What is Executive Compensation ?
Executives hold the top most position in the company, and it is obvious that the compensation package or the remuneration earned by them is comparatively higher than the other employees of the company. These executives mainly comprise of high grade managers and CEO of the enterprise. In simple words, executive compensation is the salary along with the other components paid to the top executives and the Chief Executive Officers the corporation and is generally decided by the board of directors. With the passage of time, executive compensation has become a significant element of organisational governance, and has increased to a very high level as compared to the compensation of an average worker.
Definition of Executive Compensation
According to Tapomoy Deb :
"Executive compensation refers to short-term and long-term financial and non financial rewards given to the top ranking executives under a contractual, legal and contractual mandate".
According to Robert W. Kolb :
"Executive compensation refers to the total reward provided by the firms to the top level of executives in corporation, such as Chief Executive Officer (CEO), Chief Operating Officer (COO), Chief Financial Officer (CFO), and a handful of other executives who occupy the very highest level of management".
Objectives of Executive Compensation
Objectives of executive compensation are as follows :
1) To Match Managerial Interest with Organisational Interest :
The main motive of linking a considerable part of compensation package of the executives with the organisational performance is to link their personal interest with the organisational interest. Though the base salary remains fixed, but the rewards and incentives on the basis of their performance raises the pay package of the executives, which motivates them to play an active role in the company-related matters.
2) To Acquire Best Executives :
Presently, every company desires for the most talented executives or managers for themselves. The reason why the companies are ready to pay higher packages to the senior managers is the increasing competition in the market. By increasing executive compensation, organisations not only attract talented and competent managers, but also retain them for a longer duration. Low or unsatisfactory compensation packages may increase the prospects of the rival companies to lure the skilled managers of a particular company by offering higher salary package.
3) To Increase Employee Participation, Commitment, and Motivation :
The remuneration package of the executives aims at motivating them to take up their responsibility seriously, perform effectively, and work in the interest of the organisation for long term. The future of the organisation entirely depends upon the decision-making of the executives. Thus, their involvement and commitment towards the organisation is of much more importance than that of other non-managerial staff.
4) To Encourage Managerial Efficiency :
Managerial efficiency and dedication can be encouraged by offering them managerial commission in addition to their fixed salary. This managerial commission of the executives is decided on the basis of net profit earned by the organisation and is generally shown in the financial records of the company. This component of compensation package also improves the competency levels of the managers.
5) To Ensure Overall Financial Security :
The decisions taken by the top management executives are not only difficult, but also very risky. The cost of this risk is paid not only by the organisation, but also by the individual executives. Thus, organisations provide a financial security to the executives within the compensation package to inspire them to take calculated risks while making the decisions.
6) To Encourage Progressive Learning :
Executives should be able to adjust themselves with the changing requirement of the organisation. For this, they need to develop their knowledge and abilities. Improving their knowledge and keeping it up-to-date as per the environmental changes can help them to identify and face the upcoming challenges.
Features of Executive Compensation
There are certain characteristics which determine executive compensation. Some of them are as follows :
1) Highest Paid Compensation :
Executives are the most important part of the company because they manage all organisational functions. They also make all the decisions regarding the strategies to be used by the concern. Top management employees cover almost 1-2% positions in the organisation, and are considered as the most highly compensated employees of the company.
2) Performance Measurement Based on Organisational Performance :
The overall performance of the organisation or of any particular business unit forms the basis of measuring the executive performance and the time duration for this measurement is usually long. Since CEO and COO are the highest position holders, their performance is measured only on the basis of the entire result of the organisation. The measurement of the performance of the executives involves frequent computation and recording of their job. performances using accounting systems. Various factors such as profit earned, return on investment and equity, return on shareholders, income development, increase in economic value and market share help in evaluating the executive's performance and reward them accordingly. Though the performance of business or functional unit is considered effective for measuring the performance of the business unit or top functional executives and second level of executive management, their measurement is also likely to be based partly on the overall performance of the organisation.
3) Differences in Overall Compensation :
Executive compensation package cons of large number of variable rewards and long-term incentive programmes which make it very different from the compensation packages given to other employees of the organisation.
4) Substantial Influence of Laws :
The rules and regulations of the company, laws, and tax legislation's are considered as a very important aspect while deciding the compensation of the executives. Management must have sufficient knowledge about all these sets of laws to guarantee economic effectiveness.
5) Separate Discipline :
Compensation management treats the remuneration given to the executives as a separate branch. In few organisations, executive salary is decided by the board of directors and is not treated as HR function, whereas. some organisations even allow senior managers to decide their salary package on their own.
Components of Executive Compensation
For the purpose of compensation, an executive is considered to be an individual who is in a management position at the highest levels. Specifically, this category includes presidents, vice-presidents, managing directors and general managers. Their compensation generally comprises five elements. Executive compensation components are :
1) Salary :
Salary is the first component of executive remuneration. Salary is supposed to be determined through job evaluation and serves as the basis for other types of benefits. But job evaluation may be only a partial solution because executives must be paid for their capabilities-for what they can do-rather than for job demands. This is the reason why norms of wage and salary fixation are generally not observed while fixing salaries for executives.
Salary as a component of total remuneration is not significant as it is subject to deduction at source and is also capped by government regulations. In order to make good the cuts and ceilings, executives are offered hefty incentives and attractive perks.
2) Bonus :
Bonus plays an important role in today's competitive executive payment programs. This type of incentive is usually short-term (annual) and is a definition of performance is crucial.
There are almost as many bonus systems as there are companies using this form of executive remuneration. In some systems, the annual bonus is tied by the formula to the share price or the return on investment. Other bonus plans are based on the subjective judgement of the board of directors and the chief executive officer.
More complex systems establish certain targets, for example, a 10 percent increase in corporate earnings from the previous year, and then a bonus pool after the target is attained. The bonus is then distributed, either in accordance with a preset formula or on the basis of subjective judgement. Executives deserve bonus because they have much more opportunity to influence organizational success than non-managerial staff.
3) Commission :
Some companies pay commission to their executives and going by the figures, commission constitutes a major share in executive remuneration. But the Companies Act puts a ceiling on the amount of commission payable to executives.
4) Long-term Incentives:
If bonus constitutes a short-term benefit, stock options are long-term benefits offered to executives Companies allow executives to purchase their shares at fixed prices. Stock options are valuable as long as the price of share keeps increasing. The share price crashes when the company starts incurring loss, and executives stand to lose in the process.
Stock options are attractive to shareholders too. First, an option is not a bonus, Executives must use their own resources to exercise their right to purchase the stock. Second, the executives are assuming the same risk as all other shareholders, namely, that the price could move in either direction. Options are a form of profit sharing that Jinks the executive's financial success to that of the shareholders.
Finally, stock options are one of the few ways to offer large rewards to executives without the embarrassment of "millions of dollars of obvious money changing lands". Nevertheless, the risk factor in this type of incentive may be too great for it to be attractive to executives.
ESOP (Employee Stock Option Plans) have lost their sheen. The companies which championed the curse of stock options have reverted hack to cash incentives. Organizations still opting for stocks are few and far between. Global economic recession has hit stock markets. With share prices crashing by the day, no more are the ESOPs attractive to employees. Employees are more worried about job security, than the so called jog term incentives.
5) Perquisites :
Perks constitute a major source of income for executives. In addition to the normally allowed. pass like provident fund, gratuity and the like, executives enjoy special parking, plush office, vacation travel, membership in clubs and well-furnished houses. Perks take care of all possible needs. Executives are rarely required to spend money from their pockets. Their holidays, servants, telephone bills and even electricity and gas bills are taken care of by their companies.
Typically, perks to executives include the following, But the list is not exhaustive.
- A company provided car
- Accessible, no cost parking
- Limousine service, the chauffeur may also serve as a bodyguard
- Kidnapping and ransom protection
- Counselling service, including financial and legal services
- Professional meetings and conferences
- Spouse travel
- Use of company plane and yacht
- Home entertainment allowance
- Special living accommodations away from home
- Club memberships
- Special dining privileges
- Season tickets to entertainment events
- Special relocation expenses
- Use of company credit cards
- Medical expense reimbursement; coverage for all medical costs
- Reimbursement for children's college expenses
- No and low-interest loans
There are two more components of executive compensation as well. One is pension and the second is termination benefits. Some companies have pension scheme in place, either specially designed for executives of open to a wide range of employees. In the US, a certain part of the compensation is often deferred until the executive reaches retirement age.
Process of Setting Executive Compensation
Setting employee's compensation and executive compensation is completely different from each other. Employee's compensation is determined by the senior executives or top managers on the basis of organisational structure and systems and remuneration level. On the other hand, executive compensation planning-consists of more difficult and demanding task like setting of CEO salary package which involves various additional aspects. Thus, setting of executive compensation follows certain process which is mentioned below :
1) Board of Directors :
For determining executive compensation and supervising, its functions, the main machinery for corporate governance within the organisation is the Board of Directors. Besides this. BOD also plays a crucial role in correcting and observing almost all the important decisions of the company, such as recruitment, lay-off, termination, and fixing up the compensation of higher level management. T becomes the responsibility of the board to supervise and observe executives on shareholders' behalf. BOD o represents shareholders and its first preference is to protect them from the self-operating management. Thus, in order to guide and monitor the executives, the board establishes various committees which are as follows :
i) Nomination Committee :
Nomination committee is responsible for recruiting and retaining the most appropriate and effective directors for the board. These directors further take decisions regarding the establishment of other committees for the company.
ii) Audit Committee :
This committee is responsible for setting various guidelines that are to be followed, while conducting external auditing process and non-audit functions.
iii) Compensation Committee :
This committee determines the remuneration level of each manager, its form, stock options, pension plans, the combination of short and long-term incentives for the managers etc, and then discusses it with the Board of Directors. The final decisions and approvals are given by BODs. Beside this, compensation committee also ensures that remuneration planning is in line with the organisational objectives.
2) Corporate Governance :
Corporate governance, in simple terms, is a process of handling and directing all the business affairs and issues for improving the accountability and performance of the organisation while considering the benefits of other shareholders Good business governance aligns the risk orientation and the agent's goals with the interests of various shareholders, and also protects the stakeholders and shareholders from selfish top-level managers. Thus, it can be said that the corporate governance takes into consideration both the performance as well as the responsibility.
In case of any discrepancies while determining the compensation level of executives and CEO, corporate governance permits the board members, managers, general employees, and shareholders to raise their voice against any injustice or bias. According to SEBI (Securities and Exchange Board of India), there are certain guidelines that are to be followed by the organisations in agreement with the practices and procedures of good corporate governance to make corporate governance an effective way of dealing with overall company affairs.
3) Pay for Performance :
According to famous economist Holstrom, the best way of maximizing the shareholder's interest is integrating the company's performance with the compensation of the executives Thus, in order to increase the value of shareholders, board of directors should design such a remuneration scheme which consists of maximum benefit for the executives. Pay for performance can prove to be a great motivator when the remuneration and performance are linked together which eventually matches the shareholder's and manager's goals.
Pay for performance programmes can be made more effective for executives by following the guidelines mentioned below :
- It must follow the principle of designing such a remuneration plan that decreases incentives to increase short-term performances at the cost of long-term development.
- It must reveal the actual performance of the executives, their job levels, and their accountability towards the organisation in achieving the company's strategic goals.
- It must involve the methods and the time duration taken to create the intrinsic value. These measures can be either absolute or relative and the time duration must be at least 3 to 5 years (or than this).
- The amount of rewards and compensation already offered to the executives must be taken into consideration.
- Pay for performance programme must ensure free flow of cash for at least three to five years and mast be according to the economic profits of the company.
- This programme must consider the prevailing remuneration level for suitably matched positions in the labour market regularly in order to determine the compensation rate of the organisation.
- It must ensure that the entire remuneration structure within the organisation should be equitable and unbiased.
4) Market for Managerial Talent :
Different economists had different arguments to find out the managerial ability regarding the factors on which the industrial market depends. According to Ciscel and Carroll, among-st other factors, the market for managerial talent as a function of supply and demand of such talent is the basis of deciding executive compensation. An economist, Kostiuk, believed that talent market is based on the size of the company as skilled executives get attracted towards the large-scale companies which provide them with higher remuneration. Beliefs of Baker, Jensen and Murphy were like that of Kostiuk also believed that since large companies are capable enough to provide higher wages to their employees, more competent and talented managers are attracted towards these organisations. These economists also discovered that the executives possessing talent were capable of further increasing their compensation levels by increasing the organisation's size without considering the interest of the shareholders. With the increase in the size of the establishment, the responsibilities of the executives also become complex and challenging, to deal with the growing organisation. Thus, the executives link the compensation with the size of the organisation.
Most of the organisations depend upon the compensation consultants to decide the market value of the managerial talents as they have good knowledge about the policies that are followed in the market and industry for the determination of executive compensation. Though these consultants are of great use, but they may become biased at some points as they are directly under the control of organisation's CEO or CFO and not the compensation committee. Such a situation creates unequal distribution of income within the organisation, as the consultants decide that compensation level is under the influence of those who employ them. Thus, in the interest of the employees, compensation committees should avoid or minimize use of such compensation consultants who also work for the compensation of lower level or actuarial compensation projects.
Principles Governing Executive Compensation
The main principles that govern executive compensation are mentioned below :
- Executive compensation must be capable of attracting and retaining the high-performance executives so that the organisation can face the upcoming competition of the market effectively.
- Executive compensation plan should be in line with the organisational, objectives, strategies and the interests of the shareholders. It must act as a mirror reflecting both the positive points as well as risks te to remuneration planning and should involve the necessary criteria based on performance which is linked to long-term value of shareholder.
- Either the independent directors recommended by the compensation committee should be given the responsibility of deciding the remuneration of the top executives including the CEO or the decisions can also be directly taken by compensation committee of the organisation.
- Before deciding the pay structure of the executives and other top managers, the compensation committee must take various factors into consideration such as retirement plans, cause of termination, benefits to be included, incentives to be added and other environmental aspects. Committee should try to offer highest payout after reviewing the compensation agreement in order to motivate the executives to work in the interest of the company.
- Consistent equity investment has a significant impact on the smooth functioning of any corporation. Thus, it should be necessitated by the compensation committee that executives build and sustain substantial amount of equity investment in the organisation.
- Expert advice plays a very important role in proper management and arrangement of the executive compensation plan. Though these consultants are experienced and are capable of providing their individual suggestions, but in order to reduce any kind of disagreement or conflict among these consultants, the committee needs to supervise them.
- The executive remuneration plan should not violate any legal rules and regulations. Committee must ensure that the plat should employ best practices and must fall in line with the law and order.
- Shareholders must be provided with exact and timely information about the various factors of executive compensation plan such as policies fallowed, decision taken, benefits offered, and other significant components of compensation plan. Besides this, the data received by the shareholders should be complete and easy to understand.
Factors Affecting Executive Compensation
There are various factors that affect the compensation offered to the executives. Some of them are as follows :
1) Changing Nature of Work :
Developing technology and increasing global competition pressure has drastically changed the traditional way of organizing and managing the work in companies. These changes have made the management process more complex and challenging. Since the top managers are solely responsible for the management and supervision of the overall affairs of the establishment, the changing nature of work has increased their demand for better and higher compensation package.
2) Investor Confidence :
Investors have confidence in only those organisations which have good market value and an effective control er vans compensation plans. Thus, an effective executive compensation package depicts the organisational in age and its authority which in turn has a great impact on the market price and value of that company.
3) Effective Bench-marking :
Many organisations benchmark the compensation rates using the prevailing market rates before deciding the compensation of the executives. Various consultants are employed by the compensation committees to determine the existing wage rate, so that the standardizing can be done on the basis of this rate.
4) Attracting and Retaining High Performance Executives :
With the changing time, the demand for more talented executives has increased in our industries. Attracting endowed and competent executives and retaining them for a longer period of time is becoming a part of competition among various companies. With the increasing demand of executives, changing nature of work, expansion of industries, globalization, flextime, demand, and telecommuting, organisation has to search out for more than one reward and benefit solutions that can attract the top level managers and make them perform effectively.
5) Fostering Right Executive Behaviors :
Compensation system covers the major part of organisational expenditure and executive compensation covers the major part of this compensation system. Executive turnover can adversely affect the overall functioning of the organisation and thus, the management must be very careful while deciding the compensation of the executives and cannot lag behind in this at any cost. Though it is true that the investment made on executives offers great return, executive compensation must ensure that executives have right behavior and can easily deal with queries related to governance, media, and stakeholder inquiries.
Criticisms of Executive Compensation
The criticisms faced by executive compensation packages are as follows :
1) Complaints of Over-Payments :
One of the major criticisms faced by the executive compensation plan is that executives are paid much more as compared to the other non-managerial staff members, irrespective of the duties and responsibilities related to their jobs. Besides this, according to critics, heavy rewards and benefits offered by the company are majorly meant for the managerial department and the growth rate of compensation is greater for executives, whereas, compensation growth rate of non-executive staff is very slow and the rewards offered are also very less.
2) Unnecessary Effect on Compensation Determination :
Generally, the remuneration package of the executives is determined by a committee under the guidance of Board of Directors of the concern. According to the critics, sometimes the decisions made by these committees regarding the salary package. are biased in nature. Top executives have excessive influence on committee members during decision making. Thus, the top managers can easily determine their remuneration and fix their perks on their own.
3) Neglect the Financial Strength of the Organisation :
Critics also state that the financial health of the company is ignored while offering bonus and incentives to the executives, which in turn disregard the interest of the company. According to them, financial business condition must be considered before granting rewards to the top level managers. Though presently, most of the companies have become result oriented and reward their executives only if the organisation has earned high profits, but there still exist some organisations that do not pay attention towards the economic health of the company to pay high perks and bonuses to the executives.
4) Lack of Transparency in Executive Compensation :
Secrecy in executive compensation plans and offering perks and perquisites to executives also raises another criticism for this plan. According to the critics, many benefits and perks given to the high level managers are non-visible and due to this lack of transparency, these benefits are not distributed appropriately among other employees.
5) Unequal Distribution of Income :
Many critics believe that the income distribution in the organisations is uneven and biased. Though many organisations offer a specific portion of company's profit to its workers in the form of yearly bonus, high level of executive remuneration packages often deprives the other non managerial employees of their share in the company's prosperity and wealth.
6) High Exit Fees :
According to the critics, many organisations follow golden parachute plan or golden handshake under which executives are offered with excessive exit fees after their termination or in case of takeover of the company by the other establishment. These payments are usually decided by higher authorities and are important during retirement, but there are some senior executives who obstruct certain key mergers and acquisitions, so that they can gain higher severance pay while leaving the organisation.
Executive Compensation in Multinational Corporation (MNC)
MNCs across the world pay attractive compensation for executives to attract and retain the best talent in order to enable them to craft and implement most appropriate strategies. They, however, pay different levels of compensation for executives in different countries, e.g., in the year 2007, MNCs paid highest compensation to expatriates from the US, and lowest to those from India.
Compensation philosophy is the set of values and beliefs that an organisation has with regard to monetary and non-monetary benefits payable to employees. This often is combined with a set of guiding principles that further assist in compensation administration. Many multinational companies report that they have no formal compensation philosophy. However, collective decisions that an MNC has made over a period of time constitutes a set of beliefs and values - a compensation philosophy - regardless of whether or not the MNC has actually committed those ideas to a formal document.
Differences in compensation philosophies are widespread. Some organisations believe in an extensive use of incentives, while others apply them to a very narrow group of employees, who are believed to contribute directly to the bottom line. This represents a significant difference between the MNCs. Another variation is the behavior of multinational companies who seek to apply compensation levels "at the market average". These MNCs differ philosophically from those multinational companies that seek to pay at the top of the market, thus enabling them to attract the competent employees. Some MNCs are proportionally more generous to certain levels of super performers, while others believe in principle of achieving equity across all employees. The openness with which compensation decisions are made, and the degree of stakeholder involvement in those decisions, is yet another example of difference that may exist between organisations. Any compensation philosophy should cover the following aspects :
As companies are expanding worldwide operations, and sectors are consolidating in both established and emerging markets, executive compensation strategies have evolved as well. In addition to various regulations, companies must also consider the governance landscape and stakeholders in areas, where they operate when it comes to constructing executive pay.
Pay philosophies are the building block in overall compensation design, and as the global marketplace has become more competitive, a number of factors are taken into consideration when constructing executive pay. Overall, competition for global talent is an area to focus for design - companies that desire candidates with the necessary skills and background required for the job must take quality of life and cost of living into account when recruiting. Another key point to consider for companies is whether or not currency variations and fluctuations affect pay.
Designing Executive Compensation for Multinational Companies
For multinational companies, the retention of key executives is critical to business success. Even in current economic conditions, companies are competing globally for the best talent. The departure of an executive can be a serious setback for business continuity and performance, and more so if he or she joins a competitor. Companies are therefore increasingly prepared to invest highly in keeping executives "on board" through their pay packages.
In a multinational company, the structure of pay packages for local executives is likely to depend upon home country considerations such as :
1) Corporate Governance Rules:
Corporate governance rules, setting out regulators and shareholders' expectations on executive pay, are having a significant impact on how companies design executive pay packages. These advise on the structure of executive pay, and are increasingly conveying the message that executive pay should be linked to corporate and individual performance, in addition to strengthening disclosure obligations.
While the rules do not generally have legal effect, they can be highly influential in shareholder voting decisions. They are aimed at listed companies but are increasingly viewed as best practice by unlisted companies.
2) Shareholder Approval Requirements :
Prior shareholder approval may be required for elements of pay. Corporate governance rules focus on disclosure to allow shareholders sufficient information, and indirect control over executive pay. Effective communication with shareholders in formulating executive pay packages is important to avoid surprises. Shareholders must be consulted about the structure and justification of pay packages, particularly where elements of these are contentious from a shareholder perspective,
3) Board Responsibilities :
The negotiation of appropriate reward packages is primarily the responsibility of Beards of Directors and remuneration committees. Directors owe duties to act in the best interests of their company and shareholders (generally more stringent for those of listed companies), and should bear these duties in mind when formulating pay packages.
4) Tax and Social Security Rules :
The impact of personal income tax rates on higher income should be considered. Different national rules on the tax treatment of cash, benefits in kind, share-based arrangements, pension and other forms of pay should be reviewed. These may vary considerably, particularly for share based benefits and pensions. Where possible, the package should be tax-efficient for the executive and the company. Favorable share incentive and pension plans, enabling reduction of income tax and social security liability or deferral of payment, are available in a number of countries.
5) Contractual Issues :
An executive pay package will determine the financial compensation that the executive may claim on termination of employment (unless otherwise agreed). A major shareholder concern has become the situation, where an executive leaves, either voluntarily or at the request of a board, after a short or unsuccessful appointment, with a significant financial reward
Companies must consider the terms, triggers and potential costs of various exit scenarios at the outset, in particular, the executive as a "good leaver" or "bad leaver" or on a change of control. Wherever possible, appropriate protections must be included in the executive's service contract and other documentation. This needs to be balanced against the need to recruit, retain and reward key executives and to monitor their performance. From a retention viewpoint, potential severance packages should also not have the undesired effect of encouraging good executives to leave.