Executive Compensation Schemes in Corporate Governance - Research Paper Example

Executive Remuneration Introduction: Reward and recognition continue to play an important role in retaining employees. Many organizations offer cashand non-cash recognition to encourage high performing employees and potential leaders. Remuneration is the compensation an employee receives in return for his or her contribution to the organization. Remuneration occupies an important place in life of an employee. His or her standard of living, status in the society, motivation, loyalty and productivity depends upon the remuneration he or she receives. For the employer too employee remuneration is significant because of its contribution to the cost of production. The HR specialist has a difficult task of fixing wages and wage differentials acceptable to employee and their leaders. Executive remuneration has assumed considerable importance in recent years. Salaries and perks paid to highest decision-makers in organizations are skyrocketing, and this sudden spurt in managerial remuneration was the result of economic deregulation and the consequent entry of MNC's into the various regions. Discussion: Basically executive remuneration is comprises of five elements. They are: Salary, Bonus, Commission, Long-term incentives & Prerequisites (Perks). In order to understand which components of remuneration are more effective, we need to understand the conceptual framework or theories of employee remuneration. Three such theories are - Reinforcement and expectancy theory, Equity theory & Agency theory. The expectancy model has its roots in the cognitive, concept of pioneer psychologists Kurt Lenin and Edward Tolman. However, the first to formulate an expectancy theory, directly aimed at work motivation, was Victor H. Vroom. Expectancy theory is based on the idea that work effort is directed towards behaviors that people believes will lead to desired outcomes. Despite its general appeal, the expectancy model has some problems. It is important to discover what kinds of behavior the model explains and to which situation it does not very well apply. Contrary to the assumption of the expectancy theory the individuals make decisions consciously; there are numerous instances, where decisions are made with no conscious thought. It is complex, and thus its validity is difficult to test in its entirety. Limitations apart the expectancy model is useful in as much as it serves as a heuristics decision tool to guide managers in dealing with the complexity of motivation in organizations. Motivation principles such as encouraging employees' performance and matching rewards to performance can be drawn from the theory. These principles can be used to guide managers in designing organizational rewards, work systems, Management by objectives, and goal setting. The equity theory is another process theory. The theory owns its origin to several prominent theorists like Festinger, Heider, Homans, Jacques, Patchen, Weick and Adams. However, it is Adam's formulation of the equity theory which is most highly developed and researched statement on the topic. The equity theory proposes that individual's attempt top reduce any inequity they may perceive as a result of exchange relationship. The equity theory is based on the judgment of fair treatment. The difficulty is that not everyone appreciates the concept of fairness equally. Equity predictions, therefore are more likely to apply to people who are morally mature, that is individuals guided by a normal system in which the fair distribution of rewards is a fundamental tenet (Steers and Porter, 1975). The agency theory focuses on the divergent interests and goals of the organization's stakeholders and the way that remuneration can be used to align these interests and goals. Employers are the two stake holders of a business unit, the former assuming the role of principles and the later the role of agents. The remuneration payable to employers is the agency cost. The agency theory says that the principals must choose a contracting scheme that helps align the interest of agents with the principals own interests. These contracts can be classified as either behavior oriented (e.g. Merit pay) basically for employees and outcome-oriented (e.g. Stock option schemes, profit sharing and commissions) generally for executives. At first sight outcome oriented contracts seem to be the obvious solution. As profit go up, rewards also increase. Remuneration, falls when profit go down. Apart from these individual remuneration models, organizations are moving towards team based remuneration plan. For instance, at Compaq Computer Corp. as many as 25% of the company's employees are on teams that develop new products and bring them to market (Hewitt Associates, Lincolnshire, II reported in Wall Street Journal 1995, November 20). All Team based pay plans normally rewards all team members equally based on group outcomes. These outcomes may be measured objectively or subjectively. The criteria for defining a desirable outcome may be broad or narrow. When properly designed team based incentives have two major advantages i.e. they foster group cohesiveness and they aid performance measurement but has certain disadvantages too. These may have possible lack of fit with individualistic culture. Intergroup competition may lead to a decline in overall performance. Identification of a meaningful team is also one of the major hurdles for remuneration distribution. But in the organizations where structure is flat and technologies allow separating work, teaming based remuneration could be implemented. Now apart from all above theories and models for remuneration, executive remuneration has certain unique features. These could be listed as: Executive remuneration can not be compared to the wage and salary schemes meant for other employees in organizations factor and variable are more numerous in management jobs and simple comparisons and ratings may not be possible; Executive are denied the privilege of having unionized strength; executive remuneration has been kept secret. Remuneration depends upon such factors as competence, length of service and loyalty to the founders; Executive remuneration is not supposed to be based upon an individual performance measure but rather on unit or organizational performance. This is because an executive own performance is assumed to be rather directly reflected in measures of unit or corporate performance. However, in practice, an executive pay may not be linked to the organizations performance; executive remunerations may be regulated by some laws or may be in different countries. According to some estimates each of the Fortune 500 CEO could live to age 95 among the top 2% of Americans if he or she saved just one year's pay. At the higher end some could have $ 1.2 million a year for life by saving one year's pay (Poster, 2002). CEO earn approximately 240 times what the average employee makes up from 42 times in 1980, and far more than any other industrialized nation both on absolute and relative grounds. That is, US CEOs make more money than CEOs in other countries and they earn more compared to what the average worker does than CEOs from other nation earns. For instance, in Japan the CEO is paid 33 times what the average worker is paid (Lublin, 2002a, and 2002b). Until the most recent bear market, the trend has been for CEO pay to be less in form of salary and more in form of long term income (stock options). Between 1995 and 1999, CEO salary as a proportion of total pay dropped by almost 20% while long-term income grew by almost 20%. This trend was a result of several factors including favorable tax treatment for long-term income; stock grants not counted as an expense in balance sheet; a rapidly rising stock market; and investors calls for greater CEO accountability (unlike salary, long term income is not assured and reflects growth in share- holder value). Ironically, the trend towards greater emphasis on long term income to rewards executives has had several unintended consequences. The bull market trend can make CEO/Executives pay soar, fueling the belief that executives/CEOs pay is out of control. Executives may decide at any time to cash the stock options they received it is difficult to link between CEO/executives pay and firms performance. When the stock market changes from bull to bear, firms face the problem of what to do with executives, whose stocks "are under water". Many firms believe that underwater options are demotivating to executives and could make those executives an attractive recruitment target by competitors. A large number of plans are used to link executives pay to firms' performance but there is little agreement which is best. This disagreement is only heightened by the huge some of money involved and the weak or inconsistent correlation between executives' earnings and firm performance (Hyman, 2000). There are numerous justifications which have been around for paying more to executives. The managerial performance and the skill is one such area. The executives have intrinsic worth and hence command hefty premiums. Managerial personnel matter much in organizations. Organizations are often positioned after great personalities. Positioning organizations after individuals is more visible in service organizations. Individuals with their technical ingenuity, financial wizardry, marketing, brilliance and sheer charisma have grown into veritable empires. Such growth has benefited all stakeholders, particularly the shareholders obviously; the executives who have made the organizations successful deserve high salary sweepstakes. These categories of people are always in short supply. One must pay heavily if one has to attract talented and competent individuals. Obviously, one should pay more to talented executives. Retaining high caliber personnel is more difficult than attracting them. The management must throw norms of wages and salary administration to winds and pay the executives well. Their remuneration must be reviewed annually and frequent salary likes should be made otherwise, there will be a flight of people and there are always opponents to hijack them. Succeeded in retaining the executive, motivates to better performance and they inspires others. The rise of high-tech, knowledge based information-tied and service oriented businesses need good brain power, which ultimately be paid handsomely. Executives' remuneration may be a symbol of social prestige. The financial reward is also a symbol of the executives' role itself, its power, its dignity and its freedom. Apart from all these rationale for high executives' remuneration several issues have cropped up in the context of remuneration provided to executive/highest decision maker in the organizations. The first question relates to the worth of an executive who has been paid so much Surely there are many numbers of employees in an organization whose competency is no less significant but their remuneration is in no way near to that of CEO or general manager. Assuming that an executive is worth that much the success of an organization does not depend only on individuals. The healthy bottom line of an organization is the result of combined efforts. Another issue relates to the gap between the pay drawn by an executive and the wages paid to a worker. Huge disparities in incomes are often dysfunctional. Disparities in pay increase the probability of top executives getting alienated from frontline employees. It creates a psychological distance and also life style disparities. This is why executives at various levels sometimes tend to feel out of touch and uncomfortable while dealing with frontline employees. One of the popular arguments in favor of lefty pay scales to executives is their motivation. They should be paid more to put in better performance. Looking at the flipside, money ceases to be the motivator beyond a certain point. Assuming that money motivates, these high-flying executives hardly stick to one organization. Majority of executives are known for organizational role less; gratitude and loyalty are words of the part. Finally the question of equity arises. When hundreds people are languishing in the job market it may be unethical to pay huge salaries and perks to select elites in the society. In the era of recession again, the controversy of executive remuneration has been cropped up. It has been seen world over that organization, shareholders, stakeholders and even governments are looking at the executive remuneration as an area of great concern when stock market almost dived down and stock values are depreciating, organizations are closing/liquidating the executive remuneration has not be affected in that ratio. Now if the organizations are not performing that well and making huge loss, even the governments are intervening and putting in tax payer money to save organizations. The hefty remuneration drawn by executives is becoming the area of serious concern. Now we will look into some aspects in the regulation which has been framed as model to frame executives' remuneration and its proper disclosure to shareholders. OECD has framed corporate governance policies for executive remuneration as well as their qualifications and relevant experiences in 2004 in their report (OECD, 2004). The report cites that the Information about board and executive remuneration is the major concern for shareholders. Of particular interest is the link between remuneration and company performance. Companies are generally expected to disclose information on the remuneration of board members and key executives so that investors can assess the costs and benefits of remuneration plans and the contribution of incentive schemes, such as stock options scheme to company performance. Disclosure on an individual's basis (including termination and retirement provisions) is increasingly regarded as good practice and is now mandated in several countries. In these cases some jurisdictions call for remuneration of a certain number of highest paid executives to be disclosed, while in others it is confined to specified position". Now keeping in mind the above parameters for corporate governance and executive remuneration justifications and disclosures most of the companies are practicing and even larger numbers of companies are not following the suggested model. Now as the major financial crisis spread around the world and government of the respective countries are intervening and providing financial packages to these companies, there is widespread concern about inappropriate practices which have been practiced all around the world about executive remuneration its disclosure to shareholders. The inefficiencies in pay-setting and pay from performances have been explained by Bebchuk and Fried (2003, 2004) on the basis of force of managerial power. Certain social structural and psychological factors directly or indirectly put OCED'S power over the board and other stakeholders in pay-setting process and CEO normally influences the process of his/her benefits. In the process of explaining managerial power and pay setting relationships, Bebchuk & Fried (2003, 2004) says that CEO's power to benefit other directors and executives (such as increasing their remuneration), friendship and loyalty between directors and CEO's norms of collegiality and directors deference to authority and cognitive dissonance in directors and the pressure of self justification. Compensation consultants add another layer to the complexity of the CEO compensation process. More specifically, these highly paid outside consultants are signaled out as helping camouflage excess pay (Bebchek & Fried, 2003). To ensure being hired in the future and to obtain other consultancy assignments they attempted to please the CEO and executive team by providing justifications for higher pay. To sort out this type of problem, Bebchuk & Fried (2003, 2004) provided us the certain ways ranging from better disclosure regarding compensation sources and the pay performance link, to improving pay arrangements through such measures as indexing options and limiting unwinding of options, to making boards more accountable to shareholders through increasing shareholders ability to place and replace directions. The ability to manage the executive remuneration and reform process for executive remuneration has already being debated and in the current financial turmoil it is taking the prime importance. There are clearly two views for executive remuneration has been surfaced. One is for reforms and restrictions on executive remuneration and other are against any reform or restrictions. The justifications for more remuneration have been given on the basis that executives are taking more remuneration because corporation are performing better and are running bigger." CEO's get paid more because they bigger, more valuable companies-if a good CEO can boost profit by $ 200 million has easily worth $10 million, or more" - (James K Glassman, American enterprises Institute, December 26, 2006). One of the main reasons has been generally put forward that executives are in short supply. "CEO's are paid what they are worth to their companies, and their high pay reflects the extraordinary value of their talent" - (Greg Mankin, former economic advisor to President Bush, Oct 14, 2006). It has been observed that the biggest component of remuneration is stock options. These options have provided the executive to manipulate short term gains at the expanse of long term returns. Options are widely being abused. But due to prevalent financial crisis, governments are willing to intervene. Critics often mischaracterize proposed pay reforms as iron-clad ceilings on executives especially CEO pay. In the recent article in Guardian, Britain Prime Minster Gordon Brown said that "rewards for failure", would no longer be tolerated (Julia Kollewe & Graneme Werarden, Guardian. co. UK 13th Oct 2008). The government in UK announced banking rescue package on 13th Oct 2008 has put a clamp on bankers pay reforms. The treasury announced that a wide ranging rescue plan under which bank bosses face a crackdown on pay and bonuses. In US there is a proposed legislation introduced on March 1, 2007. This bill would require public companies to allow an annual non binding shareholder vote on executive compensation packages. The legislation requires disclosure of "golden parachutes" that unfurl upon the sale or purchase of company asset (HR.1257) HR 1257 is a scaled back version of Frank's bill 2005 the "protection against executive compensation abuse set (HR 4291). Conclusion: After discussing at length, we come to the conclusion that apart from regulations and discussions, executive remuneration could be based on following points. 1. Income beyond a certain limit must be subject to higher taxation. Payment beyond specified limits needs the approval of government & shareholders. 2. Executive on their own must take up more and more socially responsive actions. 3. Conscious efforts must be made to increase the supply of talented people. 4. Participative management needs to be encouraged. Employees must be offered stock options. The concept of corporate governance is highly helpful in resolving the issue. There may be the formation of a remuneration committee which will determine on behalf of shareholders, remuneration to be provided to executive. Executive remuneration will probably always be more an art than science because of all the factors that must be considered and each firms unique conditions. Organizations have now realized that finding and keeping the right executives and employees also requires a multifaceted strategy. None the less, it is safe to say that an executive compensation plan is more likely to be effective if 1. It adequately balances rewarding short term accomplishment with motivating the executives to consider the firm's long-term performance. 2. The incentive provided are linked to the firms overall growth strategy. 3. The board of directors can make informed judgments' about how well the executive is fulfilling his or her role and 4. The executive has some control over the factors used to calculate the incentive amount. (Gomez- Majia, and Wiseman, 1997). References: 1. Bebchuk, L. A. & Fried, J. M. (2003). Executive compensation as an agency problem. Journal of Economic Perspectives, 17(3): 71-92. 2. Bebchuk, L. A. & Fried, J. M. (2004). Pay without performance: The unfulfilled promise of executive compensation. Cambridge: Harvard University Press. 3. Gomez- Majia, L.R. and Wiseman, R. (1997). Reframing executive compensation: As assessment and outlook. Journal of Management, 23(3), 291-374. 4. Greg Mankin, Former economic advisor to President Bush, Oct 14, 2006. 5. Hewitt Associates, Lincolnshire, II reported in Wall Street Journal 1995, November 20. 6. Hyman J. S. (2000). Long term incentives in L. Berger and D.R Berger (Eds.). The compensation hand book, New York; Mc Graw Hill. 7. James K Glassman, American enterprises Institute, December 26, 2006. 8. Julia Kollewe & Graneme Werarden, 13th Oct 2008, Executive pay set for radical clampdown, accessed from website guardian.co.uk on14th march 2009. 9. Lublin J. (2002b), The hot seat, Wall Street Journal, B-10; April 11. 10. Lublin, J. (2002a), Executive pay under threat, Wall Street Journal B-7; April, 11. 11. OECD (2004) Principles of corporate Governance, OECD publication service, France. 12. Poster, C. Z. (2002), Retaining key people in troubled companies: Compensation and Benefits Review, 34(1), 7-12, Jan-Feb. 13. Steers, R.M and L.W Porter, (1975) Motivation and work behavior, McGraw- Hill, New York, P.5. Read More