COMPENSATION PACKAGE

OF A CHIEF EXECUTIVE OFFICER

SUBMITTED BY:Ritu Tiwari (2K10B54) Shweta Pandey (2K10B46) Mahua Sarkar (2K10A29) Manika Panchal (2K10A30) Prachi Chaturvedi (2K10A55) Sonam Rathi (2k10A)

Chief executive officers (CEOs) get paid lots of money for being the top employees in the company. Why do they get paid so much? Like athletes and actors, CEOs provide a level of talent that is required to produce the desired product - in this case, a strongly performing company. The skills and responsibilities that come with the job of CEO are extreme and the number of people who can fill these roles is limited. That is why the market has determined that people with these skills are worth a lot of money to their companies.

Only about 20 percent of a CEO's pay is base salary; the rest is made up of incentives based on the company's performance. The rationale is that if the company is performing well and the shareholders are making money, then the CEO should share in that success

Executive compensation is a complex and controversial subject. For many years, academics, policymakers, and the media have drawn attention to the high levels of pay awarded to chief executive officers (CEOs), questioning whether they are consistent with shareholder interests.1 Some academics have further argued that flaws in CEO pay arrangements and deviations from shareholders interests are widespread and considerable.

CEO pay sets a ceiling for the company A CEO's compensation package affects everyone within a company. Often it can be considered the yardstick by which all other employee benefits and bonuses are measured and negotiated. Moreover, the CEO's compensation may be an indicator of how well the company is performing. This performance, in turn, could translate into a more generous compensation package for individual employees who are savvy negotiators. When companies establish pay structures, they define the compensation for the highest- and lowest-paying jobs before filling in the compensation for the jobs that fall in between. In the traditional internal equity method of establishing a pay structure, the CEO's compensation sets a ceiling for the company, and each level below is compensated at a comparably lower level. If you know how well

the CEO is compensated, you can get a sense for how generous the company is likely to be toward other employees as well. CEOs make most of their money through incentives As a general rule, base salary accounts for just 20 percent of a CEO's pay. The other 80 percent comes from performance-based pay.
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Base pay for the core role and responsibilities of the day-to-day running of the organization. This amount is very often less than $1 million because the IRS has imposed tax restrictions on "excessive" compensation.

Annual bonuses for meeting annual performance objectives.

Long-term incentive payments for meeting performance objectives to be achieved for a two- to five-year period. These awards are sometimes described as performance shares, performance units, or long-term cash incentives.

Restricted stock awards as an incentive to assure the executives are strongly aligned with the interests of shareholders. Because restricted stock awards have an actual cash value when they are granted, the proxy table shows these in dollars, not in shares.

Stock options and stock appreciation rights (SARs) for increasing share price and increasing the shareholders' returns. Options have very favorable accounting treatment for the company, which is why they are so common. Option grants are always shown as a number of shares underlying the option. In a subsequent table in the proxy is an estimation of the present value of each option grant assuming a 5 percent and a 10 percent increase per year in the stock price, or using a mathematical model (e.g., Black-Scholes) to predict the value of the option.

Total compensation for CEOs goes beyond cash and stock

Although typically excluded from pay calculations, executive benefits and perquisites are disclosed in the summary compensation table and the retirement plan section of the proxy. They include the following.
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Supplemental executive retirement plans (SERPs), which may keep the executive whole (that is, make up the difference) or better from a tax regulation that prevents the executive from receiving a pension benefit that exceeds ERISA limits ($135,000 per year or less based on the pension plan). For a CEO making $2 million a year, a $135,000 benefit may be inadequate for maintaining a comparable lifestyle.

Executive insurance plans that provide a source of retirement income and a richer death benefit to the executive's family. These plans are used to guarantee retirement benefits from bankruptcy. Unlike standard retirement plans that receive protection from bankruptcy by the federal government, SERP benefits can be lost in the event of bankruptcy.

Miscellaneous executive perquisites and other compensation for various programs or negotiated deals that don't properly fit into the above categories, including perks such as country club dues and financial planning. These are often small numbers that disclose imputed income amounts for those additional special benefits, but can also include some very large amounts for items such as loan forgiveness, special insurance programs, relocation expenses, etc.

At most companies, most of a CEO's pay comes from stock or stock option gains. At investment banks, most of it comes from annual bonuses. Companies that pay the lion's share of compensation in the form of stock options may pay little or no retirement. You can tell by looking for a retirement table in the proxy statement. If the words "SERP," "ERISA-excess plan" or "Top Hat plan" appear in the proxy, then retirement is an important part of the executive's remuneration. If not, then the executives are expected to retire on their ability to make and save money on their cash and equity earnings.

Pay philosophies often tie pay to company performance The company's Compensation Committee Report on Executive Compensation contains specifics about your company's compensation philosophy, which affects all employees. It covers the following.

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How well your company pays relative to its peers. Who the company sees as its peers. How the company's stock has performed relative to its peers and to the stock market as a whole. How the company prefers to reward its executives through its total pay practices, i.e., what proportion of an executive's total pay comes from salary, bonus, stock options, and long-term cash plans. How the company measures its performance - net income (NI), earnings per share (EPS), return on equity (ROE), return on assets (ROA), revenue growth, etc. What criteria are used for determining the size of bonus payments: corporate results, divisional results, individual goals; or whether payments are discretionary.

The degree to which your company is a success may be answered in the annual and long-term incentive payout columns in the summary compensation table. If you see large bonus payments, then it is likely that your company is successful. Stock option grants and gains are also important to look at. This information can be gleaned from three tables in the proxy statement: the stock option grants table; the aggregate option exercises in the last fiscal year and fiscal year-end option value table; and the total return to shareholders table. If there are large gains from stock option exercises and substantial amounts in both vested and unvested stock options, it may be an indicator that the company is well managed in the opinion of shareholders. Good five-year shareholder returns in the total return to shareholders table would certainly validate this opinion.

Cash compensation is the norm in nonprofits Nonprofit organizations typically offer compensation weighted heavily toward base salary. In response to competitive concerns, bonuses are becoming more prevalent as are special tax deferral programs that help executives save for retirement. Unlike comparable programs in for-profits, very few of these programs are broad-based. Participation is limited to a select few. Some watchdog organizations have been critical of the amounts paid to chief executives of nonprofit organizations. But these employers counter that they are competing for senior talent with for-profit organizations that can offer incentives such as stock options that are not available to them The Governance of Executive Pay

Contract theory shows that pay can ameliorate the agency problem by providing incentives that motivate managers to optimize the long term value or earnings potential of the firm. However, if the CEO controls the contracting process then, as Bebchuk and Fried have argued, compensation can be part of the problem rather than the solution. It is impossible to evaluate whether pay outcomes are optimal without better understanding the pay-setting process. In this section, we dig a bit deeper into what boards and compensation committees do to shed light on that relationship. The job of the board is to hire, fire, and compensate the CEO. When appointing the CEO, the board can choose to offer him an explicit employment contract or not (and, if not, the contract is implicit). Gillan ET al. and Schwab and Thomas describe the characteristics of explicit employment contracts. These contracts specify the CEOs salary, bonus, and incentive (option) package. The employment contracts typically have a fixed duration. They are not so called employment-at-will contracts, but are typically 2-to-3 year renewable. The contracts usually contain information about termination procedures, and provisions and non-compete and arbitration clauses. Schwab and Thomas show that employment contracts generally do not contain restrictions on the CEOs ability to hedge stock options. In addition, the employment contract contains information about perquisites (such as company car, country club membership, pension advice, company aircraft, and spouse travel). Gillan et al. show that less than half of S&P 500 CEOs have explicit contracts; the rest have implicit contracts. They demonstrate that contract theory explains whether the employment contract is explicit or not. For example, the contract is more likely to be explicit when there is greater potential for opportunistic behaviour post-contracting by the firm,

where the CEO is making large firm-specific investments or where there are greater information asymmetries between the parties. We showed earlier that boards and compensation committees furnish CEOs with important incentives via stock and options. The evidence on explicit CEO contracts documented by Gillan et al. and Schwab and Thomas shows that boards consider other elements of compensation, such as pensions and perquisites. Rajan and Wulf directly address whether perquisites represent managerial excess. They use proprietary data on a number of company perquisites and conclude that firms offer perquisites in situations where they are most likely to facilitate managerial productivity. As such, perquisites are not managerial excess, but instead form part of the complex contracting between the CEO and the board. In contrast, Yermack focuses on the use of company planes. He shows that when the use of aircraft is disclosed publicly to shareholders, there is a drop in stock prices of about one percent. The optimal provision of pension and perquisite arrangements in firms promises to be an important topic for future research.

Compensation Committees and Executive Pay A potential problem with pay arrangements highlighted by the managerial power theory is that compensation committees are inefficient. This section evaluates the effectiveness of this committee. Specifically, what incentives does the committee face to promote shareholder interests? Do compensation committee member incentives align with shareholders or, as managerial power theorists predict, with managers? Conyon and He explicitly test the effectiveness of compensation committees using three-tier agency theory and contrast it to a managerial power model. At the heart of the three-tier agency model is the idea that shareholders (the principal) delegate monitoring authority to a separate supervisor (e.g., a compensation committee) who evaluates the agent (e.g., CEO). Whether the supervisor will work in the principals best interest, or instead collude with the agent, is dependent on whether the supervisors interests are more tightly related with those of shareholders (principal) or management (agent). The value of the three-tier agency model is that it focuses attention on the supervisors incentives to promote shareholder welfare. To test the model, Conyon and He use data on 455 U.S. firms that went public in 1999. The study finds support for the threetier agency model. The presence of significant shareholders on the compensation committee (i.e., those with share stakes in excess of 5 percent) is associated with lower CEO pay and higher CEO equity incentives. Firms with higher paid compensation committee members are associated with greater CEO compensation and lower incentives. The managerial power model receives little support.

They find no evidence that insiders or CEOs ofother firms serving on the compensation committee raise the level of CEO pay or lower CEO incentives. A number of other studies have addressed the effectiveness of compensation committees as well. The balance of evidence suggests that the composition of the committee does not lead to severe agency problems. Studies show that executive pay is no greater if compensation committees contain affiliated directors. Compensation committees, though, have mixed effects on executive incentives. Anderson and Bizjak and Vafeas find no evidence that CEO incentives are lower when affiliated directors are on the compensation committee. However, Newman and Mozes conclude that pay for performance is more favorable to the CEO when the compensation committee contains insiders. In addition, Conyon and Peck show the link between pay and performance is greater in firms adopting compensation committees. We use the Investor Responsibility Research Center (IRRC) Directors database to further test the efficiency of compensation committees between 1998 and 2003. The data is of annual frequency and covers board members of the S&P 500, S&P MidCap, and S&P SmallCap firms. The dataset includes information on the board committees to which a director belongs, board affiliation, demographic characteristics, and other information.

The IRRC classifies a directorship as either Employee, Linked, or Independent. A linked director is a director who is linked to the company through certain relationships, and whose views may be affected because of such links, for example a former employee. A director is independent if elected by the shareholders and not affiliated with the company. In 2003, 18 percent of directors are employees, 13 percent are linked directors, and 69 percent are independent directors. The percentage of independent directors has been increasing annually, coinciding with a decrease in the number of employees and linked affiliated directors on the board. Boards, then, are becoming more independent over time. The lower part of the table focuses on those members of the board of directors who are part of the compensation committee. Compensation committees are becoming more independent over time as well. The percentage of affiliated directors on the committee fell from 12.8 percent in 1998 to 7.7 percent in 2003, and at the same time independence increased. One can hypothesize that affiliated directors are more likely to set contracts that are more favourable to CEOs relative to shareholders. For example, one might predict that CEO compensation would be greater and that the CEO would receive fewer incentives when the compensation committee contains affiliated directors. Such empirical evidence would be consistent with the managerial power perspective. To test this we performed some simple fixed-effects pay regressions.

We defined an independent binary variable equal to one if the compensation committee contains any affiliated directors and zero, otherwise. The measure is consistent with previous research. The results show that, after controlling for firm size, performance, macroeconomic shocks, and unobserved firm heterogeneity, there is no relation between CEO pay and a compensation committee containing affiliated directors. The coefficient of interest (affiliated compensation committee) is negative and insignificant in both regressions, indicating no effect on total CEO compensation or incentives. The results are consistent with the findings of Anderson and Bijack and Daily et al. who also find no relation between measures of CEO compensation and the composition of the compensation committee. The relation between incentives and firm size is also interesting. We expect firm size to relate positively to dollar equity incentives. This is because larger firms require more talented managers, who themselves are relatively wealthy compared to managers in smaller firms. In addition, Core and Guay argue that owners find it more difficult to monitor managers in larger firms and so are more likely to use equity incentives as a substitute for monitoring.