on shares Correlation higher as noise in NI lower Correlation lower for growth firms Higher weight on ROE in compensation plan when correlation between ROE and return on shares low, and vice versa

Indjejikian & Nanda (2002) Bushman, Indjejikian & Smith (1996) Baber, Kang & Kumar (1999)

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10.6 Politics Of Executive Compensation

Is executive compensation too high?
If so, suggests inefficient contracting
Jensen & Murphy (1990)
According to authors, not too high, but managers do not bear enough risk--they need to hold more stock

Does executive compensation ignore extraordinary losses?

What about extraordinary gains? Ignoring losses and including gains increases compensation

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Value of Shares and ESOs to Manager Less than Cost to Firm

Manager compensation not as high as some believe
Manager risk averse, cannot diversify share holdings Ability to sell shares and ESOs usually restricted Therefore, shares and ESOs worth less to manager than their expense to firm
Recall expense to firm based on opportunity cost

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10.7 The Power Theory

Power theory disputes efficient contracting version of PAT
Manager uses power in firm opportunistically, to earn more than reservation utility

Opportunism limited by outrage Devices to camouflage excessive compensation

Compensation consultants Peer groups

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The Power Theory in Action

Late timing of ESO awards
Another way to camouflage excessive compensation

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Controlling Excessive Manager Power over Compensation

Good corporate governance needed
Corporate governance helped by full disclosure
To reduce ability of manager to cover up shirking by earnings management To help identify persistent earnings To enable compensation committee to better tie pay to performance To limit excessive compensation by full disclosure of compensation amounts

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Two Roles for Financial Reporting for Executive Compensation

To provide a performance measure for compensation contracts
But must compete with share price

To inform the managerial labour market about manager performance and value
Reputation at least partially motivates effort
Recall Fama/Wolfson arguments

Reputation determines managers reservation utility

Both roles can be accomplished simultaneously

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10.8 Social Significance of WellWorking Managerial Labour Markets

Full disclosure helps the managerial labour market to work well
Managers reservation utility (i.e., managers market value) will then better reflect his/her ability and effort

Well-working managerial labour markets encourage productivity and social welfare

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10.9 Conclusions
Financial accounting-based performance measures are an important input into compensation contracts
Full disclosure helps compensation committees tie pay to performance, control manager power, and increase contract efficiency

Financial accounting-based performance measures can improve the operation of managerial labour markets
Full disclosure improves working of managerial labour market
But not to point where need for an incentive contract is eliminated

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