Many organizations, especially large ones, administer executive compensation somewhat differently than compensation for lower-level employees. An executive typically is someone in the top two levels of an organization, such as Chief Executive Officer (CEO), President, or Senior Vice-President.
As Figure shows, the common components of executive compensation are salaries, annual bonuses, long-term incentives, supplemental benefits, and perquisites.
Two objectives influence executive compensation: (1) ensuring that the total compensation packages for executives are competitive with the compensation packages in other firms that might employ them, and (2) tying the overall performance of the organization over a period of time to the compensation that is paid to executives. It is the second objective that critics of executive compensation believe is not being met. In many organizations, it appears that the levels of executive compensation may be unreasonable and not linked closely to organizational performance.
Elements of Executive Compensation
At the heart of most executive compensation plans is the idea that executives should be rewarded if the organization grows in profitability and value over a
Executive Compensation Components
period of years. Because many executives are in high tax brackets, their compensation often is provided in ways that offer significant tax savings. Therefore, their total compensation packages are more significant than their base pay. Especially when the base salary is $1 million or more, the executive often is interested in the mix of items in the total package, including current and deferred compensation.
EXECUTIVE SALARIES
Salaries of executives vary by type of job, size of organization, region of the country, and industry. On average, salaries make up about 40— 60% of the typical top executive’s annual compensation total. A provision of a 1993 tax act prohibits a publicly traded company from deducting pay of more than $1 million for each of its top five officers unless that pay is based on performance criteria approved by outside directors and shareholders.
EXECUTIVE BONUS PLANS
Because executive performance may be difficult to determine, bonus compensation must reflect some kind of performance measure if it is to be meaningful. As an example, a retail chain with over 250 stores ties annual bonuses for managers to store profitability. The bonuses have amounted to as much as 35% of a store manager’s base salary.
Bonuses for executives can be determined in several ways. A discretionary system whereby bonuses are awarded based on the judgments of the chief executive officer and the board of directors is one way. However, the absence of formal, measurable targets is a major drawback of this approach. Also, as noted, bonuses can be tied to specific measures, such as return on investment, earnings per share, or net profits before taxes. More complex systems create bonus pools and thresholds above which bonuses are computed. Whatever method is used, it is important to describe it so that executives trying to earn bonuses understand the plan; otherwise, the incentive effect will be diminished.
PERFORMANCE INCENTIVES—LONG TERM VS. SHORT TERM
Performance-based incentives attempt to tie executive compensation to the long-term growth and success of the organization. However, whether the emphasis is really on the long term or merely represents a series of short-term rewards is controversial. Shortterm rewards based on quarterly or annual performance may not result in the kind of long-run-oriented decisions necessary for the company to continue to do well.
A stock option gives an individual the right to buy stock in a company, usually at an advantageous price. Different types of stock options have been used depending on the tax laws in effect. Stock options have increased in use as a component of executive compensation during the past 10 years, and employers may use a variety of very specialized and technical approaches to them, which are beyond the scope of this discussion. However, the overall trend is toward using stock options as performance-based long-term incentives.
Where stock is closely held, firms may grant “stock equivalencies” in the form of phantom stock or share appreciation rights. These plans pay recipients the increased value of the stock in the future, determined by a base valuation made at the time the phantom stock or share appreciation rights are given. Depending on how these plans are established, the executives may be able to defer taxes or be taxed at lower capital-gains tax rates.
BENEFITS FOR EXECUTIVES
As with benefits for non-executive employees, executive benefits may take several forms, including traditional retirement, health insurance, vacations, and others. However, executive benefits may include some items that other employees do not receive. For example, executive health plans with no co-payments and with no limitations on deductibles or physician choice are popular among small and middle-sized businesses. Corporate-owned life insurance on the life of the executive is popular and pays both the executive’s estate and the company in the event of death. Trusts of various kinds may be designed by the company to help the executive deal with estate issues. Deferred compensation is another possible means used to help executives with tax liabilities caused by incentive compensation plans.
EXECUTIVE PERQUISITES
In addition to the regular benefits received by all employees, executives often receive benefits called perquisites. Perquisites (perks) are special executive benefits—usually noncash items. Perks are useful in tying executives to organizations and in demonstrating their importance to the companies. It is the status enhancement value of perks that is important to many executives. Visible symbols of status allow executives to be seen as “very important people (VIPs)” both inside and outside their organizations. In addition, perks can offer substantial tax savings because many perks are not taxed as income.
Figure lists some perks that are commonly available.
Board of Directors’ Role with Executive Compensation In most organizations the board of directors is the major policy-setting entity. For publicly traded companies covered by federal regulatory agencies, such as the Securities and Exchange Commission (SEC), the board of directors must approve executive compensation packages. Even many nonprofit organizations are covered by Internal Revenue Service requirements to have boards of directors review and approve the compensation for top-level executives. In family-owned or privately owned firms, boards of directors may have less involvement in establishing and reviewing the compensation packages for key executives.
BOARD COMPENSATION COMMITTEE
The compensation committee usually is a subgroup of the board of directors composed of directors who are not officers of the firm. Compensation committees generally make recommendations to the board of directors on overall pay policies, salaries for top officers, supplemental compensation such as stock options and bonuses, and additional perquisites (“perks”) for executives. But the “independence” of board compensation committees increasingly has been criticized.
One major concern voiced by many critics is that the base pay and bonuses of CEOs often are set by board compensation members, many of whom are CEOs of other companies with similar compensation packages. However, one study found little relationship between the composition of compensation committees of boards and the level of CEO compensation.
Also, the compensation advisors and consultants to the CEOs often collect large fees, and critics charge that those fees distort the objectivity of the advice given.
To counter criticism, some corporations are changing the composition of the compensation committee and giving it more independence. Some of the changes include prohibiting “insider” company officers and board members from serving on compensation committees. Also, some firms empower the compensation committee to hire and pay compensation consultants without involving executive management.
More importantly, the link between the independence of board compensation committees and organization performances is crucial. If the compensation committee’s decisions about executive variable pay lead to higher organizational performance, then the composition of the compensation committee is less of an issue. Research on compensation committees and organizational performance indicates that having more “outside” directors is linked to better organizational performance results, as the HR Perspective on the next page indicates.
BOARD MEMBERS’ COMPENSATION
Although they are not executives of the firm, outside members of boards of directors receive compensation as well.
Generally, they receive directors’ fees, either as a set amount per year or a permeeting fee. To counter some criticisms of the independence of board members, some experts have recommended that board members be paid totally or in part with company stock. This approach is seen as linking board members’ pay more closely to that of the stockholders they represent. Also, some corporations require
board members to purchase and own a minimum number of shares of stock in the company.
Bonuses for executives can be determined in several ways. A discretionary system whereby bonuses are awarded based on the judgments of the chief executive officer and the board of directors is one way. However, the absence of formal, measurable targets is a major drawback of this approach. Also, as noted, bonuses can be tied to specific measures, such as return on investment, earnings per share, or net profits before taxes. More complex systems create bonus pools and thresholds above which bonuses are computed. Whatever method is used, it is important to describe it so that executives trying to earn bonuses understand the plan; otherwise, the incentive effect will be diminished.
PERFORMANCE INCENTIVES—LONG TERM VS. SHORT TERM
Performance-based incentives attempt to tie executive compensation to the long-term growth and success of the organization. However, whether the emphasis is really on the long term or merely represents a series of short-term rewards is controversial. Shortterm rewards based on quarterly or annual performance may not result in the kind of long-run-oriented decisions necessary for the company to continue to do well.
A stock option gives an individual the right to buy stock in a company, usually at an advantageous price. Different types of stock options have been used depending on the tax laws in effect. Stock options have increased in use as a component of executive compensation during the past 10 years, and employers may use a variety of very specialized and technical approaches to them, which are beyond the scope of this discussion. However, the overall trend is toward using stock options as performance-based long-term incentives.
Where stock is closely held, firms may grant “stock equivalencies” in the form of phantom stock or share appreciation rights. These plans pay recipients the increased value of the stock in the future, determined by a base valuation made at the time the phantom stock or share appreciation rights are given. Depending on how these plans are established, the executives may be able to defer taxes or be taxed at lower capital-gains tax rates.
BENEFITS FOR EXECUTIVES
As with benefits for non-executive employees, executive benefits may take several forms, including traditional retirement, health insurance, vacations, and others. However, executive benefits may include some items that other employees do not receive. For example, executive health plans with no co-payments and with no limitations on deductibles or physician choice are popular among small and middle-sized businesses. Corporate-owned life insurance on the life of the executive is popular and pays both the executive’s estate and the company in the event of death. Trusts of various kinds may be designed by the company to help the executive deal with estate issues. Deferred compensation is another possible means used to help executives with tax liabilities caused by incentive compensation plans.
EXECUTIVE PERQUISITES
In addition to the regular benefits received by all employees, executives often receive benefits called perquisites. Perquisites (perks) are special executive benefits—usually noncash items. Perks are useful in tying executives to organizations and in demonstrating their importance to the companies. It is the status enhancement value of perks that is important to many executives. Visible symbols of status allow executives to be seen as “very important people (VIPs)” both inside and outside their organizations. In addition, perks can offer substantial tax savings because many perks are not taxed as income.
Figure lists some perks that are commonly available.
Board of Directors’ Role with Executive Compensation In most organizations the board of directors is the major policy-setting entity. For publicly traded companies covered by federal regulatory agencies, such as the Securities and Exchange Commission (SEC), the board of directors must approve executive compensation packages. Even many nonprofit organizations are covered by Internal Revenue Service requirements to have boards of directors review and approve the compensation for top-level executives. In family-owned or privately owned firms, boards of directors may have less involvement in establishing and reviewing the compensation packages for key executives.
BOARD COMPENSATION COMMITTEE
The compensation committee usually is a subgroup of the board of directors composed of directors who are not officers of the firm. Compensation committees generally make recommendations to the board of directors on overall pay policies, salaries for top officers, supplemental compensation such as stock options and bonuses, and additional perquisites (“perks”) for executives. But the “independence” of board compensation committees increasingly has been criticized.
One major concern voiced by many critics is that the base pay and bonuses of CEOs often are set by board compensation members, many of whom are CEOs of other companies with similar compensation packages. However, one study found little relationship between the composition of compensation committees of boards and the level of CEO compensation.
Also, the compensation advisors and consultants to the CEOs often collect large fees, and critics charge that those fees distort the objectivity of the advice given.
To counter criticism, some corporations are changing the composition of the compensation committee and giving it more independence. Some of the changes include prohibiting “insider” company officers and board members from serving on compensation committees. Also, some firms empower the compensation committee to hire and pay compensation consultants without involving executive management.
Executive Perquisites
More importantly, the link between the independence of board compensation committees and organization performances is crucial. If the compensation committee’s decisions about executive variable pay lead to higher organizational performance, then the composition of the compensation committee is less of an issue. Research on compensation committees and organizational performance indicates that having more “outside” directors is linked to better organizational performance results, as the HR Perspective on the next page indicates.
BOARD MEMBERS’ COMPENSATION
Although they are not executives of the firm, outside members of boards of directors receive compensation as well.
Generally, they receive directors’ fees, either as a set amount per year or a permeeting fee. To counter some criticisms of the independence of board members, some experts have recommended that board members be paid totally or in part with company stock. This approach is seen as linking board members’ pay more closely to that of the stockholders they represent. Also, some corporations require
board members to purchase and own a minimum number of shares of stock in the company.
