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Executive Compensation

Nature of Executive Compensation

Chapte r
Nature of Executive Compensation

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Executive Compensation

Nature of Executive Compensation

MEANING OF EXECUTIVE COMPENSATION

Executive Compensation means any reward given to top ranking executives such as Chairman, Vice Chairman, Executive Chairman, Managing Director, Joint Managing Director, Dy. Managing Director, Directors, Chief Technology Officer, Chief Financial Officer, Chief Operating Officer, etc., for services and expertise rendered to an organization. Executive compensation can be broadly classified as: Base compensation: This usually consists of salaries, allowances, medical and insurance benefits. Performance linked compensation: This usually consists of bonuses, incentive payments, deferred compensation plans, and stock options. Perquisites: This usually consists of personal staff, personal transportation, company leased or provided house, club membership, exclusive car parking, and paid vacations.

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Terminal benefits: This usually consists of severance pay, retirement Copyright 2009, Tapomoy Deb benefits, etc.
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Executive Compensation

Nature of Executive Compensation

DEFINITION OF EXECUTIVE COMPENSATION

Robert W. Kolb (2006) defines Executive Compensation as follows: Executive Compensation refers to the total reward provided by the firms to the top level of executives in a corporation, such as the CEO, COO, CFO, and a handful of other executives who occupy the very highest level of management. Author defines Executive Compensation as:
Executive Compensation refers to short-term and long-term financial and non-financial rewards given to top ranking executives under a contractual, legal and contractual mandate.

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Executive Compensation

Nature of Executive Compensation

AGENCY THEORY AND EXECUTIVE COMPENSATION

The association between shareholders and executives is an example of agency relationship. This relationship was defined by Jensen and Meckling (1976) as a contract under which one or more persons (the principal/s) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making. The underlying assumptions and sequence of action involved in agency theory/model are as follows:
Assumptions
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Principals (shareholders) are risk neutral or risk averse; Agents (executives) are risk-averse or risk neutral; Material incentives are necessary and sufficient to motivate executives to work; Higher sum of monetary compensation causes higher executive effort; and The effort of an executive is difficult to observe.
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Executive Compensation

Nature of Executive Compensation The sequence of actions Stage 1: Shareholders create a contract having or not the condition of awarding premiums; Stage 2: Executives sign or not;

Stage 3: Executives decide on quantity and quality of work they want;

Stage 4: Executives handle a work; Stage 5: Shareholders (through board of directors) evaluate the results; and Stage 6: Shareholders pay for work provided including premiums.
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Executive Compensation

Nature of Executive Compensation

AGENCY PROBLEM

AGENCY COST

ORGANIZATIONAL OUTCOMES

Conflict arising out of

separation of Ownership & Management Interest Divergence: Shareholders self - interest Executives self interest

Information asymmetry Moral Hazard Adverse Selection Empire building tendencies Collusive agreement between executive & supervisor/employee

Performance Risk Diversification Acquisition Sale of firm Executive compensation

Model of Agency Theory

CONTROL STRUCTURES UPON THE AGENT

Shareholders Remedies

Monitoring Incentives Bonding Writing of contracts

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Executive Compensation

Nature of Executive Compensation

PRINCIPLES OF EXECUTIVE COMPENSATION

Executive compensation is critical to the long-term interest of shareholders and attainment of organizational goals and objectives successfully. Therefore, executive compensation must be based on certain sound principles as under: 1. 2. 3. 4. 5. 6. 7.
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Attracting and retaining executive talents Upholding shareholder interests Performance based compensation Effective compensation committee Executives to shareholders Compliance of law Transparent disclosure
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Executive Compensation

Nature of Executive Compensation

FACTORS AFFECTING EXECUTIVE COMPENSATION

Milkovich and Rabin (1991) argue that executive compensation is more complex than meets the eye and that a strategic perspective on compensation needs a look beyond how much executives earn. The dichotomy of attraction, motivation and retention of good executives versus tough corporate governance and media spotlights, places compensation decision-makers in a difficult position (Merchant, 1989).
The factors affecting executive compensation are as follows: 1. 2. 3. 4. 5. Changing nature of work Investor confidence Effective benchmarking Governance Attracting and retaining high performance executives

6.
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Fostering right executive behaviours

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