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CHAPTER 11
Compensating Executives
Learning Objectives
11-1. Explain the difference between executive pay and pay for nonexecutives.
11-2. Define executive status.
11-3. List the components of executive compensation packages.
11-4. Discuss the principles and processes of setting executive compensation.
11-5. Summarize the executive compensation disclosure rules and the reasons why they have
been established.
11-6. Briefly explain the executive compensation controversy as it relates to whether U.S.
executives are paid too much.
Outline
I. Contrasting Executive Pay with Pay for Nonexecutive Employees
II. Defining Executive Status
III. Executive Compensation Packages
IV. Principles and Processes for Setting Executive Compensation
V. Executive Compensation Disclosure Rules
VI. Executive Compensation: Are U.S. Executives Paid Too Much?
VII. Key Terms
VIII. Discussion Questions and Suggested Answers
IX. End of Chapter Case; Instructor Notes, and Questions and Suggested Student Responses
X. Crunch the Numbers! Questions and Suggested Student Responses
XI. Assisted-graded Questions
XII. Additional Cases from the MyManagementLab Website; Instructor Notes, and Questions
and Suggested Student Responses
Lecture Outline
I. Contrasting Executive Pay with Pay for Nonexecutive Employees
A. Overview
1. CEO is the seller of his/her services and the compensation committee is the buyer
2. Under classic economic theory reasonable price (of goods and services) is
obtained through negotiations with an informed buyer and informed seller) that
are “arm’s length apart”
3. CEO hires a professional compensation consultant to determine own
compensation, however, this can be a conflict of interest
4. Executive pay often contradicts an organizations performance-based pay strategy
as executives are often rewarded even after they fail
II. Defining Executive Status
A. Who are executives?
1. The Internal Revenue Service (IRS) recognizes two groups of employees that play
a major role in a company’s policy decisions
a. Highly compensated employees
b. Key employees
2. The IRS uses “key employees” to determine the necessity of top-heavy provisions
in employer-sponsored qualified retirement plans that cover most nonexecutive
employees
3. The IRS uses “highly compensated employees” for nondiscrimination rules in
employer-sponsored health insurance benefits
B. Key employees
1. At any time during the year must be
a. An officer having annual pay of more than $170,000
b. An individual who for 2015 was either:
i. A 5 percent owner of the company
ii. A 1 percent owner whose annual pay is more than $150,000
C. Highly compensated employees
1. One of the following during the current or preceding year:
a. 5 percent owner
b. For the preceding year, had compensation from the employer in excess of
$120,000 in 2015, and
c. If the employer chooses, was in the top paid group of employees for the
preceding year where top-paid employees are the top 20 percent most highly
compensated
III. Executive Compensation Packages
A. Overview
1. Current or annual core compensation
2. Deferred core compensation: Equity agreements
3. Deferred core compensation: Separation agreements
4. Clawback provisions
5. Employee benefits enhanced protection programs and perquisites
B. Components of Current Core Compensation
1. Base Pay
a. The fixed element of annual cash compensation
b. Companies that use formal salary structures may use pay grades and ranges
for all employees, except for the CEO
c. CEOs are not included in the pay structure because
i. CEO’s work is highly complex and unpredictable and it is not possible to
specify discrete responsibilities and duties
ii. Setting CEO’s compensation differs dramatically from the rational
processes compensation professionals use to build market-competitive pay
structures
d. Base pay represents only a small part of CEO’s total compensation because:
i. It takes years before the fruits of the CEO’s strategic initiatives are realized
ii. The IRS limits the amount of annual salary a company may exclude as a
business expense
2. Bonuses
a. Represent single-pay-for-performance payments used to reward employees for
achievement of specific, exceptional goals
b. Compensation professionals design bonuses for merit pay programs, gain
sharing plans, referral plans, and sales incentive compensation programs
c. Four common bonuses for executives
i. Discretionary bonus
ii. Performance-contingent bonus
iii. Predetermined allocation bonus
iv. Target plan bonus
d. Discretionary bonuses are awarded on an elective basis with the amount based
on four factors:
i. Company profits
ii. The financial condition of company
iii. Business conditions
iv. Future prospects
e. Performance-contingent bonuses are based on attainment of specific
performance criteria
f. Predetermined allocation bonus has a bonus pool based on a fixed-formula
g. Target plan bonus ties bonuses to executive’s performance
3. Short-Term Incentive Compensation
a. Used to recognize executives’ progress toward fulfilling competitive strategy
goals
b. Uses current profit sharing plans and gain sharing plans
c. Designed to reward executives for meeting intermediate performance criteria
that are dictated by competitive strategy, like:
i. Change in company’s earnings per share over a one-year period
ii. Growth in profits
iii. Annual cost savings
d. Usually applies to more than one executive because of the synergy that results
from the efforts
D. Components of Deferred Core Compensation
1. An agreement between an employee and a company to render payments to the
executive at a future date
2. A hallmark of executive compensation packages designed to create a sense of
ownership and align the interests of the executive with those of the owners or
shareholders over the long term
3. Generally two types of plans
a. Equity plans provide an executive with ownership stakes in the company
through a variety of mechanisms, including various stock option plans and
stock purchase plans
b. Separation agreements guarantee that an executive will receive a lucrative
compensation package upon employment termination
E. Equity Agreements
1. Company stock and stock options provide the foundation for equity agreements
2. Stocks:
a. Company stocks represent the total equity of the firm
b. Company stock shares represent equity segments of equal value
c. Equity interest increases positively with the number of stock shares
3. Stock options
a. Incentive stock options entitle executives to purchase stock in the future at a
predetermined price
i. The predetermined price equals the price at the time an executive receives
the stock option
ii. Executives are generally purchasing the stock at a discounted price
iii. Executives generally purchase the stock after the price increases
dramatically
b. Capital gains is the difference between the stock price at the time of purchase
and the lower stock price at the time an executive receives the stock option
c. A capital loss occurs if the stock price at the time of disposition were lower
than at the price of the stock option grant
d. Nonstatutory stock options do not qualify for favorable tax treatment
i. Executives pay income taxes on the difference between the discounted
price and the stock’s fair market value at the time of the stock grant
ii. Executives do not pay taxes in the future when they choose to exercise
their non-statutory stock options
4. Restricted stock plans, restricted stock units, and performance stock awards
a. Restricted stock plans allow a company to grant executives with stock options
at market value or discounted value, or they may provide stock
b. Executives do not have any ownership control over the disposition of the
stock for a vesting period
c. Restricted stock units are shares of company stock that are awarded to
executives at the end of the restriction period
d. Under a performance plan a company chooses to add to the vesting period a
performance criterion for determining whether to award stock options or stock
units
5. Stock appreciation rights
a. Provide executives income at the end of a designated period, like restricted
stock options
b. Executives never have to exercise their stock rights to receive income
c. The company awards executives based on the difference in stock price
between the time the company granted the stock rights at fair market value to
the end of the designated period
6. Phantom stock
a. Boards of directors promise to pay a bonus in the form of the equivalent of
either the value of company shares or the increase in that value over a period
of time
b. Can convert these into real shares, under two conditions:
i. Executives must remain employed for a specific period
ii. Executives must retire from the company
7. Employee stock purchase plans
a. Allows participating employees to purchase stock after a designated period of
time.
b. The span of time over which employees are permitted to contribute to their
accounts is referred to as the offering period
F. Separation Agreements
1. Golden parachutes
a. Provide pay and benefits to executives following their termination resulting
from a change in ownership or corporate takeover, that is, the merger or
combining of two separate companies
b. Boards of directors include these clauses for three reasons:
i. They limit executives’ risks in the event of these events
ii. They promote recruitment and retention of talented executives
iii. To prevent a CEO from working against a takeover bid in order to save his
or her job
c. Companies can treat these as business expenses
2. Platinum parachutes
a. Lucrative awards that compensate departing executives with severance pay,
continuation of company benefits and even stock options
b. Given in order to avoid legal battles or critical press reports
c. Given in the event the CEO is terminated after a period of unsatisfactory
performance as determined by the shareholders and other company executives
G. Clawback provisions
1. Allow boards of directors to take back performance-based compensation if they
were to subsequently learn that performance goals were not actually achieved
2. These provisions are becoming more common:
a. Because of the increasing scrutiny of CEO compensation packages by the
public and shareholders
b. Particularly since the recent global financial crisis in the late 2000s
3. Led to passage of the Sarbanes-Oxley Act of 2002
a. Administered by the SEC
b. Imposes rigorous requirements for companies’ financial disclosure to limit the
chance that covert misuses of corporate funds will occur
H. Employee Benefits: Enhanced Protection Program Benefits and Perquisites
1. Executives receive discretionary benefits like other employees, however, they
differ in two ways:
a. Protection programs include supplemental coverage that provide enhanced
benefit levels
b. The services component contains benefits exclusively for executives called
perquisites or perks
2. Enhanced protection program benefits
a. Supplemental life insurance
i. Pays additional monetary benefits
ii. Provides executives favorable tax treatment
b. Supplemental retirement plans
i. Are designed to restore benefits restricted under qualified plans
ii. Make up the monetary difference between IRS limits and desired
compensation amounts
3. Perquisites
a. Also known as perks, are an integral part of executives’ compensation
b. Four purposes
i. Recognizes the status the executive has achieved
ii. Use for personal comfort or as a business tool
iii. Use of a corporate aircraft could be considered a security measure
iv. Permit executives to have fewer distractions (services such as financial
planning)
c. Many companies have been scaling back offerings
IV. Principles and Processes for Setting Executive Compensation
A. The Key Players in Setting Executive Compensation
1. Executive compensation consultants
a. Propose several recommendations for alternative pay packages that are based
on strategic analysis
b Possible conflict of interest as consultants are hired by CEOs
c. Recommending lucrative packages could bring the consultant or consulting
company more business
2. Board of Directors
a. Supposed to represent shareholders’ interests
b. Most boards contain fifteen members that generally include:
i. CEOs and top executives of other companies
ii. Distinguished community leaders
iii. Well-regarded professionals like physicians or attorneys
iv. Top-level executives of the company
c. Give final approval of the compensation committee’s recommendations
d. Possible conflict of interest as CEO’s recommend Board members and the
Board members receive compensation for serving
e. SEC rulings and the passage of the Dodd-Franc Act have increased the
transparency of how executives are compensated as well as board members’
accountability for approving sound executive compensation packages—
supportive of shareholders’ best interests
3. The compensation committee
a. Is comprised by Board of Directors members
b. Inside company board members
c. Outside board members
i. Help to minimize conflicts of interest
ii. Make up the majority of most committees
d. Perform three duties:
i. Review consultants’ alternative recommendations
ii. Discuss the assets and liabilities of each recommendation
iii. Recommend the best proposal to the board of directors to consider
B. Theoretical Explanations for Setting Executive Compensation
1. Agency theory
a. Ownership is distributed among thousands of shareholders in large companies
b. Shareholders delegate control to top executives
c. Agency problem exists because executives may pursue activities that may
benefit themselves instead of shareholders
2. Tournament theory
a. Casts lucrative executive compensation as the prize in a series of tournaments
among middle- and top-level managers who aspire to become a CEO
b. Winners at one level enter into the next level
c. Chances of winning decrease dramatically as winners rise through the ranks
3. Social comparison theory
a. Individuals compare themselves to individuals of similar or greater stature
b. Demographics and occupation are common comparative bases
c. CEOs on compensation committees might rely on their own compensation
packages and those of other compensation CEOs of equal or greater stature to
determine executive compensation
V. Executive Compensation Disclosure Rules
A. Securities and Exchange Act of 1934
1. The Securities and Exchange Commission (SEC) requires companies that sell and
exchange securities (i.e., stocks, bonds) to file a wide variety of information
including executive compensation practices
2. The Securities Exchange Act of 1934 applies to the disclosure of executive
compensation
a. Companies are required to file Form 10-K which contains a detailed picture of
a company’s business, the risks it faces, and the operating and financial results
for the fiscal year
b. Companies are required to complete a Definitive Proxy statement that reveals
detailed information about the compensation of the CEO and Named
Executive Officers (NEO)
i. NEOs are generally the four most highly compensated officer after the
CEO
c. Compensation Discussion and Analysis is the narrative report that presents and
unambiguous explanation of all executive compensation information
contained in the tables
3. In 2008, the SEC unveiled additional rules for disclosing executive compensation
that require companies to reveal how much executives are paid making previously
hard-to-find information as such as pension and estimated severance package
totals, transparent
4. In 2009, the SEC Chairperson announced that the Commission would consider
further changes in the disclosure of executive compensation in a company’s
summary compensation table pertaining to the reported value of stock options and
stock rewards
B. Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act)
1. Enacted to further enhance the transparency of executive compensation practices
2. Commonly referenced to as the Dodd-Frank Act, requires four provisions for
companies that trade stock on public exchanges:
a. Requires say on pay that gives company shareholders the right to vote yes or
no on executive compensation proposals
b. Details independence requirements for compensation committee members and
their advisors (e.g., compensation consultants and legal counsel)
c. Requires that companies disclose the circumstances under which an executive
would benefit from a golden parachute agreement
d. Requires companies to report the ratio of CEO compensation to the median
compensation of its employees in SEC filings
VI. Executive Compensation: Are U.S. Executives Paid Too Much?
A. Comparison between Executive Compensation and Compensation for Other Worker
Groups
1. Median annual earnings for all civilian U.S. workers was $47,320 in 2014
a. Least paid nonexecutive—fast food cooks at $19,480
b. Highest paid nonexecutive—anesthesiologists at $246,320
2. Wall Street Journal/Hay Group survey reports average annual total compensation
amounts for CEO’s at $11.4 million
B. Strategic Questions: Is Pay for Performance?
1. A simple statement cannot be made about the relationship between CEO pay and
company performance because of mixed evidence
2. Shareholder returns most often describe company performance, but there are
complex forces beyond the control of CEOs that may influence shareholder
returns
C. Ethical Considerations: Is Executive Compensation Fair?
1. Attract and retain top executives
a. The Board of Directors and compensation professionals believe lucrative
compensation for top executives is vital
b. Many CEOs are recruited from other organizations
2. Income disparities
a. Typical CEO salaries are nearly 180 times more than the typical fast food
cook’s pay, and approximately 15 times greater than the typical
anesthesiologist’s annual pay
b. Labor unions argue that substantial pay discrepancies are socially unjust and
promote economic inequality
3. Layoffs borne by workers but not executives
a. Between late 2008 and mid 2009 alone, more than two million employees lost
their jobs while a scant few executives lost theirs
D. International Competitiveness
1. Has forced companies to
a. Become more productive
b. Consider the competitive impact of the vast differences in compensation
levels between the CEOs of US and foreign companies
2. International compensation comparisons
a. Difficult to make comparisons because foreign countries do not require same
disclosure rules as SEC
b. However, research has shown that U.S. CEO’s make upwards of 300 percent
more than their counterparts in other countries
c. Variance in how much of total compensation is salary
3. Undermining U.S. companies’ ability to compete
a. No evidence the high U.S. executive compensation practices have undermined
efforts to compete internationally
b. However, massive U.S. worker layoffs might
i. Heightens workers’ job insecurities
ii. Workers may lose faith in pay-for-performance system
End of Chapter
VII. Key Terms
Key employee: Defined by the Internal Revenue Code to determine the necessity of top-heavy
provisions in employer-sponsored qualified retirement plans that cover most nonexecutive
employees
Highly compensated employee: Defined by the Internal Revenue Code for nondiscrimination
rules in employer-sponsored health insurance benefits
Discretionary bonuses: Boards award these bonuses to executives on an elective basis
Performance-contingent bonuses: Bonus paid based on the attainment of specific performance
criteria
Predetermined allocation bonus: The total bonus pool for the is based on a fixed formula
Target plan bonus: Ties bonuses to executives’ performance
Equity plans: Provides an executive with ownership stakes in the company through a variety of
mechanisms, including various stock option plans and stock purchase plans
Separation agreements: Guarantee that an executive will receive a lucrative compensation
package upon employment termination
Deferred compensation: An agreement between an employee and a company to render
payments to an executive at a future date
Company stock: Represents total equity of the firm
Company stock shares: Represent equity segments of equal value
Incentive stock options: Entitle executives to purchase their companies’ stock in the future at a
predetermined price
Capital gains: The difference between the stock price at the time of purchase and the lower
stock price at the time an executive receives the stock option
Capital loss: If the stock price at the time of disposition were lower than at the price of the
stock option grant
Nonstatutory stock options: Do not qualify for favorable tax treatment
Restricted stock plans: Under these plans, the company may grant executives with stock
options at market value or discounted value, or they may provide stock
Restricted stock units: Shares of company stock that are awarded to executives at the end of
the restriction period
Performance plan: A vesting period that includes performance criterion for determining
whether to award stock options or stock units
Stock appreciation rights: Provide executives income at the end of a designated period, much
like restricted stock options; however, executives never have to exercise their stock rights to
receive income
Phantom stock: A compensation arrangement whereby boards of directors promise to pay a
bonus in the form of the equivalent of either the value of company shares or the increase in that
value over a period of time
Offering period: The span of time over which employees are permitted to contribute to their
accounts
Golden parachutes: Provide pay and benefits to executives after a termination that results from
a change in ownership or corporate takeover, that is, the merger or combining of two separate
companies
Platinum parachutes: Lucrative awards that compensate departing executives with severance
pay, continuation of company benefits, and even stock option
Sarbanes-Oxley Act of 2002: Mandates a number of reforms to enhance corporate
responsibility, enhance financial disclosures, and combat corporate and accounting fraud
Perquisites: Exclusive executive benefits
Perks: Exclusive executive benefits
Supplemental life insurance: Plans that increase the benefit to designated beneficiaries upon
death and provides executives with favorable tax treatments
Supplemental retirement plans: Designed to restore benefits restricted under qualified plans
Executive compensation consultants: employed by large consulting firms that specialize in
executive compensation or advise company management on a wide variety of business issues.
Board of directors: Represents shareholders’ interests by weighing the pros and cons of top
executives’ decisions
Compensation committee: Made up of board of directors members within and outside the
company
Agency theory: Shareholders delegate control to top executives to represent their ownership
interests
Agency problem: Actions of executives on behalf of their own self-interest
Tournament theory: Casts lucrative executive compensation as the prize in a series of
tournaments or contests among middle- and top-level managers who aspire to become CEOs
Social comparison theory: Individuals need to evaluate their accomplishments, and they do so
by comparing themselves to similar individuals
Securities and Exchange Commission (SEC): A nonpartisan, quasi-judicial federal
government agency with responsibility for administering federal securities laws
Securities Exchange Act of 1934: Applies to the disclosure of important company financial
information as well as information about executive compensation practices
Definitive Proxy Statement: Reveals detailed information about the compensation of the CEO
and Named Executive Officers (NEOs)
Named Executive Officers (NEO): Generally are the four most highly compensated officers
after the CEO
Compensation Discussion and Analysis (CD&A):
Wall Street Reform and Consumer Protection Act of 2010: Law to further enhance the
transparency of executive compensation practices
Dodd-Frank Act: What the Wall Street Reform and Consumer Protection Act of 2010 is
commonly known as
Say on pay: Gives company shareholders the right to vote yes or no on executive compensation
proposals that are contained in proxy statements, including current and deferred components and
golden parachute agreements
