Designing a Compensation Strategy - Literature review Example

?Running head: Design and Justify an Optimal Compensation Scheme to Reward Bank CEOs Introduction There has been an intense debate over the high level of payment to the CEO. Compensation of the executive is often a continuous and complex subject that involves the nature and process of the pay setting as well as the results such a setting generates. When the performance of a given firm is linked to the executive, it can generate a desired incentive that would enable the managers to bring their interest into line with those of the shareholders. The executives may be faced with dismissal following an action they undertook where the interests of the shareholders are not met. In the banking industry therefore, these relationship in governance may be quite complicated in the sense that the regulatory oversight is very likely to compromise the alignment of incentives. Several arguments have been advanced to suggest that the huge payment packages to the executive emanate from the influence of powerful managers who design the payments as well as extracting rents from companies. On the other hand, some argue that the large pay package for the executives is a result of optimal contracting in a market that is fairly competitive especially for talents in management. The importance of regulators as Berger et al. (2000) argue is to evaluate the bank holding condition. The supervisor analyze firm on the basis of financial conditions and risk management as well as present a bank with an assessment that is confidential. The issue of supervisory rating is related to executive compensation in banks, in that weaker ratings are closely related to intensive outside monitoring by the regulators. As such, the most favorable executive compensation design can be developed from a trade-off between risk shifting and perk consumption both of which are agency problems that the executives are faced with. Risk shifting can be said to be the risky behavior that managers undertake because of an incentive based compensation or reward. Perk compensation on the other hand, is consuming perks to the detriment of shareholders especially when there is little or no incentive based compensation for the managers. In instances where there is strong outside monitoring by the regulators, the limit risk usually shift on the managers part paid equity, consequently, an optimal design of executive compensation is achieved with improved sensitivity of pay for performance. Consequently, regulatory monitoring is capable of increasing the risk adverse behavior on the part of the executive. It therefore follows that in order for the executive to perform, their payment must be related to their performance. The banking industry is a unique sector in the sense that it must be able to operate within the regulatory confines (Sierra et al. 2006). The importance of government regulation cannot there be overemphasized. This is because the deposit insurance as well as system of payment ensures that the government can effective make a claimant on the assets of a bank. Discussion In the current global financial crisis, there are several causes that have been on the spotlight to explain the state. This causes as advanced include: the guiding philosophy for the global neo liberalism, the increase in the number of the subprime mortgages, and also the presence of the real estate market that is uncontrolled. That notwithstanding, it is the contention of this paper that there is more to current status than the aforementioned causes and that the main contributor to the current crisis has its roots in the problem of incentive. According to Fee & Hadlock (2003), an incentive can be defined in simple terms as a way of convincing persons to do less of the bad things and more of the good ones. It goes without saying that incentives form the basis of corporate life, especially in instance where the executives are involved, understanding them can be a key factor in addressing almost any riddle in an organization. However, the current corporate governance practices are called into question particularly those that are related to the payments of the executive. This may be due to the existence and continues dominance of the Agency theory, which has been used to handle the issues of executive pay. Through this theory, which espoused a shareholder as the principle and the manger as an agent, the principle is charged with the responsibility to design contracts of compensation in an effort to improve the opportunism of the manager, as the principles’ major objective is to maximize the value of a firm. Alan Blinder in his theory suggests that stock options can effectively be used in compensating the executives. In his theory, Blinder suggests that incentives should be created even for the imprudent risk taking. With the stock option, the executive can be able to take decisions to engage in excessively risky investment with OPM. In the event such an investment thrives, the executive is rewarded. This option of rewarding the CEO is optimal as they are left unpunished in the event of failure. According to the theory, the perspective of shareholders in a company is that the individuals who provide the Other People’s Money is complete insanity. To the shareholders, taking a risky investment with OPM looks like they have got a share of winnings on the heads, but at the tail they have to soak up the losses. Blinders’ theory suggest that when smart people are given go for break incentives they will not hesitate to go for broke. The pervasive incentive pay according to the theory remains the rule on Wall Street up to date, notwithstanding the emergence of some exceptions. CEO taking excessive risk is usually bound by fear. However once fear allows greed to come in, then most executives may take the bad antique incentives unless the system is modified. Fama (1980), Jensen & Meckling (1976), argue that following the logic of the theory, several best practices as they were called, were developed. These practices involve; separation of the CEO position from the chairman one, the use compensation tools based on outcome, and the independence of the board. Unfortunately, study shows that these practices have been applied to the black letter by quite a big number of even the recently failed companies. Even though there are substantial heterogeneity across different companies in respect of executive pay practice, in most cases the compensation package of CEO’s include five basic components. These components include: annual bonus, salary, restricted stock grants, restricted option grants, and payouts from long-term incentive plans. Additionally, the executives also receive, various perquisites, severance payment in instances of their departure, as well as contributions to pension plans benefits that are defined. Unfortunately, changes over time have considerably eroded the importance of these elements of compensation. It is worth noting that not all the best practice compensation tools that are ineffective in providing incentives for the CEO to enable him or her take a risk with other people’s money. The long-term outcome based incentive is one of the compensation tools that stand out from the best practices. With this tool, the CEOs may be offered stock options as an incentive in an effort to create or develop a better association between the shareholders and managers; this according to Jensen et al, (1976), p. 46 would cultivate an executive that is employment undiversified that is capable of assuming risks that are suitable to bring to the shareholders the desired value. Study shows that majority of the firms that drowned following the financial crisis of 2008, compensation packages of their executives were offered on the basis of a valuable, annual incentive performance based delivered in equity awards and cash. Actually, the aforementioned compensation practices have been the tradition in huge many huge financial service companies. Westphal & Zajac, (2001) are of the opinion that these large financial firms maintain such norms with the aim of mitigating the problem of information asymmetry but also for purposes of being at per or even outshine other rival companies. The stock option as a tool for executive compensation is and can be a great incentive as the executive will benefit in periods when the prices of stock rise and their real wealth is not affected in case there is a decline in the stock price. According to Murphy (2002), Hall & Murphy (2003), using the stock option as a tool for CEO compensation is a double edged sword as the executive will benefit in periods when the prices of stock rise, yet, the executive does not fill the pinch when the stock price decline since his real wealth does not reduce. For this reason, the executives are more likely to take actions involving excessive risk after all in the event of a drop in the stock price they will not at any one given point experience the loss of their wealth. To put it in a simple way, the mangers of a firm are likely to achieve better earnings following an undertaking that is extremely tentative, without having to worry about the possibility of the losing their wealth. It has been argued that the act of rewarding CEOs through programs of compensation can alleviate financial performance following the incentives. It is however worth noting that dismissal threats for performing poorly can also be a motivation for the managers to strive in an effort to maximize the value of a firm. The likelihood of executive turnover and the performance of the company are generally perceived to be inversely related. To have a comprehensive executive incentive measure, all possible links should be taken into consideration especially between that executive wealth and the firm performance. Academic literature has recorded long debate s on the CEO incentives and their right measure. In their work, Baker & Hall (2004) suggests that the right measure of the executive incentives is dependent on their behavior effect in regard to the value of the company. It is quite difficult to determine whether the compensation contract that are observed optimally alleviate the moral hazard that exist between CEOs and the shareholders. In that case, the strength of the optimal incentive is highly dependent on the unobservable parameters, such as the risk aversion by the executive, marginal product of executive effort, the executive’s outside wealth and the executive’s cost of effort. The forgoing free valuables in the words of Garvey and Milbourn 2003 reduce to bare bones the development of the principal agent versions that are compatible with various empirical patterns. Since the separation of corporate control from corporate ownership, a problem arose between the shareholders and the executive. As a matter of fact, if the shareholders (principal) cannot monitor the managers and the managers are self interested, there is a high possibility that the executives would undertake activities that serves their interests at the expense of the shareholders interest (Berle & Means 1932). In their argument, Jensen & Meckling (1976) suggest that the principal agency problem can be address through aligning the interests of the shareholders with those of managers. Basically, this means that the most informative indicators should be the basis of executive pay such as whether the actions taken by the executive maximize the value of the shareholder. This can be a workable tool as the shareholders often than not are very unlikely to be knowledgeable of the actions that are likely to maximize value. Thus, incentive contracts are based on shareholder. Compensation linked to equity provides necessary incentives to the executive to pursue actions that benefits the shareholders; this can be achieved through effectively giving the CEO a stake of ownership in the company. This contract there for provides equilibrium between too much volatility in the executive pay against incentive provision. It is therefore important to design an optimal scheme that can reward the executives regardless of the performance of the firm. There have been suggestions that a formula of compensation scheme should be adopted. This formula should include an element of constancy (K) in that compensation of executives remains independent of the profits of the firm and the state of the economy. The formula should also have an element that varies with the profit of the company ?? (e): S (e) = K + ?? (e) Sometimes however, executive incentive contacts may not always bring out the intended objectives of the shareholders. For instance, that exit package of the executive often referred to as golden parachutes. This is usually a clause included in the employment contract of an executive specifying that he should get certain benefits in the event of termination of the employment relationship. Even thought there are valid arguments that are advanced to justify this form of compensation, in the sense that they are able to protect the manager against risks that are beyond their control. However, these golden parachutes may represent ridiculous amounts of cash. It follows that putting in place such exorbitant packages for the exit of the executive may produce negative effects to the company since this would be like the firm is rewarding failure. Logically speaking this kind of an incentive can properly induce the executives to undertake extreme risks especially if the future of the firm is not promising. After all, he has a hefty package to take home. Arguments have been advanced to suggest that the current compensation system of rewarding the executive fall short of the intended outcome. The existing incentives for the executives may in the short run generate billions of dollars while in the long run produce deleterious consequence. According to Hartzell et al (2003) the system rather than encouraging the CEOs to undertake beneficial actions shareholders, it promotes instead self-centered behaviors among the executives. Conclusion Indeed, there is no easy solution to the problem of executive incentives. Some of the compensation tools may seem theoretically adequate to address the issue of incentives, and yet produce disastrous outcomes when they are put into practice. It should be noted that designing compensation tools is not a one-day task; it involves a lot of trials and error to come up with the appropriate design. It is quite unfortunate that even the existing principal theory has overtime failed to avail an adequate and effective compensation design that is capable of bringing into line the interests of managers, shareholders as well as those of the society at large. For this reason, all the stakeholders must work together in an effort to develop an adequate solution for the incentive problem. There is a lot to be learnt about incentives especially from the financial crisis of 2008. Even though risks must be taken for any business in order to get returns, the 2008 financial crises were provoked by excessive risks that had disastrous consequences. This is a clear indication that designing a compensation strategy that encourages the executive to simply take risks ignoring other factors can be disastrous for the company. Study shows that the stock option as a tool for executive compensation is and can be a great incentive as the executive will benefit in periods when the prices of stock rise and their real wealth is not affected in case there is a decline in the stock price. Additionally, most of the existing compensation tools do not comprehensively cover the fundamental elements of uncertainty and risks. According to John and Qian (2003), these tools have been proved to defunct and they need urgent modification or as Wheelock & Wilson (2005) put it they need to be eliminated and other tools such as using the stock option as a tool for CEO compensation. References Baker, G., & Hall, B. 2004. CEO incentives and firm size. J. Labor Econ. 22(4):767—98 Bebchuk, L., & Fried, J. 2004. Pay without Performance: The Unfulfilled Promise of Executive Compensation. Cambridge, MA: Harvard Univ. Press Berger A, et al., 2000. Comparing market and supervisory assessments of bank performance: who knows what when. 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An examination of multiple governance forces within bank holding companies. J Financ Serv Res 29:1–20 Westphal, J and Zajac, E., 2001. Decoupling policy from practice: The case of stock repurchases programs. Administrative Science Quarterly, 46, pp. 202-228. Read More