In light of the recent financial crisis and “Great Recession,” CEO and executive compensation schemes have come under fire by employees, investors, and the United States Government. Businesses and more specifically, financial firms, assumed high levels of leverage and risk, and over the past two years have reported massive and mounting financial losses as a result of poor investment decisions. Yet, amid these losses, company executives and CEOs have still experienced large bonuses and compensation packages, much to the chagrin of shareholders, laid off employees, and even the U.S. government. This has led boards of directors, policymakers, and investors of all types to question how CEO compensation packages should be structured. The focus is currently on c-suite executives at banking and financial institutions, whereas in the past it has been on other types of companies, such as automobile manufacturers, and in the future it will be on another industry experiencing losses with highly paid CEOs. However, while I cannot offer an end-all, be-all answer or a definitive formula to calculate how exactly to compensate CEOs, I will put forth in this paper the optimal pay strategy that will serve the best interests of the company, its employees, and its shareholders. To maximally incentivize and obtain the best possible performance from its CEO, companies should utilize a compensation structure that is cash-based, low salary-high bonus, and involves only a preset salary and no preset bonus figures or benchmarks. Furthermore, total compensation and year-end bonuses should be decided upon by utilizing a high degree of managerial discretion.
To begin the discussion, it is best to take a step back and actually visit what it is exactly a company seeks to extract from its CEO and what it is the CEO demands in return. The CEO oversees the entire operations of a company, putting the final stamp of approval on the company’s major investment and business decisions. These decisions are made with the intention of generating revenue, profit, and ultimately creating value for distribution to company investors, shareholders, and employees. In return, the CEO demands compensation for his or her time, effort, and results, essentially earning a piece of the created value pie. The question of how this piece of the pie should be composed to yield the maximum overall size of the pie is what requires discussion.
Contrary to widespread practice today, compensation packages should be paid in cash, rather than equity. Common equity-based pay devices include shares of stock, stock options, and warrants. The salary and bonus paid to a CEO should be cash-based, where the salary is paid in cash periodically throughout the year, and the bonus is paid in cash at the time the compensation decision is made. Indeed, research shows that companies exhibiting sustained earnings over time tend to compensate their executives more with cash than equity (#1). Nonetheless, in nearly every Fortune 1000 company, CEOs receive a significant portion of their total compensation from equity-based pay. The problems associated with this type of pay structure and the specific case for cash over equity is best made by pointing out of the shortfalls of equity-based pay and the issues they create.
Equity, and more specifically, stock option compensation allows the CEO to personally profit from inside information, which could very well cause outside investors and the company itself to lose. As a CEO accumulates ownership and shares of stock in a firm, he or she will rationally elect to exercise stock options and sell shares of stock to yield the highest possible profit. Typically, this will occur at a point in time when the CEO believes the company’s stock price to be at a high – in other words, the CEO expects poorer performance going forward and wants to cash out while the company is hot. By selling shares or exercising options, the CEO is indirectly communicating his or her expectation of weaker future performance; the investment community picks up on this and reacts by selling shares and taking similar bearish positions on the company’s stock. Studies have shown that large option exercises typically occur after abnormally positive earnings performance, and post-exercise, the company tends to perform more poorly (#7). So in the process, the CEO gains by cashing out at a high point, and shareholders lose by a stock price decline as a result of the large sale of stock by the CEO and the ensuing sell-off by the investment community taking a bearish position.
It can be argued that the above stated problem can be solved by awarding stock options with periodic, set exercise dates. The investment community would then not react negatively to the exercise of the stock options, and the CEO could not take advantage of inside information to sell stock at a high. However, this may cause the CEO to alter his or her strategy for the company and not take on projects or investments it might otherwise take on. As pointed out in a study, managers are more likely to take less risky endeavors for their company in order to preserve the company’s stock price if his or her options are in-the-money, and if their options are out-of-the-money, the manager may be more risk-tolerant in an effort to possibly boost the company stock to an in-the-money range (#9). The CEO should make decisions that are best for the company with personal interests set aside, and stock options with set exercise dates alter this decision-making process.
A final problem that comes with equity-based pay is the increased incentive for the CEO to make financial accounting manipulations – legal or otherwise – to potentially boost the company stock price before he or she exercises stock options. Especially if the CEO expects weaker performance in the future, manipulations to the accounting statements can be made to artificially inflate earnings at present (there are legal ways to do this), which could result in a higher stock price, allowing the CEO to exercise his or her options and maximize personal profit. However, for reasons mentioned earlier, this will cause the company’s shareholders to lose. In addition, it has been proven that poor earnings in post-exercise periods are a result of the reversal of inflated earnings in the pre-exercise period (#7).
Because the two main ways to compensate a CEO are through equity and cash, the information presented thus far against equity-based pay points to cash as the optimal choice. Although the company will need to have the cash on-hand to make payment, it avoids the aforementioned equity-based problems, as well as possible cash flow or stock dilution issues in the future come stock option exercise time. If a CEO truly believes in the performance of the company going forward, he or she can always use the cash compensation to purchase actual shares of the company and obtain the equity that way. The main argument against cash-based compensation is that it does not cause the CEO to have a personal vested interest in positive company performance, as stock ownership would. However, this issue can be side-stepped by implementing a low salary-high bonus pay scheme.
A low salary-high bonus compensation structure involves paying a CEO a salary that is very low relative to the bonus he or she could possibly earn, which will incentivize the CEO to seek optimal company performance. The year-end bonus could end up being as much as five or ten times the CEO’s salary, or even more. The reasoning behind this strategy is that a salary is a fixed, guaranteed amount the CEO will earn, regardless of company performance. No matter how the company performs, the CEO earns that fixed salary. A high salary with low bonus will provide a smaller incentive for the CEO to maximize his or her firm’s performance, because the CEO stands less to gain from improving firm earnings. Shifting compensation from a salary form to bonus form puts the CEO in a position in which his or her compensation is almost entirely based upon company performance, so the CEO will put forth his or her best effort and the most time into making sound strategic investment and growth decisions for the firm.
A problem cited with this type of pay structure is it causes the CEO to place too much emphasis on the current fiscal year performance to get a large cash bonus, rather than a long term growth and performance strategy for the company. As mentioned earlier, riskier projects or certain accounting manipulations could be made in order to boost current-year earnings. This problem is also reason to avoid certain bonus benchmarks, such as a set dollar bonus if some company performance metric (stock price, earnings, revenue growth percentage, etc.) reaches a specific level. Again, the CEO may engage in some clever financial footwork to achieve certain same-year performance levels. That being said, evidence suggests that CEO pay does increase in the short term with unexpectedly good accounting performance, but this later reverses and is followed by lower CEO pay in later years as the company does not perform as well in the future. This same evidence suggests there is a net zero gain in CEO compensation from unexpectedly good accounting performance (#2). While the aforementioned is a problem – at least in the short run – the problem can be averted by implementing a high degree of managerial discretion in the bonus decision-making process.
Managerial discretion as it pertains to compensation can be defined as the ability of managers to use their own opinions and evaluation of performance in determining the compensation of an employee. The goal of managerial discretion is to better link the pay of a CEO to his or her performance and give a fair, earned, and deserved bonus to the CEO. Managerial discretion eliminates the possibility of a CEO receiving a bonus based on short-term above-expected financial performance as a result of accounting manipulations or short-term budget cuts, because directors can recognize the manipulations and limit their influence as a factor in the true evaluation of the CEO’s performance. Indeed, a study found that executive compensation is more closely related to performance when a high degree of managerial discretion exists, as compared to a firm with low managerial discretion (#4). While budget cuts or financial manipulations may serve a purpose and provide some measure of value to the company, company directors want to compensate the CEO and other managers for the true value they create for the company. A high degree of managerial discretion in the pay process can ensure they are compensated for value-adding, long-term activities, rather than short-term fancy financial footwork.
A high degree of managerial discretion in a cash-based low salary, high bonus CEO compensation structure will allow the company to extract as much as possible from its CEO and ensure all of his or her decisions are in the best interest of the company. The optimal medium between what the firm gets from its CEO and what the CEO gets from the firm can be found, maximizing the value created for employees and investors. The incentive issues associated with equity-based pay, such as temptations to make accounting manipulations, take on unnecessary risk, or sacrifice long-term performance for short-term success, are eliminated with cash-based pay. The low salary, high bonus structure compensates for true performance, and the managerial discretion makes sure the performance is both accurate and in the best interest of the company. Yet, today most companies still pay their CEOs primarily with equity and a low degree of managerial oversight. It is still a mystery as to why this is happening, but the solution – or at least, the theoretical solution - with supporting evidence is there.
#1 Executive Compensation and Earnings Persistence. Allan Ashley, Simon Yang.
#2 Accounting and Stock Price Performance in Dynamic CEO Compensation Arrangements. Boschen, Duru, Gordon, Smith.
#4 Bank Performance and Executive Compensation: A Managerial Discretion Perspective. Magnan and St-Onge.
#7 Private Information, Earnings Manipulations, and Executive Stock-Option Exercises. Bartov, Mohanram.
#9 Executive Stock Options: Early Exercise Provisions and Risk-taking Incentives. Brisley.
This was a very interesting article, especially in light of the recent debacle. While obviously paying someone through bonuses is going to be the best way to ensure performance, its the issue of measuring that performance that bothers me. CEOs have recently taken multi-million dollar bonuses after receiving stimulus money and justifying this by saying that they were able to keep the company afloat. So let me get this straight, the company would have gone bankrupt because of the actions of the CEO, but since the government bailed them out, they were able to survive out the recession, so therefore they feel justified pocketing tax-payer money. I'm just trying to establish what part of your system provides a check against the self-interest of upper management. I know that the free-market regulates itself since companies act on what's in their best interest, but even Alan Greenspan admits that this check may not be a legitimate check for companies.
ReplyDelete"I made a mistake in presuming that the self-interests of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms."
This is because the personal self-interest of those in charge are ultimately what's the primary influence on their decisions. What's to stop CEOs by crippling a company, but presenting the numbers in such a way that they look like the good guys?
I just don't see a way to fair way to quantify a CEOs success that is free of corruption. What statistical measures should be used? Should we look at the bottom line, the number of jobs lost, the value of the company's stock, the potential for future growth and development, improvement based on past measures? I feel like there's too much bias in any of these systems.
Anyways, the other gripe with the big bonus plan is just this concept that you need to motivate your CEO. Do the men and the few women who overcome discrimination have no intrinsic motivation to do a good job? If CEOs care so little about the rest of the company that they need to be motivated by extra zeros at the end of their paycheck, are these really the guys that should be running these companies?
You paint a sad picture of leadership, Mr. Bathe Man. The most powerful individuals in our nation are as greedy as toddlers.
I paint not a picture of leadership, but a picture for the compensation of leadership. I think your comment stems from much more of a philosophical standpoint, offering more questions and no answers; whereas I recognize the questions and attempt to provide answers.
ReplyDeleteFor example, in your second-to-last paragraph, you took issue with CEOs to motivation for the company to do well. This is more of a philosophical complaint about how American company heads don't find satisfaction in their company doing well without receiving something other than intrinsic or emotional compensation. I can't offer an explanation, nor do I think one is necessary. "Greed is good," and it is this compensation and desire for more that has built the U.S. into biggest economy the world has ever seen. Good luck finding a competent person who will run a multinational, multi-billion dollar corporation and not require a few zeros at the end of their paycheck.
I also don't see a clearcut, specific way to quantify a CEOs success. I also don't support a system using benchmarks or statistical measures, for reasons mentioned in my post. Managerial discretion, although theoretical in nature and difficult to construct objectively, is the best way to quantify a CEOs success free of bias.
You also asked what is to stop a CEO from crippling a company and presenting information in a self-fulfilling, paycheck enlarging fashion. What a CEO has to lose from crippling a company is their career and the possibility of ever running a company of the same size and magnitude ever again. If a CEO destroys Major Agricultural Firm A and is subsequently fired, do you think Major Agricultural Firm B is going to hire that CEO? And to tackle the second part of your question, in my post I mentioned ways in which to minimize the chance of financial manipulations and falsifying of information to be self-serving to the CEO and present performance. My optimal structure calls for low salary-high bonus, cash over equity, and a high degree of managerial discretion...all of those are done to minimize what you fear in your question.