978-1259532726 Chapter 14 Lecture Note Part 1

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CHAPTER FOURTEEN

COMPENSATION OF SPECIAL GROUPS

Overview

This begins the three chapter Part Six – Extending the System. In the prior chapters, the

authors described compensation programs as if they were fairly uniform across all jobs in an

organization. However, a number of employee groups require, because of their importance to

strategic success, special consideration in the way compensation packages are designed. This

chapter focuses on several employee groups that do not fit in the basic model. Their special

employment status dictates the design of compensation policies and practices that often differ

from the more traditional designs presented in the earlier chapters.

The first part of the chapter identifies and describes the unique characteristics that apply to

special groups. The remaining part of the chapter focuses on the key considerations in

designing a compensation strategy for each of the following special groups:

Supervisors

Corporate directors

Executives

Scientists and engineers (professionals)

Sales forces

Contingent workers

The key conflicts faced by each special group are identified, along with the specific nature of

the equity concerns of each group. Based on the conflicts, consideration of equity concerns,

and research evidence, specific compensation practices which are most applicable to each

group are described.

Lecture Outline: Overview of Major Topics

I. Who Are Special Groups?

II. Compensation Strategy for Special Groups

III. Your Turn: A Sports Sales Plan

Learning Objectives

Define the characteristics of special groups and their importance to the organization.

Identify compensation strategies for supervisors, corporate directors and executives

with an emphasis on components of an executive compensation package including base

salary, short-term incentives or bonuses, long-term incentives and capital appreciation

plans, employee benefits, and perquisites.

Discuss executive compensation, distinguishing between the perspectives of the critic,

the press, and the academic.

Understand compensation for other special groups including professionals, sales staff,

and contingent workers.

Lecture Outline: Summary of Key Chapter Points

I. Who Are Special Groups?

Special treatment, either in the form of add-on packages not received by other

employees or in the form of compensation components entirely unique in the

organization, tends to focus on a few specific groups.

Special groups share two characteristics:

oThey tend to be strategically important to a company. If they don’t succeed at

their jobs, success for the whole organization is in jeopardy.

oTheir positions tend to have built-in conflict that arises because different factions

place incompatible demands on members of the group.

Exhibit 14.1 describes the nature of the conflicts faced by such special groups as

supervisors, top management, boards of directors, scientists and engineers, sales

personnel, and contingent workers.

When both the above mentioned characteristics are present, employers tend to

find distinctive compensation practices adopted to meet the needs of these special

groups.

II. Compensation Strategy for Special Groups

A. Supervisors

Supervisors are caught between the demands of upper management to meet

production goals and the needs of employees to receive rewards, reinforcements,

and general counseling.

The major challenge in compensating supervisors centers on equity. Some

incentive must be provided to entice nonexempt employees to accept the

challenges of being a supervisor.

Supervisor jobs often are exempt from overtime pay. If the job requires more than

forty hours of work per week, every extra hour is paid at straight time rather than

time and a half.

Organizations have devised several strategies to attract workers into supervisory

jobs.

oThe most popular method is to key the base salary of supervisors to

some amount exceeding the top-paid subordinate in the unit (5 to 30 percent

represents the typical size of the differential).

oAnother method to maintain equitable differentials is to pay supervisors

for scheduled overtime.

The biggest trend in supervisory compensation centers on increased use of

variable pay. Slightly more than half of all companies now have a variable pay

component for supervisors, up from 16 percent in prior years.

B. Corporate Directors

A board of directors comprises individuals from both inside and outside a firm

who provide strategic advice on decision making.

Most boards have between eight and eleven directors.

Probably due to increased attention to CEO pay and concerns about impartiality,

companies are trying to populate their boards with outside directors. Outside

directors are harder to bring up to speed about a company’s values and

environment, but they are perceived to be less prone to bias than internal

directors.

What used to be a “rubber stamp” process by internal board members beholden to

the CEO is now a highly charged analysis of, among other things, CEO

compensation. There is considerable risk in these jobs. Stockholders are prone to

sue directors when CEOs receive large pay increases despite poor company

performance on key financial measures.

In exchange for assuming this risk, directors are well rewarded, with a typical

member, working 30-40 hours per month, is compensated (median) $240,000.

C. Executives

Every spring when the major business publications announce the top-paid

executives in the country, they spark a flurry of articles detailing stockholder

disgust with CEO pay and vitriolic demands that something be done. Especially

infuriating, stockholders argue, is a reward package worth millions when, by all

financial measures, the company is doing poorly.

Even if the CEO is terminated for poor performance the outcome is often

controversial. Exit compensation, often called “Golden Parachute,” handed over

to the CEOs on termination, is growing at a staggering rate.

The disconnect between pay and performance of the nation’s top executives has

been a source of contention for over 30 years.

Components of an Executive Compensation Package

oThere are five basic elements of most executive compensation packages.

Base salary

Short-term (annual) incentives or bonuses

Long-term incentives and capital appreciation plans

Employee benefits

Perquisites

Because of the changing nature of tax legislation, each of these at one time or

another has received considerable attention in designing executive compensation

packages.

oExhibit 14.2 traces the trend in these components over time.

oExhibit 14.3 shows overall compensation for the top 5 executives in

2014.

Base Salary

oAlthough formalized job evaluation still plays an occasional role in

determining executive base pay, other sources are much more important.

Particularly important is the opinion of a compensation committee, composed

usually of the company’s board of directors or a subset of the board.

oFrequently the compensation committee will take over some of the data

analysis tasks previously performed by the chief personnel officer.

oOne empirical study suggests the most common approach (60 percent of

the cases) of executive compensation committees is to identify major

competitors and set the CEO’s compensation at a level between the best and

worst of these comparison groups.

oWhere pay fell in this range depends on a number of factors. CEOs who

are particularly likely to be raided, according to one study, were more likely to

have higher compensation than peers.

oLarger companies also tended to hit the high end of the compensation

range by selecting “peer companies” to benchmark against that were tilted

towards the high-paying end.

Bonuses

oAnnual bonuses often play a major role in executive compensation and

are primarily designed to motivate better short-term performance.

oOnly 20 years ago, just 36 per cent of companies gave annual bonuses.

Today bonuses are given to 90 percent of executives.

oThough, the portion of executive compensation allotted to bonuses is

smaller this decade than in the past.

oPart of the explanation can be traced to the motivational impact of

bonuses. Bonuses caused CEOs to approve decisions with great short-term

payouts but clear long-term dire consequences. Less of this motivation is

better.

oA second reason for lower portion of pay allocated to bonuses is their

subjectivity. Perhaps to lessen this subjectivity, 65 percent of companies in a

recent survey indicate they are introducing new financial measures for their

annual incentive (bonus) schemes.

oPart of this move is towards new objective measures that account for

different aspects of performance. Some leading companies are linking

executive bonuses to customer satisfaction.

Long-Term Incentive and Capital Appreciation Plans

oBucking a trend toward ever-rising long-term incentives (e.g., stock

options), both the dollar allocation and the portion of dollars allocated to

long-term incentives has been declining recently.

oPart of the reason for the recent decline is the furor over stock options’

tax advantages. In just the last few years companies increasingly have been

pressured to expense stock options in their annual reports, showing

stockholders the real cost of options.

oA second factor is stockholder dismay at the ease with which options are

granted and exercised.

People just went through some of the toughest stock market years in

history, yet many executives in underperforming firms are lined up for

huge incentive payouts. Only public outcry and government intervention

prevented this injustice.

Passage of the 2010 Dodd-Frank Act is one signal that executive

compensation will be monitored closely. This act gives shareholders a

nonbinding vote assessing the fairness of a CEO’s compensation package.

Companies are subjecting their CEOs to increased scrutiny. This means

greater links of stock options to performance by CEOs and their

companies.

oA third reason why traditional stock options may be declining in favor is

linked to recent illegal backdating allegations.

Some companies have been accused of backdating the granting of stock

options to coincide with dates when share prices were particularly low.

When prices rebound, executives profit greatly.

Executive decisions have an important impact on corporate success.

Responsibly linking executive compensation to stock price is a very

effective way to make sure executives are motivated to seek corporate

successes. In comparison, base wages seem like an entitlement.

Bonuses also are flawed. They pay-off for good short-term performance.

What’s good in the short-run isn’t necessarily responsible in the long-term.

Stock options, which typically are vested (meaning they can’t be exercised

for a specified length of time, often three years), have a built–in incentive

for executives to strive for long-term success.

oExhibit 14.4 describes and comments on long-term incentives for

executives.

Executive Benefits

oSince many benefits are tied to income level, executives typically

receive higher benefits than most other exempt employees.

oBeyond the typical benefits, however, many executives also receive

additional life insurance, exclusions from deductibles for health-related costs,

and supplementary pension income exceeding the maximum limits

permissible under ERISA guidelines for qualified (eligible for tax deductions)

pension plans.

oVarious sections of ERISA and the tax code restrict an employers’ ability

to provide benefits for executives that are too far above those of other

workers. The assorted clauses require that a particular benefit plan:

Cover a broad cross-section of employees (generally 80 percent).

Provide definitely determinable benefits

Meet specific vesting and nondiscrimination requirements

Executive Perquisites

oSince 1978, various tax and regulatory agency rulings have slowly been

requiring companies to place a value on perquisites or “perks”.

oExhibit 14.5 shows common perks today in Fortune 100 companies and

provides a loose comparison to perks in general for CEOs in 1990.

D. What’s All the Furor Over Executive Compensation? What the Critics and Press

Say

Empirical data shows CEO pay averages $14.3 million dollars. Many critics feel

that this level of compensation can’t be justified under any circumstances.

Part of the argument includes comparisons to other countries. Wages in the

European Union, for example, are much lower.

oWages plus incentives for French CEOs, the highest-paid EU executives

average about $2 million in a sample of the 300 largest European companies.

oU.K. salaries for CEOs are about one-half that of their American

counterparts, and other European executives fall even further behind.

Some argue that executive compensation reflects changes in the market.

Others argue that maybe executives earn their increases. Increasingly boards are

trying to make this very argument by linking pay to performance.

oLarge pay can then be explained by great company performance. A

typical argument would be as follows:

If the company performance exceeds industry standards, big bonuses and

stock payouts follow. Poor financial performance means much smaller pay

packages.

Exhibit 14.6 gives a brief history of the path executive compensation took to

reach the incredible heights. Pay attention to the way the granting of stock options

has gradually played a bigger role in executive compensation.

The world of compensation is very different in not-for-profit organizations. Top

officers in charities rarely make more than a million dollars a year.

oFurther, a large fraction of total compensation in the not-for-profit arena

—much more than in the private sector—is allocated to expense accounts and

employee benefits.

Some experts today argue that executive compensation could be reined in by

making sure the board of directors has explicit knowledge of how much CEOs

receive each year.

oAlthough it might sound strange but figuring out the worth of

compensation package in any given year isn’t exactly easy.

Only recently have companies started to capture the true value of an entire

compensation package, using a simple tool called a tally sheet.

oA tally sheet gives a comprehensive view on the true value of executive

compensation. It’s a simple concept that is making its way into the executive

board room: Tally up the value of base salary, annual incentives, long-term

incentives, benefits, and perks.

oPart of this process includes estimating the current value of stock options

(using the Black–Scholes model), stock appreciation rights, vested and

unvested pensions, and payouts upon termination.

oExperts argue that a tally sheet gives board members a single figure that

they can then debate over: Is this competitive? Does performance justify this

amount?

An alternative way to rein in executive compensation is to increase government

regulation.

oIn 1992 the Securities and Exchange Commission entered the

controversy. Stockholders are now permitted to propose and vote on limits to

executive compensation. And it appears these votes make a difference.

oOn another front, the 1993 Revenue Reconciliation Act limited employer

deductions for executive compensation to $1 million and capped the amount

of executive compensation used in computing contributions to and benefits

from qualified retirement plans.

oHowever, this very law has set a new standard: many executives who

had been making less that $1 million are finding avenues to rise up to this

amount.

oIronically, this very law may be contributing to the growth of executive

compensation. The $1 million mark now serves as a new standard: Many

executives who had been making less than $1 million are finding their pay

quickly rising to this amount.

One way to answer the question, “Is CEO compensation excessive?” is to look at

the different ways executive compensation is determined and ask, “Does this

seem reasonable?”