Compensation structures for the better alignment of management and shareholder interests

Christopher B.

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Compensation structures for the better alignment of management and shareholder interests

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Abstract

In recent years there has been much controversy surrounding the supposed ‘high' levels of executive compensation in large publicly traded firms. CEO pay packages, measured as multiples of average non-corporate worker pay, reached a peak of 525 times in 2000. Pay packages have also grown far more complex as bewildering combinations of stock, options, deferred compensation, bonuses, golden handshakes and parachutes have been employed. The goal, however, of all these tools is clear: it is to attract and retain top management talent whilst aligning their interests with owners in the pursuit of maximum shareholder returns. This paper will discuss the common forms of compensation available for a company and the advantages and disadvantages of each compensation option. We will then analyze the existing academic literature on the topic of executive pay and alignment of interests. Finally, we will propose what we believe to be the ideal mix of compensation vehicles that balance the interests of shareholders and management.

<ol class="ollevel1">
<li>Introduction<ol class="ollevel2">
<li>Topic Introduction</li>
<li>Importance of issue</li>
<li>Clarification of question and specific model company</li>
</ol></li>
<li>Compensation options<ol class="ollevel2">
<li>Guaranteed salary – Benefits and downsides</li>
<li>Bonuses – Benefits and downsides</li>
<li>Stock options – Benefits and downsides</li>
<li>Stock appreaciation rights – Benefits and downsides</li>
<li>Restricted stock – Benefits and downsides</li>
</ol></li>
<li>Academic research<ol class="ollevel2">
<li>Presentation of academic research on topic</li>
</ol></li>
<li>Suggested compensation guidelines</li>
<li>Conclusion</li>
</ol>

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[...] The only incentive to perform is the risk of being removed from the position, which is at best a negative reinforcement and does not align management and shareholder interests at all. Bonuses Benefits and Downsides Bonuses are variable payments based upon achievement of certain success criteria during a single year's performance. Performance in this instance is most commonly defined as accounting profits, though EPS, ROA and ROE are also used on occasion. This method of compensation aligns management and owner interests in a simple manner whereby if certain performance thresholds are reached, pre-specified bonus amounts are paid out. [...]

[...] We feel strongly that based upon the empirical studies, the current stock market conditions, and the wider calls for CEO/top management pay accountability by shareholders, the best compensation structure for top management is one that encompasses a of incentives, a structure which utilizes cash (salary and annual bonus), as well as stock grants. However, the caveat here is that such a structure is based upon accounting- based measurements as well as market-based measurements. The primary reason for this “mixed approach” is to take advantage of the way in which stock ownership provides a great incentive for top management, while also carefully setting specific accounting goals which prevent manipulation and reckless short-term and long-term senior management decisions in the name of self-enrichment but at the expense of shareholder value. [...]

[...] While it is important for the compensation structure of all employees to be designed in such a way as to align their interests with the interests of shareholders, it is the top management themselves that usually controls the hiring and compensation of other employees, with the owners' responsibility limited to employing the top management. A final assumption that we will make is that the owners desire long-term growth and profitability. While some shareholders may not share this goal, holding assets for ulterior motives or for a shorter term perspective, we believe that long term growth and profitability are the most fundamental and basic goals of any business and market. [...]

[...] Stock Appreciation Rights Benefits and Downsides While stock options have several attractive features such as that they require no initial cash outlay, they tie compensation to shareholder returns, and create retention incentives - the inherent volatility of the stock market is a major limitation to their use. Thus, in an effort to preserve the benefits and reduce this limitation of stock options, public companies have started to introduce a compensation mechanism called stock appreciation rights (SARs). Like options, SARs provide the holder with a profit equal to the difference between a company's stock price on a certain date and the derivatives issuing price. [...]

[...] Finkelstein and Boyd have stated that the return on assets is suitable for measuring firm performance in terms of executive compensation as it represents efficient employment of available assets. Ciscel DH, and Carroll, TM. (1980). determinants of executive salaries: an economic survey.” The Review of Economics and Statistics. Healy P. (1985). effect of bonus schemes on accounting decisions.” Journal of Accounting and Economics. 85–107). Lewellen WG, and Huntsman, B. (1970). “Managerial pay and corporate performance.” The American Economic Review. 710–720). [...]

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