14 – 1 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich
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
Chapter 15 looks at compensation in unionized firms. As we see, the role of a compensation
person in a unionized organization is different. In the final extension of the system, Chapter
16, the authors focuses on international employees. If we are truly to embrace the
globalization of business, the globalization of compensation must be a key ingredient.
The first part of this 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
Learning Objectives
• Define the characteristics of special groups and their importance to the organization.
• Identify compensation strategies for supervisors, corporate directors and executives
Chapter Fourteen: Compensation of Special Groups 14 – 2
Lecture Outline: Overview of Major Topics
I. Who Are Special Groups?
II. Compensation Strategy for Special Groups
A. Supervisors
B. Corporate Directors
C. Executives
D. Why is Everyone So Interested in Executive Compensation? And…Some Different
Perspectives
E. Scientists and Engineers in High-Technology Industries
F. Sales Forces
G. Contingent Workers
III. Your Turn: A Sports Sales Plan
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Lecture Outline: Summary of Key Chapter Points
I. Who Are Special Groups?
• Special treatment,
o either in the form of add-on packages not received by other employees, or
• Special groups share two characteristics:
o They tend to be strategically important to a company.
▪ If they don’t succeed at their jobs, success for the whole organization is in
• 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.
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.
• Supervisor jobs often are exempt from overtime pay.
• Organizations have devised several strategies to attract workers into supervisory
jobs.
o The most popular method is to key the base salary of supervisors to some
Chapter Fourteen: Compensation of Special Groups 14 – 4
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variable pay. Slightly more than half of all companies now have a variable pay
component for supervisors, up from 16% 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.
o 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.
o Outside directors are harder to bring up to speed about a company’s values
• In exchange for assuming this risk, directors are well rewarded, with a typical
member, working 30-40 hours per month, is compensated (median) $260,000.
C. Executives
• In the 500 largest companies in the U.S., the average pay for the chief executive
officer (CEO) is $12.7 million.
o As Exhibit 14.2 shows, the highest paid executives make much more.
• CEO pay is larger in large companies.
o When comparing S&P 500 companies to S&P SmallCap 600 (companies
having market capitalization of $450 million to $2.1 billion)
o CEO pay to median employee compensation (in the same firm) is larger in
• How do Americans feel about these CEO pay levels and how much CEOs make
relative to other employees (the CEO pay ratio)?
o One broad survey reported 74% of respondents said CEOs were overpaid.
14 – 5 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich
o The median respondent believed the CEO should make no more than 6 times
more than the average worker.
• These results capture the wide divergence of opinion on CEO pay.
o There is no right or wrong answer to how much CEOs should get paid or how
much they should get paid relative to the average worker. It comes down to:
o There is a need to align CEO pay with company performance.
• Research suggests that while there a few cases of CEO pay gone bad, on the
whole, CEO pay and company performance are strongly aligned.
o The pay-performance relationship for CEOs is often not studied in an optimal
manner.
o After correcting these and other issues, the authors found strong positive
relationships between CEO return and the total shareholder return.
• There is a legitimate concern with how the structure of CEO compensation can
sometimes contribute to CEOs engaging in behaviors that can have very negative
consequences.
o For example, heavy use of bonuses and stock-based compensation may result
in executives taking too large of risks, especially with other people’s money.
Consumer Protection Act, which states as its purpose:
▪ To promote the financial stability of the United States by improving
accountability and transparency in the financial system.
▪ To end “too big to fail.”
Chapter Fourteen: Compensation of Special Groups 14 – 6
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▪ To protect the American taxpayer by ending bailouts.
▪ To protect consumers from abusive financial services practices.
▪ And for other purposes.
• Let’s return to the argument that CEO compensation is not aligned with/related to
company performance.
o In some cases, what looks like a lack of alignment probably is not.
▪ In 2005, Capital One shareholders earned a one-year return of 2.7%, and
over five years, earned a return of 5.8%.
▪ A survey reported that Richard Fairbank, the CEO, received $249.3
million in total direct compensation in 2005.
• Has anyone actually asked shareholders whether they approve of how much
executives running their companies get paid?
o Yes. Another provision of the Dodd-Frank Act is a requirement that
shareholders vote to approve or disapprove (at least every three years) the
company’s proposed compensation plan for its five highest paid executives.
▪ The vote is nonbinding.
▪ Exhibit 14.4 reports the results of shareholder votes from 2011-2018.
• Even though the required vote is non-binding, most companies view a no-vote as
a public relations disaster.
o The small percentage that don’t pass the “say on pay” vote, most often
overhaul their system to obtain stockholder approval.
o Exceptions are sometimes companies still run by their founders, such as
Oracle, whose founder, Larry Ellison, is chairman of the Board of Directors.
▪ Oracle has lost their say on pay votes for all six years in a row.
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▪ Recent executive compensation changes at Oracle include the cutting of
executive long-term equity grants and freezing of new grants.
▪ New grants will only vest if the company meets share price, market
capitalization, and operational goals.
• The Institutional Shareholder Services (ISS) recommends approval of the say on
pay vote roughly 90% of the time.
o When ISS recommends approval, say on pay vote approval occurs 94% of the
time.
o When ISS recommends against approval, shareholder say on pay vote
approval occurs only about 64% of the time.
o ISS uses three dimension to evaluate company executive compensation plans.
▪ Pay for performance.
• ISS uses both qualitative and quantitative measures.
▪ Problematic pay practices.
• Exhibit 14.5 shows some of the most serious examples of problematic
▪ Compensation committee communication and responsiveness.
• This refers to how the compensation committee responds (by
modifying the executive pay plan) to say on pay votes where there is
less than 70% support.
Components of an Executive Compensation Package
o There are five basic elements of most executive compensation packages.
▪ Base salary
o Exhibit 14.6 shows total CEO compensation, which includes all five
components, over time.
▪ This reports the first three components of CEO compensation separately.
Chapter Fourteen: Compensation of Special Groups 14 – 8
• This suggests that CEO pay must be linked to short-term and long-
term company performance, usually defined in terms of profitability
o Exhibit 14.6 also shows average weekly earnings of production and
nonsupervisory workers in all companies (not just the 500 largest) and the
ratio of CEO pay (in the largest 500) to worker pay.
▪ As such, the ratio of 302 is a bit of an “apples and oranges” comparison as
Base Salary
o Although 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.
o One empirical study suggests the most common approach (60% 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.
▪ Where pay fell in this range depends on a number of factors.
Annual Incentive Plan / Bonuses
o Annual (short-term) incentive plans, or bonuses play a major role in executive
compensation and are primarily designed to motivate better short-term
performance.
▪ Only 20 years ago, just 36% of companies gave annual bonuses.
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▪ They report that 83% use a non-discretionary plan, all using one or more
financial measures.
• The most commonly used financial measures were
o Profit at 92%.
• Non-financial measures were used in 52% of these plans.
o 42% were strategic measures such as safety, customer service,
• When determining payout amounts, financial measures on average
carry a weight of 82%, compared to 18% for non-financial.
o As Exhibit 14.6 shows, from 1990 onward, bonuses have become a smaller
portion of executive compensation.
▪ One explanation is the shift in the time horizon that companies want
executives to focus on.
• Bonuses are short-term incentives and they reward good short-term
results.
o Although companies have many common performance measures in their
annual incentive plans, they typically tailor these to their own objectives and
strategies.
▪ Exhibit 14.7 draws on the proxy Ford filed with the SEC, and shows
Ford’s (non-discretionary) annual incentive bonus plan for its top five
executives determines payouts using the following performance measures
(and weights):
• Revenue (20%)
• Operating margin (30%)
▪ Exhibit 14.8 provides more detail on the quality part of Ford’s annual
incentive, showing that it is a composite of three equally weighted
measures: Industry data on “things that go wrong” and customer
satisfaction, as well as Ford’s own warranty spend.
Chapter Fourteen: Compensation of Special Groups 14 – 10
Long-Term Incentive
o Long-term incentive plans assess performance over a period longer than one
year.
▪ Exhibit 14.9 provides a detailed classification of long-term incentive
plans.
▪ Exhibit 14.10 shows the FW Cook three-part classification of stock
options/stock appreciation rights (SAR), restricted stock, and performance
awards.
• This shows performance awards are the most used long-term incentive
o The authors note that FW Cook data from 2008 showed that 79% of
companies used stock options/SAR at that time.
▪ The drop of 20 percentage points since then is due to bodies such as ISS
taking the stance that service-vesting stock options are not performance-
based equity.
▪ And the change in accounting treatment of stock options from “intrinsic
value” to “fair value.”
• Under the former intrinsic value standard, compensation expense was
zero at the time of the stock option grant as long as the stock price and
option/exercise/strike price as equal at the time of the grant.
• With the change to fair value, stock options must be taken as an
expense at the time they are granted.
o How does a stock option work? Briefly.
▪ Consider an employee at a company with a current stock price of
$50/share.
▪ If the employee chooses to exercise their right to 100 shares at $50 a
share, they would save $1,000.
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and worthless until stock prices rise again.
o This brings up the question of how to compute the value of a stock option.
▪ The most rigorous approach is to use an options pricing model such as
Black-Scholes.
▪ Here, the text provides a demonstration of some basic properties of the
Black-Scholes options pricing model.
• Exhibit 14.11 shows the impact of two parameters on option value,
expressed here as percentage of the stock price.
o First, the higher the volatility, the better.
o Second, the lower the dividend rate, the greater the Black-Scholes
value of an option.
▪ Returns to shareholders for their investment takes the form of
either dividends or price appreciation (an increase in stock
price).
o To use Exhibit 14.11, let’s again take the example of an employee
who receives 100 stock options with an option price of $50/share.
o One concern with stock options is that they sometimes do not link as closely
as desired to performance of the executive.
▪ In a rising market where everyone’s stock is going up, executives can
exercise options at much higher prices than the initial grant price.
▪ In a falling market, stock options are under water
• One response by the corporate compensation committee is to issue
new stock options with a lower exercise price.
▪ A final reason for the concern about stock options as an incentive tool is
the ability to “game the system.”
o Whatever the challenges in paying them, executive decisions have an
important impact on corporate success.
▪ Linking executive compensation to stock price is an effective way to
motivate executives to seek corporate success.
Chapter Fourteen: Compensation of Special Groups 14 – 12
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▪ In comparison, base wages seems like an entitlement.
▪ Annual, short-term bonuses or incentives are not adequate alone as short-
term success is not necessarily good for the company in the long run.
o Performance awards are now the most important long-term incentive program.
▪ Returning to the survey of corporate directors, when asked to choose the
single best metric to measure company performance:
• 40% chose total shareholder return
▪ FW Cook also provides data on the most frequently used performance
metrics under performance share plans, see Exhibit 14.12.
• It shows that TSR is the most common performance measure and note
that it is typically used in a relative manner.
o The executive is evaluated on whether the firm’s TSR is better
than that of competitors.
Executive Benefits
o Since many benefits are tied to income level, executives typically receive
higher benefits than most other exempt employees.
▪ Beyond the typical benefits, many executives also receive
• Additional life insurance
o Various 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:
o Cover a broad cross-section of employees (generally 80%).
Executive Perquisites
o Since 1978, various tax and regulatory agency rulings have slowly been
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requiring companies to place a value on perquisites or “perks.”
▪ Examples of interesting perks:
• 7% of Fortune 500 firms give cash allowances, averaging $32,000.
o Ken Chenault, CEO of American Express, gets $21 million in
salary but still needs a $35,000 allowance for incidentals?
o Or Paul Murray, CEO of Calvin Klein needs a $20,000 clothing
allowance?
• S.L. Green Realty spent $51,882 on a personal car for Chairman
Stephen Green – plus another $119,050 for a chauffeur.
o That works out to $468 a day, enough to drive 233 miles a day for
a year in a New York City cab.
• When Dennis Kozlowski’s second wife hit the magic age of 40 in
o Exhibit 14.13 shows common perks today in the S&P 500.
D. Why is Everyone So Interested in Executive Compensation? And…Some
Different Perspectives
• One issue has to do with income inequality in the U.S. and other countries.
o Should anyone get paid so much if others in society are earning so little they
cannot get by?
• Another perspective is that executive pay in almost every other country,
• Why do executive pay committees recommend the amount and manner of
executive pay?
o The most basic reason is that the committee and the Board are responsible for
representing shareholder interests.
▪ While CEO pay is a major cost to shareholders, it pales in comparison he
difference in shareholder return that can come from having a high
performing versus low performing CEO.
Chapter Fourteen: Compensation of Special Groups 14 – 14
o Related to this, an argument could be that executive compensation reflects
changes in the market.
▪ Yes, executive pay has risen dramatically since 1990, but so has the pay of
other groups.
• Hedge fund, private equity, and venture capital investors have had fee
increases multiply by a factor of 5-10 times what they were in the
period 1994-2005.
• Compare this, supporters say, to the increase in CEO pay during the
same period – a multiplier of 4-5.
▪ Many critics don’t buy these arguments but there is still strong evidence of
a strong pay-for-performance link in the pay of executives.
• How did executive pay get to where it is today?
• One explanation for the high pay of executives involves social comparisons.
o In this view, executive salaries bear a consistent relative relationship to
compensation of lower-level employees.
o Criticism of this theory – and criticism of executive pay in general – is the
gradual increase in the spread between executives’ compensation and the
average salaries of the people they employ.
• A second approach to understanding executive compensation focuses less on the
difference in wages between executive and other jobs and more on explaining the
14 – 15 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich
level of executive wages.
o The premise in this economic approach is that the worth of CEOs, or their
subordinates, should correspond closely to some measure of company success,
such as profitability or sales or firm size.
▪ A different economic perspective looks at labor markets – CEO salaries
are strongly influenced by labor markets, competitor pay levels matter.
• CEOs who are in demand are more likely to receive higher wages, or
have pay tied less to annual performance.
• Some research suggests taking into account environmental performance and
social responsibility when measuring company value.
o One study found the environmental performance (such as pollution
prevention) is an important determinant of CEO pay in polluting industries.
o Two other studies combined both social comparison and economic
explanations to try to better understand CEO salaries.
▪ Size and profitability affected level of compensation, but so did social
comparisons.
• A third view of CEO salaries, called agency theory, incorporates the political
motivations that are an inevitable part of the corporate world.
o Sometimes, this argument runs, CEOs make decisions that aren’t in the
economic best interest of the firm and its shareholders.
o A new variant on agency theory, called behavioral agency theory, suggests