Executive Compensation

An executive compensation plan is an agency contract between the firm and its manager that attempts to align the interests of owners and manager by basing the
managers compensation on one or more measures of the managers performance in operating the firm. (Scott, p. 383)

Net income motivates managers and as well informs investors

It will not measure performance efficiently and will not enable the market to properly value the manager's worth
Unless net income has desirable qualities of sensitivity and precision, it will not be informative about manager effort
Usually based on two performance measures - net income and share price
Multiple performance measures increase contracting efficiency
Manager with a higher reputation for creating high payoffs for owners, will receive higher compensation (higher market value)
Thus manager will not shirk
As managers who is tempted to shirk looks ahead to future periods, the PV of reduced future compensation will equal to or greater than the immediate benefits
of shirking

Assuming efficient managerial labour market, which is enhanced by full disclosure of the manager's performance
Manager who shirks, thus reporting lower payoffs on average, will suffer a decline in market value
There, incentive contract for lower-level managers is still necessary
Exploiting the ability of managers to monitor each other can reduce agency costs of moral hazard, it does not eliminate them
GAAP to a certain extent, limits the manager's ability to cover up shirking
If reputation building completely eliminated the undercompletion problem, we would not see investors paying less when the problem is greater
While market forces can reduce the managers' moral hazard problem, they do not eliminate it
Internal and market forces may help control managers' tendencies to shirk, but they do not eliminate them
Theory of Executive Compensation
The rate at which the expected value of the measure respond to manager effort
The rate at which the expected value of a performance measure increases as the manager works harder, or decreases as the manager shirks
Links to the effort managers put in
Contributes to efficient compensation contracts by strengthening the connection between manager effort and the performance measure, thereby making it
easier to motivate that effort

If manager changes effort, the expected value of the performance measure should change accordingly
Sensitivity
The reciprocal of the variance of the noise in the performance measure
Measuring the reaction to manager's effort
There will always be a trade off between sensitivity and precision
When a performance measure is precise, there is a relatively low probability that it will differ substantially from the payoff
Contributes to efficient compensation contracts, by reducing the manager's compensation risk
Uncertainty is involved
Precision
The lower the noise in net income and greater its sensitivity to manager effort, the greater should be the proportion of net income to share price in determining
the manager's overall performance

Increases sensitivity since more of the payoffs from manager effort show up in current net income
Double-edged sword since it also tends to reduce precision
If negative precision effect of the current value accounting outweighs its positive sensitivity effect, a bit of conservatism, such as in historical cost
accounting, may be preferable to current value for compensation contracting

Reduce recognition lag by moving to current value accounting

Increases sensitivity by enabling the compensation committee to better evaluate manager effort and ability, and thus to evaluate earnings
persistence

Persistent earnings are a more sensitive measure of current manager effort than transitory or price-irrelevant earnings, which may arise
independently of effort

Expected value reflects manager's true effort

Reduced earnings management increases sensitivity by reducing the manager's ability to disguise shirking
Full disclosure, particularly of low-persistence items
Ways to increase sensitivity of net income:
Compensation has a short term perspective
I.e., managers effort were put into R&D, but it is not observable in current period. Therefore, expected value for current period did not respond to
manager effort

Management may take actions that don't show up in net income until future times (i.e., payoffs from R&D expenditures)
It is precise due to financial standards, but may not be sensitive as we dont capture long term effect components in net income
Compensation Based on Net Income
I.e., factoring out changes in accounting policies that dont affect cash flow (although often not in the case of economic consequences), low persistent
earnings, etc.

Although share price often reflect net income, but in case where net income is noisy, an efficient market will adjust to all publicly available information and
reflect an accurate share price

These effects may say relatively little about current manager effort
I.e., if interest rates increase, the expected effects on future firm performance will quickly show up in share price
Low precision due to the effects of economy-wide factors
The sensitivity of share price is sufficiently great that it will always reveal additional payoff information beyond that contained in net income
Based on manager's performance
More noise reduces precision
Relies on market efficiency
Captures long run perspective than net income
Therefore, share price reflects management effort
More sensitive but less precise than net income, as it relies on market efficiency - an investor will reflect all publicly available information (management
behavior and action - provided that they are disclosed) in the share price

Compensation Based on Share Price

I.e., manager's effort dont pay off in the current period, therefore less sensitive (as in the case of R&D)
Owner/principal, can adjust the relative proportions of earnings based (net income) and share price based (share price) compensation to exploit the fact that
current net income aggregates the payoffs from only some manager activities in the current period

Coexistence of both performance measures create an opportunity for the compensation plan to influence the length of the manager's decision horizon
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I.e., manager's effort dont pay off in the current period, therefore less sensitive (as in the case of R&D)
Reduce the proportion of the manager's compensation based on net income and increase the proportion based on share price
It'll be in the manager/agent's best interest to increase R&D in current period as there are no penalties because weightings had been shifted to
share price

Compensation will rise more strongly due to securities market response to an increase in R&D, and there will be less compensation penalty (such as
loss of bonus) from writing R&D costs off currently.

To encourage R&D (long run effort and effect)

Net income will aggregate the favorable cash flow effects of cost cutting quickly and accurately than share price, if the cost cutting measures are
complex or constitute inside information, or if the market is concerned about the longer-run effects of cost cutting

Also, share price may not perfectly aggregate the cost-cutting information in the presence of noise trading or market inefficiencies
Then, the firm may wish to increase the weigh of net income relative to share price in the manager's compensation
Cutting cost (short run effort and effect)
Decision horizon must be traded off with the sensitivity and precision of performance measures
Risk in Compensation
In the presence of moral hazard, the manager must bear some compensation risk if effort is to be motivated
Rational, risk averse individuals trade off risk and return, the more risk managers bear, the higher must be their expected compensation if reservation utility is to
be attained

To motivate the manager at the lowest cost, designers of efficient incentive compensation plans try to get the most motivation for a given amount of risk
imposed or, equivalently, the least risk for a given level of motivation

If not enough risk is imposed, the firm suffers from low manager effort
If too much risk is imposed, the manager may underinvest in risky project even though such projects would benefit diversified shareholders
Upside risk compensation might be more than expected
Downside risk compensation might be less than expected
Managers face both risks before the period starts
Ex ante risk and ex post risks
Using stock options make managers think like shareholders and maintain a long term perspective. However, if the manager sellsthe stock option immediately, they wouldnt
keep that long term perspective. Furthermore, they will have to take on diversified portfolio, hence does not actually reducerisk

Role of Risk
Instead of measuring performance by net income and/or share price, performance is measured by the difference between the firm's net income and/or
share price performance and the average performance of a peer group of similar firms, such as other firms in the same economy or industry

By measuring the manager's performance relative to the average performance of similar firms, the systematic or common risks that the industry faces will
be filtered out of the incentive plan, especially if the number of firms in the peer group is large

I.e., at least some of the effects on share price and earnings of a downturn in the economy, such as reduction in sales, will also affect other firms
When there are noisy performance measures in the contract, there will be some risks that are common to all peer group firms
Under RPE, it is possible for a manager to do well even if the firm reports a loss and/or share price is down, providing the losses are lower than those of the
average peer group firm

When the industry performance well, manager compensation decreases. Vice versa.
When industry performance is low, high earnings and/or share price performance for the firm in question is even more impressive since it overcomes
negative factors affecting the whole industry

When industry performance is high, high earnings and/or share price for the firm in question is less impressive, so that lower bonuses are awarded
If RPE is valid, we would expect to observe manager compensation negatively related to average economy or industry performance
The need to identify a firm's appropriate peer group
I.e., when demand for an industry's product falls, relatively small firms, with relatively low production volumes, may suffer more from fixed
costs and/or financing problems than larger firms in the same industry that may enjoy economies of scale and greater financial flexibility

Firm size must also be taken into account since different size firms are affected differently by industry-wide events
If all firms can enter into a cooperative pricing contract, competition is softened and raises profits for all firms in the industry
In oligopolistic industry, where the demand for a firm's product depends not only on its own product price but also on the prices of its competitors'
product

Complications:
Relative performance evaluation (RPE)
Incentive compensation does not kick in until some level of financial performance - 10% return on equity, for example - is reached
The manager does not have to pay the firm if there is a loss
If the bogey is not attained, the contract does not award any incentive compensation
Otherwise the manager would have everything to gain and little to lose, which could encourage excessive risk taking
Incentive are capped so cease compensation beyond a certain level
If downside risk (lower limit to compensation) is limited, upside risk (cap on compensation) is also limited
Conservative accounting promotes contract efficiency (contract with lowest costs associated with all components) by constraining the manager's
ability to inflate current earnings, and hence compensation, by recording unrealized gains (which is prohibited under conservative accounting - only
write down losses, but cant write up unless earnings are realized)

No compensation will be received unless and until a project starts to generate realized profit
Hence, share price based performance measure for compensation can substitute
However, compensation based on conservative accounting, hence conservative earnings, gives the manager little incentive to invest in risky projects,
because they cant recognize unrealized gains, which will give them a boost in earnings, hence bonus

Conservative accounting also controls upside risk by delaying recognition of unrealized gains and discouraging premature revenue recognition
I.e., ESO provide this incentive since, if managers succeed, ESO can become very valuable. If not, the lowest ESO can be worth is zero
Therefore, shares of a firm may be overvalued
Opportunistic - manager's self interest
Manager effort may be diverted away from value-increasing projects into opportunistic actions to increase share price, hence the value of their
ESOs

While ESOs encourage upside risk, they impose little downside risk, and so may promote excessive risk taking
Share price will quickly reflect unrealized profits on long-term projects (equivalently, to incur upside risk), managers can be encouraged to invest in such
projects by basing compensation on share price performance

Bogey
I.e., if the firm reports a loss, or earnings below the bogey, the committee may award a bonus anyway, particularly if it feels that the loss is due to
some low persistence items

However, if the committee is overly generous in not penalizing the manager for state realization that are not his/her fault, it will destroy contract
The Board has the ultimate responsibility to determine the amounts of cash and stock compensation, and it has flexibility to take special circumstance into
account

Compensation committee of the Board

Control of Risk
Chapter 10 Page 2
rigidity and reduce effort incentive
Therefore, compensation plans typically constrain this possibility by restricting the manager's ability to dispose of shares and options upon exercise
I.e., manager can shed compensation risk by selling shares and options acquired and investing the proceeds in a risk-free asset and/or a diversified
portfolio; therefore defeats the purpose of an ESO - manager is no longer motivated and will put in effort to increase share price or net income

Not only is hedging costly, but effort incentive will suffer if the manager works out from under risk this way
Firm may limit manager's hedging behavior
Manager can also shed risk by excessive hedging
Despite effort to control compensation risk, it is important that the manager cannot work out from under this risk
In summary, compensation in the form of ESOs and/or company shares encourage upside risk and a longer run decision horizon.
Net income based compensation, at least if deferred and subject to clawback, imposes some downside risk to discourage the excessive risk taking that pure share
based compensation may create

The lower the noise in net income, the better it predicts the payoff
Relationship between ROE (net income based) and cash compensation strengthened when net income was less noisy relative to return on shares (share price based)
For growth firms, net income is relatively less sensitive to manager effort than it is for the average firm
Historical cost based net income tends particularly to lag behind the real economic performance of a growth firm, because this basis of accounting does not
recognize value increases until they are realized

However, an efficient market will look through to real economic performance and growth opportunities and will value the shares accordingly
Thus, ROE should be related less to compensation than share return for such firms
Managerial compensation for growth firms' executives tended to have a lower relationship with ROE than average firms
The fundamental problem of financial accounting theory - the investor-informing and the manager performance motivating dimension of usefulness must
be traded off

When net income is relatively uninformative to investors (low correlation between share return and ROE - as usually higher performance in one measure will
result a higher performance in the other measure), that same net income is relative informative about manager effort (higher weight on ROE in the
compensation plan - as manager put in more effort in ROE than net income since they are compensated on ROE than net income)

For firms where the correlation between share return and ROE was low, there tended to be a higher weight on ROE in the compensation plan, and vice versa
Such a focus supplies useful information to the manager to aid in the investment decision and provide low cost stewardship information to monitor and
motivate manager effort

If the investment decision is hard to evaluate (i.e., investment is unique, complex and/or has a long payoff period) and shirking is relatively easy to detect, reported
net income should contain a relatively strong stewardship focus (i.e., conservative accounting)

The less complex the investment decision, the less subject it is to manager covering up of shirking by bias prone current value estimation
Then, the better can investment decision quality be measured by fair value based net income
If shirking is hard to detect, and the quality of the investment decision is relatively easy to evaluate, net income should contain a relatively strong evaluation focus
(i.e., fair value accounting)

Firms will substitute out of salary into bonus as firm risk is less
Consistent with efficient contract because when firm risk is relatively low, the incentive benefits of a bonus can be attained with relatively low compensation
risk loaded onto the manager

The lower the variability of ROE, the higher the target bonus relative to base salary
Firms in high risk environment (hence, more volatile share prices) rely more on accounting based performance measures relative to those based on stock price
performance

Target bonus tend to increase, relative to base salary, with the volatility of return on shares
Other Factors in Compensation
CEOs were not overpaid relative to shareholder value created or to increases in per capital income over time, but that their compensation was far too unrelated
to performance, where performance was measured as the change in the firm's market value (change in shareholders wealth)

CEOs did not bear enough risk to motivate good performance, and consequently they recommended larger stock holding by managers
An increase of even a small proportion of firm's large increase in value, in the CEO's remuneration would likely attract media attention
We would expect the relationship between pay and performance to be low for large firms, simply because of size effect
An executive whose pay is highly related to performance would have so much to lose from even a small decline in firm value that this would probably
lead to excessive avoidance of risky projects

Excluding losses however will reduce manager's effort incentive to avoid those losses, because they would anticipate that losses will not affect
their compensation

Therefore, the compensation committee may exclude low persistence losses when deciding on bonus awards, particularly if the loss is relatively
uninformative about manager effort

It is difficult to put downside risk on an executive

Counterarguments:
Managers do not bear enough risk, it is also difficult to impose much downside risk on managers
Additional amount of compensation (bonus depending on performance measures, in addition to base salary) is then required to make managers work
harder, and at the same time increases compensation risk

Hardworking, risk averse, manager's compensation contract must reimburse for these elements if reservation utility is to be attained
Compensation costs are necessary to overcome the moral hazard problem between manager and owner
If managers bore no risk and did not incur the extra effort disutility of working hard (i.e., if they were paid only by a salary), their salary increase would not have
been out of line with the average increase in income society over this period

Rather, it was driven by a dramatic increase in the costs of overcoming moral hazard in compensation contracts
The manager does not benefit from this compensation component, since in effect, it reimburses the manager for the utility costs of risk and effort;
therefore, managers are not overpaid, not their compensation was unrelated to performance, rather simply a reimbursement for the increased cost in
overcoming moral hazard to the manager

Large increases in average executive compensation over time was not driven by managers securing higher compensation at the expense of the average wage
earners

Some firms replaced ESOs with restricted stock as a method of overcoming the problems associated with ESOs, such as pump and dump, which defeats the
purpose of using ESOs to increase management effort in a long term perspective for the benefit of shareholders and the firm

Government interferences such as bonus control for bailed out companies, prohibitions of bonuses and dividends for financial institutions whos legal capital falls below
threshold

It is often excessive in payment

Golden parachute refers to a payment made to an executives when he/she leaves the company
Since ESOs bear little downside risk, and golden parachutes reward even poor performance, this supports that executives do not bear enough risk
golden parachute oblige a company to pay multi-million dollar settlements to executives who leave
Reduction when restrictions on ESO value to manager
The value of a given amount of share-based compensationto a manager is lower than it might appear
Much compensation is to compensate for the effort disutility and compensation risk the manager bears
Due to deferral of bonuses and requirements to hold share-based compensation for some time, managers bear firm-specific risk
Conclusion: on average managers are not overpaid relative to shareholder value created or to increases in per capital income over time
Politics of Executive Compensation
Chapter 10 Page 3
Much compensation is to compensate for the effort disutility and compensation risk the manager bears
Due to deferral of bonuses and requirements to hold share-based compensation for some time, managers bear firm-specific risk
Power theory suggests that executive compensation in practice is driven by manager opportunism, not efficient contracting
Managers have sufficient power to influence their own compensation, and that they use this power to generate excessive pay, at the expense of shareholder
value

Managers can influence the Board of Directors and their behavior, through influencing the selections, therefore influencing the compensation committee
Power theory questions the efficient operation of the managerial labour market, much like how the behavioral finance questions efficient securities market
theory

If compensation awards become too high, they attract negative publicly and at some point the board will have to step in to exercise its responsibility
Since consultant would consider their future consulting engagements, it is in their best interest to favor the manager
Hire a compensation consultant to add legitimacy to compensation awards
Creates pressure for total compensation to ratchet up over time as firms compete for competent personnel
Tie total compensation to a peer group of similar companies
However, there are ways to camouflage excessive compensation
The theory acknowledges that there are still limits to the manager's power over compensation
Late timing of ESO rewards is an example of power theory
Improve corporate governance where studies have suggested that pay is more excessive when governance is weak
Full disclosure enables better identification of earnings components with low persistence and informativeness
Limit the amount of manager compensation deductible for tax purposes
How to move towards efficient contracting:
Power Theory
Chapter 10 Page 4