Alternative Approaches to Executive Compensation - Essay Example

Summary Affiliation Alternative Approaches to Executive Compensation Shareholders have no control in some publicly traded companies. This gives the managers a lot of substantial power Managers may use this power to serve their interests There are two ways of linking executive competition and agency problem, which include the optimal contracting approach and the managerial power approach. Limitations of Optimal Contracting Agency problem experienced by managers CEO can influence the nomination process for the board directors The directors may never challenge the CEO’s pay, as they may want to please the CEO.

Market forces are not strong enough to assure optimal contracting outcomes Failure of maximizing the shareholder value Directors’ interest in the firm is nominal and therefore may not be serious with the company management. Some agreements of the directors may be affected by market forces especially those affecting capital. Managerial power approach The Managerial power approach gives managers an opportunity to camouflage especially when extracting rent, The approach may lead to the use of structures unfavorable to the firm performance and managerial incentives.

The compensation arrangement design depends on the perception of the outsiders The managerial power approach may influence the relationship between power and pay without considering performance The CEO’s compensation may be influenced by transparency and salience disclosure. Power and Camouflage at Work Practices explained by power camouflage include Power Pay Relationship Pay is higher in if managers have higher power The board is ineffective There is a small outside shareholder Fewer institutional shareholders Managers are protected by antitakeover arrangements Managers with antitakeover policy compensate themselves more Compensation consultants Employed to provide advice on executive compensation May increase their incentive to please the CEO Used to justify executive pay instead of optimizing it Provides compensation data, which favors the CEO Stealth Compensation This is where a firm may use camouflaging practices to enable them to pay the executives large sums of money.

Payments include deferred compensation Loan forgiveness and consultation contracts Use of executive loans with favorable interest rates Golden goodbyes A practice in which the board pays the outgoing CEO gratuity or benefits not counted as compensation contracts Given even hen executives depart due to low performance The gratuities are influenced by the management Suboptimal Pay Structures Suboptimal Pay Structures include The pay without performance Executives receive huge pay to increase the value of shareholders Increased equity-based compensation May involve very large amounts of compensation to executives Option Plans, that fail to Filter Out Windfalls Stock option plans fail to filter out stock price rises Reduced windfall option plans may filter out some stock price increase.

Using the market-wide index and vesting may help in filtering At-the Money Options Another Sub optimal pay structure in which the executive is paid with the current market price without considering other factors such as inflation and their length of contract. The exercise price is above the current market price Are the most favorable to managers Managers’ freedom to unwind Equity Incentives Another challenge of the optimal contracting approach where managers sell their shares The action may force the company to give them new incentives.

Unwinding weakens the managers’ incentives Managers have the freedom of determining when to unwind The Perceived Cost Explanation Directors perceive conventional options to be or to grant or cheap Directors may overlook the costs of options to shareholders Inadequate information is one cause of misperceptions Cost to Shareholders The excess amount that the executive receive to compensate their power increases the costs on the firm’s shareholders. The executive is only interested in the compensation schemes, which can camouflage their extraction of rent.

Conclusion The power of management and extraction of rent influences the compensation of the executives. The executive compensation design is always influenced by the managerial power especially in the firms in which control and ownership are separate. References Bebchuk, L. A., & Fried, J. M. (2004). Executive compensation as an agency problem. Journal of Economics Perspectives, 117(2).