Changes in CEO/Executive Pay since 2000 - Research Paper Example

Changes in CEO/Executive pay since 2000 1. Introduction The debate on the issue of executive compensation has generated intense debate in the recent past. It has been argued that Chef Executive Officers are paid too much money that does not necessarily commensurate with their performance. Some of the high earning CEOs run companies that perform poorly and are on the verge of collapsing. Yet, some authors have suggested that the job of CEOs is very demanding and has very high expectations therefore the holders of those positions deserve to be paid well. As Howard (2004) points out, the job of a CEO has many risks and sometimes if a person is sacked from such a position it is very difficult to gain employment elsewhere. Therefore, he proposes that their pay should reflect the uncertainty involved with their jobs. The trend of executive pay since the year 2000 reflects a consistent increase in the amount of compensation that the CEOs receive. According to Michaels (2006), the average amount that each CEO of Fortune 500 earned was more than ninety five percent of what a household earned. Statistics indicate that the highest paid CEO in America earned an average of fifty million dollars per annum in direct salaries. This figure excludes the more generous bonuses and stock options that run into millions of dollars per annum. In the wake of the recent global financial crisis, questions were asked on the logic and sustainability of the high executive pay. Most of the companies have revisited the compensation packages for the executives and the trend is towards compensations that are performance based. This paper seeks to evaluate the trends in CEOs pay since the year 2000 in international companies. The paper also analyzes the compensation trends and the ramifications of the emerging methods of compensating Chief Executive Officers (CEOs). 2. Amounts The amount of money that CEOs are paid has significantly increased over the years. In the year 2000, the highest paid Chief Executive Officer took home a net salary of $219 Million. The average compensation of CEOs grew by over forty five percent between the years 2000 to 2007. Average compensation rose from US$ 12 million per annum in the year 2000 to approximately US$ 25 million per annum in 2007 (Murray 2008). These figures only take into account the values for the basic fixed salaries. In fact, if the values of stock options and other bonuses are put into consideration, the amount of money earned by the Chief Executive Officers reached over one hundred million dollars per annum. In comparison, the average pay of an American worker rose by 2.7% over the years 2000-2007. This implies a large disparity in the pay that the CEOs received as compared to that of the average workers in their companies. In another instance, the salaries of average executives rose by about 15% during this period. It is evident that the CEOs received the highest pay increases overall. The compensation increase was most significant for CEOs compared to all other workers. Glaringly, the CEOs pay excluding bonus and stock options represented 71 times to 103 times the wage of an average worker. With the inclusion of share based compensation and bonuses, executive pay represented between 103 times to 521 times average wages (Murphy 2008). However, some companies reduced the direct salaries earned by their CEOs due to the global financial crisis witnessed in 2008. Although there was a pay cut for majority of the CEOs, there net income per annum still remained high due to generous bonuses and stock options. According to Forbes (2011) the highest paid CEO took home over US $ 120 million in direct salaries in 2011. Adding stock options and other bonuses, this CEO of United Health Group earned over two hundred and fifty million dollars in 2011. 3. Compensation Trends The compensation trends for CEOs have evolved significantly over the past decade. Between the years 200-2007, the compensation for CEIs was majorly based on the fixed pay portion. The largest part of the compensation was the salary that the CEO received. Other additions to the total compensation were bonuses and cash rewards. Towards 2007, stock options were introduced but their adoption was slow and did not have a very big impact on the total the compensation. The financial crisis of 2008 saw the compensation for the executives take a dip due to the tough financial times. Most of the pay perks and benefits that CEOs received were withdrawn in austerity measures. The compensation packages for executives were tailored to suit a performance based methodology. Executive pay began to be pegged on the performance metrics that were set for the CEOs. However, according to Cook (2011) the executive pay levels have begun recovering from the economic meltdown of 2008/2009. Most companies have realigned there executive compensation models to suit a differentiated and strategic objective rather than competition based. The salary cuts witnessed due to the financial crisis have been reversed and executive salaries have increased by between 2-3%. There is a general trend towards incentive based compensation based on pre-defined metrics. There has been an inclination towards ethical compensation policies that are not harmful to a company’s finances. Long term incentives were also on the also so as to tie the executives to the long term strategy of the companies that they served in. performance based stocks and time restricted shares have also been used in executive pay strategies in the recent times. The new financial legislation also demand that companies implement shareholder advisory “ Say on Pay” voting is also likely to transform the executive pay models since the voice of shareholders will have to be considered. 4. Methods Executive compensation packages usually consist of various components. Compensation can be in form of cash or no cash. The other distinction in the methods of compensation for executives is the immediate and the deferred compensation. More often than not, executive pay is usually a combination of more than two forms of payment. One of the main methods used in executive compensation is the use of fixed compensation. This can be defined as the basic salary that an executive earns. In determination of the fixed compensation for an executive, the recognized practice is the use of competitive benchmarking. A general salary survey and detailed analysis of comparable industries is normally used to determine the fixed salary of an executive. It should be noted that in the recent past, salaries account for a small portion of the total compensation that executives believe. The other method of paying executives is the use of the variable compensation strategies. The use of bonuses is one of the variable compensation strategies. The bonuses can be paid as per the performance of an individual or that of a business unit (Bruce 2009). However, there has been criticism on the payment of bonuses as they mostly target paying high bonuses to the executives without necessarily putting the interests of the shareholder first. Long term compensation is also a method of executive compensation. This is usually based on certain long term performance criteria established in advance. For instance, performance based stocks are only awarded to the executives after they meet the set performance goals. Restricted stock units are given under the requirement that an executive has to stay with a company for a certain period before they can fully acquire the stocks. Generally, the use of share based compensation is used to tie the executives with the company for a certain period. This is critical in the sense that financial success of the executive is dependent on the financial performance of the company. Severance payments are also used as a method of executive compensation. Essentially, the severance payments are meant to safeguard the executive in case the employment contract is terminated prematurely. This is a reality in the corporate sector and an executive may be sacked pre maturely due to hostile take-over, ownership changes and other issues. In case the CEO is sacked and this circumstances, severance pay is paid in full. Recent cases where CEOs have received severance pay include the recent case of HP’s Leo Apotheker who received over two million dollars as severance pay. Stock options give the executives a right to purchase stocks at a quoted price over a certain period of time. The exercise price is usually at that the stock option is given. The catch is that a vesting period before which the stock option can be exercised is several years hence the executive has to perform well in the course of the set period so the stock appreciates in value. Hence, when the executive finally buys the shares, the market price will be considerably higher than the pre-determined price of offer. Recently, the concept of stock appreciation rights (SAR) has gained value. This is whereby the executive has a right to receive payment according to the appreciation of the stock. The effect is therefore comparable to that of stock options. SAR are, however, easier to manage as they do not require the company to provide stock or executives to buy and to sell the shares in order to benefit from the increase of the share price. Compensation packages may also combine share-related goals with supplementary objectives. 5. Agency Model of Management In the agency theory, the core assumption of the owner is that the manager of the firm will entirely seek to maximize their personal interest. Essentially, the manager is assumed to have personal pursuits in the running of the company. This means that whenever the manager makes decisions about the firm, the owner assumes that the manager will favoring the stakeholders, not the organization. In order to handle the perceived conflict of interest, the owner is forced to put in place mechanisms to check the manager’s decisions. The owner will put controls that limit or restrict the decision making process so that the interests of the owner are taken care of. Agency theory is the most prominent leadership theory of the recent times. It has been the main management style that is practiced in most companies whereby the management is given checks and controls to ensure that their policies are in line with those of the shareholders. According to (Meckling, 2006), the focus of any organization is to ensure that it maximizes utility and the managers are simply supposed to advance the interests of the owner. Therefore, the business owner places controls to ensure that the interests of the manager do not override the ones of the owner. The agent is not empowered but rather restricted in a manner that allows the owner to exercise oversight on the manager. The manager is not given a free hand to make decisions and the owners’ exercises influence on the key decisions in the organization. Most organizations practice this style of leadership. This is because the organizations lay heavy emphasis on neoclassic economic theory whose main argument is that of utility maximization. It is assumed by default that the executives will pursue self interests. Hence, the executives are given performance contracts that clearly outline the expectations of the owners and the executives are supposed to follow the given guidelines. The CEO does not have a free hand to pursue business prospects that are not aligned to the vision of the owners. Criticism to this theory has been forthcoming especially considering its simplistic understanding of human beings. According to Klein (2009), human beings are complex and simply giving them hard coded instructions does not present them with the opportunity to give their best performance. He further argues that sometimes the vision of the owners might not be in line with the business realities on the ground. The owners should trust the executives to give them the necessary support. 6. Steward Theory of Management The stewardship theory of management is based on the assumption that the executives are supposed to act in the best interests of the owners of the company. According to the theory, the model of man proposes that the executive will in favor of the organization and put the ideals of the company above self interests. The CEO is considered as a steward of the company and in that sense, the CEO will work to ensure that the performance of the organization is maximized. Over the period beginning from the year 2000, few organizations have implemented the steward based theory of management. Notably, Apple has applied this theory and it has been successful as evidenced being such a profitable company in the world. The company board entrusted its CEO, the late Steve Jobs, the overall management of the company operations and the business lines it was going to pursue. In contrast to the agency theory, the steward theory of management seeks to empower the CEO. Thus, the CEO is given all the necessary information, support and authority to make what favors the company. In fact it has been argued that putting little or no restrictions on the CEO helps to improve the performance of the company (Gilbert, 2009). This is because people are more productive when they feel trusted to make decisions by themselves. It is imperative that too much control and restrictions may be counterproductive as they curtail the spirit of self initiative that is vital for success of any enterprise. With the immense advantages of the stewardship theory, it would seem obvious that it should be the best choice for management in companies. However, the uptake of this theory in practical nature has been low due to the risks associated with it. By implementing the stewardship theory of management, the owners have to cede some of their influence in the running of the organization. Also, the successful implementation of the stewardship theory requires that the owners build the requisite relationships of trust. However, it should be noted that the stewardship theory of management has a lot of advantages if implemented correctly. Donaldson and Davis (2007) argued that the agency model places a limit on potential of an organization since it seeks to control costs and minimize risk. However, the stewardship theory of management seeks to maximize the potential of a business and empowering the executive to be the best that they can be. The successful implementation of the stewardship theory requires that the organization should develop the tenets of open communication, trust and long term orientation. According to research (Baker, 2005), these values are critical for an organization to be successful. Mayer (1999) also pointed out that open communication helps to develop high commitment levels in an organization. It should be noted that the stewardship theory is vital especially in the highly dynamic business environment. CEOs need the flexibility and the freedom to make business decisions quickly in response to the changing business environment. In the case of the agency theory, the executives have to consult the owners before making any major decision concerning the business. This may take time and thus the business may not be able to adopt the business strategy. As such, management that is based on the premise of agency theory may lack the competitive decision making versatility that is required to be successful in business. 7. Conclusion CEOs have been on the driving seat of the very dynamic business environment. Since the year 2000, the compensation packages for CEOs have increased tremendously. The scope of the pay to CEOs includes fixed payment and variable payments. Due to the tough economic times occasioned by the economic crisis in 2008, the pay packages of executives were lowered. However, according to the statistics the pay that CEOs receive is still high. The theory of management practiced by most firms is the agency based model which lays emphasis on the control and minimal empowerment of executives. This management strategy is defective in that it limits the potential of a business. The CEOs of such companies have little lee way in the direction that the business will take and have to strictly abide by the desires of the management. However, the alternative theory of stewardship is more advantageous especially in the present business environment. CEOs need to be empowered to make decisions in the companies that they run. According to research, companies that consider their CEOs as stewards have been succesful compared to those that restrict the decision making ability of the CEO. In conclusion, it is evident that the CEOs pay packages have increased significantly. This might put more pressure on the resources of the companies that they run but it is also important to appreciate that their jobs are extremely demanding. In order to justify the high payments that the executives receive, the compensations should be tied to their performance. Also, companies need to implement the stewardship theory of management to give CEOs the ability to make decisions effectively. References Baker, J. (2008). Pay Without Performance: The Unfulfilled Promise. New York. Pearson. Bruce, D. (2008). The Complete Guide To Executive Compensation. New York. McGraw Hill Charles, M., Garry, P. (2007). Executive Compensation Trends. Oxford. Oxford University Press Donaldson H., Davis R. (2007). The Myth of Management: Agent or Steward? Oxford.. Oxford University Press. Gilbert .L. (2009). Agency Management Theory. New York. Bantam Books Howard, M. (2004). Analysis of Executive Compensation. London. Oxford University Press Haberberg , A (2004). Strategic Management: Theory and Application. New York. Pearson Klein J. (2007). Executive Perks: Are They Justified. New York. McGraw Hill Publishing Co. Michael A, Robert J. (2008). Strategic Management Theory. London. Cambridge. Murray K (2008). Effective Executive Compensation. London. MacMillan. Read More