SHORTCOMINGS OF COMPENSATION PHILOSEPHIES

Shortcomings of Compensation Philosophies

Amirsaleh Azadinamin
Doctorate of Finance Candidate

Swiss Management Center (SMC) University

December 7, 2011

Electronic copy available at: http://ssrn.com/abstract=2017448

SHORTCOMINGS OF COMPENSATION PHILOSEPHIES Abstract This paper looks upon traditional performance measurements and compensation philosophies and assesses their shortcomings in todays competitive market. Paper suggests that new methodologies are needed in order to properly align the interest on the employees with that of the employer. It also recommends new methods of compensations that are more properly aligned with the employees productivity and effectiveness. In such a system both employees and employers can benefit from the system. Managing the value and tools to measure the added value are the main topics of discussion here. The paper first talks about the traditional and dominant compensation philosophies and then focuses the discussion on the topic of ownership versus pay and the effectiveness of each. The pros and cons of each method, equity ownership and pay for performance, are each debated.

Electronic copy available at: http://ssrn.com/abstract=2017448

SHORTCOMINGS OF COMPENSATION PHILOSEPHIES Performance Measurements and Their Effectiveness New talents enter the fast-changing economy and it is up to the old economy to modify itself into the new one. Performance measurements and reward schemes have always been the subject of discussion in finding proper compensation methods. Authors Pettit and Ahmad (2000) discuss the main methods of compensation and whether they need to be the subject of change or modifications to achieve a more efficient strategy that is more effectively aligned with employees productivity and efficiency. One may also state that in a system where the interest of the employee is aligned with the interest of the organization, the incentive compensation will benefit both the company and the employee. Managing the value and tools to measure the added value are the main topics of discussion here. Measures that are obtained from financial statements lack the sufficiency to indicate the added value. These numbers fail to consider the weighted cost of capital. The only cost item mentioned in financial statements is the cost of debt; however, the cost of equity capital is overlooked. Thus, the income statement profit does not properly illuminate the added value. This has been discussed as of the main deficiencies of accounting standards. Furthermore, the cost of equity is not the sole factor distorting the financial statements. Saeedi and Akbari (2010) state yet another factor distorting the balance sheet: Considering the issue that the economic value added is calculated using information produced from conventional historical cost accounts, inflation can distort information content and applications of the performance measurement criteria. Inflation can distort economic value added through three factors, i.e., the operating profit, the cost of capital, and capital base and these distortions potentially result in inefficient investment and compensation outcomes.

SHORTCOMINGS OF COMPENSATION PHILOSEPHIES Accordingly, many managers take on projects that make the balance sheet seem more attractive, but may ultimately fail to generate added value. Judging from the previously failed compensation philosophies, one may believe that a new compensation philosophy is called for. The Dominant Compensation Philosophy Competitive levels of compensation, pay-for-performance, and significant levels of pay at risk are currently the dominant compensation philosophies. The primary focus of compensation committees seems to be determining an optimal level of competitive pay reflecting widespread belief that their most difficult challenge is to find an optimal balance between competitive pay and total cost (Pettit & Ahmad, 2000, p. 2). Management is often the sole decision making authority in determining the target capital structure and policies regarding pay distribution. This will ultimately lead to agency issues, which stems from the managerial team having the decision making authority affecting two parties with conflicting interest, the interest of managers with those of the shareholders. Pettit and Ahmad (2000) emphasize that pay-for-performance or incentive pay must avoid violating the existing balance among three competitive objectives, and furthermore, in compensation design for executives, one must take extra care to govern the balance between these factors: align employee interest with value creation, limit retention risk risk of losing good people during inevitable periods of poor or volatile performance, and to achieve this all at a reasonable total economic cost (p. 2). However, the question remains and one may ask whether the existence of balance among all three elements is effective in the compensation design. In a statistical regression analysis of thousands of executives, we found very little correlation between pay and performance (Pettit & Ahmad, 2000, p. 2). Pettit and Ahmad (2000) go on to explain that the total shareholder return, TSR, explains only 1% of the

SHORTCOMINGS OF COMPENSATION PHILOSEPHIES variation in the CEO pay. This is yet further evidence that dominant compensation philosophies have not been very effective, if not futile. Despite the discouraging results of our regression analysis we did find that most CEO pay seems to be pay at risk even more so for the New Economy CEOs. Base salary constitutes only about 30% of the Old Economy CEO pay at the 25th percentile, and less than 20% of pay for 75th percentile. Overall, more than 70-80% of total pay is typically pay at risk. For New Economy companies the proportion is even higher overwhelmingly in equity. Yet, its not working (Pettit & Ahmad, 2000, p. 3). In practice, variable pay is based on the ex post or the actual return, as opposed to the fixed pay salary which disregards the actual returns. With a robust compensation system in place that can truly align the interest of the owners with the interest of employees, both employees and managers can benefit from the system, as owners can enjoy the value added and managers can enjoy their share of the resulting pie. With proper compensation design in place, both parties will enjoy the fruition of the company. Ownership versus Pay Failure in effectiveness in other forms of compensation has driven organizations to use equity stocks or the ownership method. Equity based compensation plans have been widely embraced, specifically in the last decade due to the bull market. Bronstein (1980) believes that [a]n ownership position which established an economic basis for equating executive interests with corporate goals is fundamental to compensating the executive, whose responsibilities exert a basic economic effect on business outcomes (p. 64). However, criticism about the efficiency of the ownership design still remains.

SHORTCOMINGS OF COMPENSATION PHILOSEPHIES Compensation consultants and governance critics alike have effectively given up on compensation as a tool to achieve any alignment in interests whatsoever, resigned to the status quo where entrenched thinking and over-riding concerns with competitiveness have subordinated the alignment and motivational aspects of compensation (Pettit & Ahmad, 2000, p. 4) However, the equity schemes are not free of flaws, and there must be a strong owneremployee compensation contract. Based on the current literature, the wide use of stocks and stock options has also failed to cover the shortcomings in aligning the interests of owners with employees. There are some limitations to equity based compensation packages. Volatility and the price fluctuations is the first of the limitations. Many may not be able to psychologically handle the volatility, and to many others bearing the downside risk may be frustrating. Also, since the shares are always granted from the same company, the employee cannot enjoy diversification. The second factor imposing limitations on the scheme is the vague understanding that the majority of employees have on valuation, and in general from the global equity market. Besides, many employees may care about capital growth and the increase in stock prices, while the company may forgo the growth in stock prices for a market expansion. The third factor imposing limitation is the lack of direct link between the actions and the incentives. In case of cash incentives, the employee would receive the incentive for her decisions in a shorter period in comparison to equity based packages where the change in share prices has no correlation with the actions of the employee. There is yet another open question regarding the design which could ultimately be recognized as a flaw in the incentive design. The following question can best illuminate the issue. Should the managers pay be a function of performance and managerial ability as it is

SHORTCOMINGS OF COMPENSATION PHILOSEPHIES intended to be, or is it a function of the size of the company? A study has been done, as mentioned by Wyld (2008) which contributes to the understanding of managerial pay, and whether the pay will change if the manager is replaced by a manager with less or more managerial capability. [P]erhaps the money invested by top firms to attract and retain superstar management talent doesnt improve market returns relative to less talented (and cheaper) executives (p. 83). This study is yet another proof of ineffectiveness in aligning the pay with performance. The Case for Change A comprehensive design with the capability to eradicate the dysfunctional impact of compensation designs has yet to emerge. There have always been elements of the design that are impractical but recurring, that do not perfectly align the interests of the company with that of the employees. These elements may cause the employees to act and follow lower work ethics than those expected of them. The insufficiency in the design may be due to various factors. Pettit and Ahmad (2000) explain these factors as the following: Too many measures. The performance metrics that have been traditionally used have not been able to completely convey the values that have been initially intended for the incentive packages to imply. Besides from the fact that they are numerous, many of them appear vague to the employees as how they can maximize their pay based on compensation designs intended for them. Performance legacy issues. Value is created when performance is increased. Reaching a high, but previously obtained performance target, does not add value to the organization. This is yet another factor overlooked in design packages. Tying incentives to absolute levels

SHORTCOMINGS OF COMPENSATION PHILOSEPHIES performance, rather than performance improvements, effectively pays for history (Pettit & Ahmad, 2000, p. 6) Budget arbitration. The concept of fixed annual budget that comes out of the negotiation table will undermine the efforts of those who over perform and rewards those who are not performing up to the expectations of the organization. Performance floor and ceiling. Very similar to the previous point, if the performance index is below the floor or over the ceiling, it will cause the employee to slack off in bad or good years respectively. If the performance target of the employee falls outside the range of given range, outside the floor or the ceiling, then the employee has no motivation to act. Short time horizon. Compensation pay practices are mostly done annually, and this comes in conflict to long-term goals of organizations. The short-time horizon of the employee may come in conflict with the interest of organizations that are mostly based on a long-term horizon. Sharing Value Creation As it was mentioned above by Pettit and Ahmad (2000) there are clearly shortcomings to the design compensation processes. These are the limitations that would lead to ineffectiveness of the incentive packages and their failure to align the interest of the company with the employees. A new approach is needed, and it must encompass new measures to effectively align the interests of both parties. This approach can only be reached through a comprehensive combination of tools and features that would effectively create an owner-employee contract to share value creation. The following are suggested features offered by Pettit and Ahmad (2000):

SHORTCOMINGS OF COMPENSATION PHILOSEPHIES A proper single measure. Economic value added could be named as a single and most credible measure that captures true profit. It bears into self the capital and cost of it, and thus, it is a clear indication of improvements and growth. Value-based goal-setting. Goals that are based on value will appear essential in establishing the correct performance standards in which the values are shared by both the company and its employees. These sets of goals create a common ground for both parties, and it avoids the issue regarding conflict of interest. Multi-year accountability. This element will eradicate the discrepancy in the time horizon for the employee and that of the company. This will create an annual payment as a function of annual performance, but holding a draw against cumulative, multi-year performance (Pettit & Ahmad, 2000, p. 7). Equity-like payoff. In order to eliminate the mentioned factor of performance floor and ceiling, a straight line incentive, where there is no limitation to upward /downward incentives and employees are paid in proportion to their performance, is called for. Following this design feature, employees would be aware of short-term misbehavior as it will affect their performance even in the short run. This measure would not only guard against short term damages in case of a random misbehavior, but it would also ensure the continuous flow of payments. Concluding Remarks Equity shares are granted to managers as part of the reward schemes intended for pay-forperformance compensation packages. Through these programs stocks are granted to those whose performances meet a certain predefined criteria. The performance matrices are not free of flaws, and they have been rather insufficient in aligning the pay with performance, which ultimately leads to conflicts of interest of the company and that of the executive. Performance measures

SHORTCOMINGS OF COMPENSATION PHILOSEPHIES commonly used are mostly based on business growth indicators such as earning-per-share, which fail to consider the cost of equity. These measures fail to consider the true cost of doing business, and hence, they fail to illuminate the true profits or the economic value added. And again, this poses as an obstacle in aligning the pay to the performance. In addition, the time horizon of an organization may differ with that of executives, which may lead to managers with priorities that are not in the best interest of the organization. Goals that are value based and multi-year are better performance measures and are ultimately better replacements for a new compensation philosophy.

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SHORTCOMINGS OF COMPENSATION PHILOSEPHIES References Bronstein, R. J. (1980). The equity component of the executive compensation package. California Management Review, 23(1), 64-70. Pettit, J., & Ahmad, A. (2000). Compensation strategy for the new economy age. EVAluation, 2, 1-9. Saeedi, A., & Akbari, N. (2010). Impacts of inflation on the effectiveness of EVA: Evidence from Iranian companies. International Research Journal Of Finance & Economics, (37), 66-78 Wyld, D. C. (2008). Bigger CEO pay packages: Does market value matter more than ability?. Academy Of Management Perspectives, 22(4), 82-83. doi:10.5465/AMP.2008.35590357

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