Benefits and risks of a top manager reward system

(1)

BACHELOR THESIS FINANCE TILBURG UNIVERSITY

MAY 2011

The benefits and risks of a top manager‟s

reward system

ANR s897535

Name Paul van Doorn

Study Program International Business Type of thesis : Literature review Name supervisor : Elena Pikulina

Topic : Long-term versus short term incentives in top manager remuneration

(2)

2

Introduction

In the current economic times top manager remuneration has become a renewed topic of discussion. While state funds were needed to save key firms in our economy, news about the bonuses and other components of top manager remuneration granted in the same firms spreads fast. Recently, the top management of ING bank, refrained from accepting their bonus after much public dispute about the level of it: top manager Jan Hommen of ING bank would receive 1.35 million euro of which half would be paid in cash and the other half in stock options on top of his base salary of 1.25 million euro. Furthermore he would receive a 2% base salary increase in 2011 (NRC Handelsblad, March 22, 2011). News regarding the executive remuneration is not limited to Netherlands listed firms, firms listed in the US have been increasing base salary and the maximum cash and equity bonuses are increasing as well (NRC Handelsblad, March 20, 2009). This news raises the question what drives remuneration and its individual components in particular. The goal of this paper is to provide a deep understanding of the remuneration schemes nowadays. In order to reach that goal, three research questions will be discussed. In chapter one I will discuss where the remuneration package of a top manager consists of. Subsequently, in chapter two more insight is given into the function of a reward system. Then, chapter tree will discuss the risks that are involved in a top managers reward system. Taken all these chapters into account, enough information is provided to gain a clear understanding of remuneration schemes. Last but not least, this will enable us to answer the main research question in the conclusion: what are the benefits and risks of a reward system for top managers in a company.

(3)

3

1. Where does the remuneration package of a top manager consist of?

1.1. Different forms of remuneration

According to Murphy (1999) most executive remuneration packages contain four basic components: a base salary, an annual bonus tied to accounting performance, stock options, and long-term incentive plans (including restricted stock plans and multi-year accounting-based performance plans). In addition, executives participate in "broad-based" employee benefit plans and also receive special benefits, including life insurance, and supplemental executive retirement plans (SERPs). Combined with other benefits in kind this paper uses „other remuneration‟ to refer to these latter benefits. In this part these ingredients of compensation are briefly discussed.

1.2. Base salary

Balsam (2002, pp. 35-36) defines base salary as: “Base salary is the fixed contractual amount of

compensation that does not explicitly vary with performance. However, it can be affected by

performance, as good performance can lead to higher salary in future periods.”

Base salary is a fixed amount of money, meaning that it doesn‟t change with firm performance. The top manager is therefore likely to take his base salary as a given, and will not be affected by any of his actions. Although base salary comprises a declining percentage of total compensation, from 38% in l 992, till around 18% in the early years of this century for CEO's of the S&P 500 firms (Jensen and Murphy, 2004), it is still one of the most basic and important types of the remuneration in the package for top managers.

The large payments of top managers are often defended by referring to the fact that their level is set in the context of the market ((Main, 1993) and Murphy and Zábojník (2004)). Thus, one could say that the level of base salaries is mainly determined through a type of benchmarking, wherein the level of executive base salary in firms in the same industry or market serves as a benchmark for the level of executive base salary in a firm (Murphy,1999). Because almost no top manager wants to earn a `below-average' base salary, firms often pay an above-average salary, thereby increasing the average level of pay in the industry. This can be regarded as a continuous cycle raising the level of base pay. According to Eaton and Rosen (1983), managers should be rewarded for the actions that they take at the moment and such that the results of their actions can be observed by shareholders. Looking at the base salary from this perspective it becomes clear that the base pay is only a compensation for past performance as suggested by Main et al. (1996). This is in line with the earlier suggestion of Main that pay is set to the market. Managers that have performed the best over time are the most wanted managers at the moment, and can thus ask for a large base salary. This explains what Balsams (2002) mentioned in his definition of base salary: base salary can be affected by performance, as good performance can lead to higher salary future periods.

(5)

5

Base salary serves a couple of functions. First of all, base salary serves to attract top managers to firms. In general top managers don‟t work for free, and base salary provides them with a basic compensation for their efforts. Secondly, base salary compensates the top manager for the risks inherent in the other, variable parts of their remuneration, part of which is beyond the executive's control (Core et al., 2003). As a consequence, base salary gives the top manager some certainty over his income, as a considerable part of his total remuneration is uncertain, and this uncertainty partly results from events beyond his control, such as e.g. a general economic downturn. To illustrate, according to Murphy (1999) risk averse executives will prefer a dollar increase in their base salary to a dollar increase in their target bonus or variable compensation. This could be explained by the fact that risk averse executives are not willing to take excessive risk to reach high target goals. As a consequence, they are forgoing their variable payments accompanied with engaging in risk taking.

Last but not least, most other compensation parts of top manager remuneration schemes are tied to base salary levels. For example, bonuses are often expressed as a percentage of base salary, options are expressed as a multiple of base salary and pension benefits and compensation for loss of office are also dependent on base salary (Murphy, 1998). Consequently, it‟s very worthwhile for a top manager to devote considerable attention to base salary negotiations since this has positive repercussions on many other remuneration components.

1.3. Annual bonus plan

An annual bonus plan rewards managers for their performance over the past year. Therefore, it can be considered as a short-term bonus which is a variable part of top manager remuneration. In figure 1 a graphical representation of a typical short-term bonus plan is shown. First of all, no bonus is paid until a pre-determined performance threshold is reached. Accordingly, when the threshold performance threshold is reached, the minimum bonus is granted to the top manager. The target bonus is granted when firm performance reaches its pre-determined standard which lies in the so called incentive zone: as performance improves beyond the threshold, so does the bonus until a maximum which is called the bonus cap (Murphy, 2001 and 1999).

(6)

6

According to Murphy (2001 and 1999) top manager annual bonus plans can be categorized in three basic components: performance measures, performance standards, and the structure of the pay-performance relationship.

Performance measures are the indicators that serve to determine the performance level that was achieved. In practice, companies can use one or more performance measures, which can be quantitative or qualitative, financial or non-financial, accounting-based or based upon other measures. Examples include operating profit, earnings-per-share growth, return on equity, customer satisfaction, etc. Bonuses are usually not, in practice, based strictly on a performance measure, but rather on performance measured relative to a performance standard (Murphy, 2001) .

Performance standards describe the targets or goals that should be achieved in order for the executive to be eligible for a short-term bonus . They typically correspond to expected

performance or, more precisely, the level of performance required to attain the executive's target bonus (Murphy, 2001). Murphy (2001 and 1999) distinguishes between budget standards, prior-year standards, discretionary standards, timeless standards and cost of capital standards. In the case of budget standards performance is measured against a company‟s business plan. Prior-year standards, compare results with the previous year. In contrast, discretionary standards are a subjective evaluation of performance. Peer standards are measured against that industry or market peers. Timeless standards, however, measure performance relative to a standard that is fixed over the years. Last but not least, cost of capital standards are performance standards based on the company‟s cost of capital.

(7)

7

Pay-performance structures determine the payout from a bonus plan. They ultimately set the minimum performance threshold and the performance cap above which better performance does not result in a higher short-term bonus. Thus, the pay-performance structure sets the incentive zone in which a pay-performance relationship exists. A graphical representation of this is shown in figure 1 above.

According to Murphy (1988), in the case that a company uses financial performance measures, most companies (91%) have at least one measure of accounting profits in their annual bonus plan. Non-financial measures like individual performance are included as well in the determination of bonuses. Since most companies use two or more performance measures to determine bonuses, both measures can also be used together.

The annual bonus for top managers is often based on a measure of accounting profit (Murphy, 1999). However, the use of accounting performance to determine bonuses not always triggers the right incentives, to maximize shareholders value. Accounting profits are namely backward-looking and look at the short-run.

For instance, managers who only focus on accounting profits, may avoid investing in things, like research and development, which increase future profits, but reduce current accounting profits (Dechow and Sloan, 1991).

Furthermore, account profits can be manipulated, either through discretionary adjustments in accruals, or by shifting earnings across periods (Healy, 1985). The performance standards and the pay-performance structures have incentive effects as well, in which managers can influence their bonus.

According to Eaton and Rosen (1983) the performance related bonus is a short term bonus often paid in cash or stock. In order to receive a cash- or stock bonus short term performance measures have to be met. The goal of these bonuses is to provide incentives to the management team to act in the best interest of the shareholders on the short term. Meeting the performance measures mentioned before should result in positive results for the shareholders.

However, shareholders should be aware of the fact that managers could manipulate the results on a short term in order to receive their bonuses. Namely, with earnings management, managers can manipulate the share price around performance measurement dates (Cornett et al. 2008). This negative effect can be overcome by using stock based compensation schemes. Equity ownership by managers can result in enhanced firm performance by providing incentives, or be a substitute for monitoring (Core et al. 2003). Nevertheless, it should be taken into account that this is only the case when the firm poses restrictions on the stocks that are rewarded.

In the case of restricted stock such as the investment shares, the manager is provided with an incentive over a longer period. If he is able to keep up the performance of the firm over a period of three years he benefits from it in two different ways. Firstly, his wealth increases due to an increase in the share price due to the fact that the firm doubles the number of stocks he possesses.

(8)

8

Secondly, since performance is measured over a longer period of time, the use of earnings management is mitigated.

1.4. Stock options

1.4.1. Stock options and their restrictions

Stock options are contracts which give the recipient the right, but not the obligation, to buy or to sell a share of stock at a pre-specified exercise price for a pre-specified term. In the UK, executive options are most of time exercisable between three years after the grant until ten years after the grant. They are non-tradable and lapse most of the times if the executive leaves the firm before vesting (i.e. fully owned by the executive and exercisable) (Murphy, 1998). Stock options granted to executives are always call options on shares of the company which they govern. A call option gives the holder the right, but not the obligation, to buy a share of stock at a pre-specified exercise or strike price for a pre-specified period of time (Ross et al. 2002). Call options granted to executives often are non-tradable, vested over time and are forfeited if the executive leaves the firm before the options are vested (Murphy, 1999). Therefore, options provide executives with a retention incentive (Hall and Murphy, 2003). Most of the options granted to executives are at the money: their exercise price is set equal to the grant-date market price (Murphy 1999). However, if a company would also grant out-of-the-money options, it could grant more options and increase the executive's reward for doing particularly well (Bebchuk and Fried 2003). Once an option is vested and in the money (i .e. the actual share price is greater than the exercise price) an executive can exercise it. He then sells the option for the difference between these two prices in the market, which generates a profit. Typically, as options are exercised, new shares are issued, thereby increasing the number of shares outstanding (Hall and Murphy, 2003). If the option never is at or in the money over its life, it expires worthlessly. In this case, the executive who holds it does not make money, but he does not lose any money either.

Core et al. (2003) write that `a fundamental reason for the use of equity incentives is the desire by firms to link changes in executive wealth directly to changes in stock price, thereby providing executives with incentives to maximize shareholder wealth'. Murphy (1999) points out that this does not hold exactly, as stock options reward only stock-price appreciation and not total shareholder return, since the latter includes dividends. However, expected dividends are implicit in the share price. Therefore, one might argue that stock options also reward total shareholder return .

(9)

9

Granting options does provide executives with an incentive to take actions that are in the best interest of the shareholders. For instance, Ahold writes in its 2005 annual report that:

"Long-term incentives [which include stock options] are intended to reinforce sustainable performance consistent with the Ahold strategy; and to align (more closely) the interests of executives with those of the shareholder."

1.4.2. Motivation for managers

The importance of executive options as a percentage of total remuneration of CEO's increased strongly for the S&P 500 firms between 1992 (24%) and the early years of this century (50%) (Jensen and Murphy, 2004). In the market there are different types of options. Some can only be vested if a certain performance level is reached, others are normal options and others are related to management savings . However, they all have in common that they are linked to the stock market price. In almost all the cases (95%) the exercise price equals the grant-date fair market value, while some discount (3%) or premium (1.5%) options were granted as well (Murphy, 1998). In Murphy's (1998) US sample of almost 63% of the CEO's received options, most of them received multiple grants. Stock options provide a direct link between managerial rewards and share price appreciation. However, the incentives from stock options do not have the same incentives as stock ownership. Only in few cases, options are issued to increase the stocks in hands of the management after that the executives have exercised their options. Due to diversification reasons they decrease their shareholdings and after exercising the options they sell the options immediately (Ofek and Yermack, 2000). Murphy's (1998) findings agree with this, since he shows that managers with large stock option holdings reduce their shareholdings.

An important thing on determining the value of an option is the different value executives and outside investor place on the value of a stock option. The reason for this is that executives cannot trade or sell their options, and also it is forbidden to hedge the risks by short selling company stock (Murphy 1998) . Furthermore, he states that executives are unable to diversify properly by having their physical as well as human capital invested in the company. Yermack (1997) has a different opinion on this issue. According to him the management can have superior information about the state of the company and the prospects for the future and are able to determine their option grants.

According to Yermak (2004), equity incentives are often used to encourage risk-averse managers to pursue valuable but uncertain risky investment opportunities. When an executive receives compensation in the form of a fixed base salary only, he has no incentive to search for new and profitable investment opportunities (Duffhues et al., 2002). In order to provide the right incentives, this implies that when there are profitable investment opportunities, an executive's remuneration scheme should have a greater slope and more convexity with respect to the firm's

(10)

10

equity value than in the absence of these opportunities. Award stock options can provide these incentives, as stock options exhibit convexity with respect to the underlying stock price. In this way, stock options can mitigate problems with executive risk aversion (Hall and Murphy, 2003). Another reason for the frequent use of stock option compensation is that different and often advantageous tax rules apply to granting stock options. For example, in the United States tax deductions can be made for exercised options, while possibilities for tax deductions for cash compensation are limited ((Yermack, 2004) and Conyon and Murphy (2000)) . Similarly, in the Netherlands stock options are taxed when they are granted, and at a fiscal value that can be well below the true value of the options (Duffhues et al. (2003). However, taking all factors into account there may be fiscal advantages to granting stock options rather than other types of remuneration to executives.

Moreover, stock options may also provide flexibility in the cost of labour (Duffhues, (2000). By introducing variability into the remuneration structure of the company, firm risk diminishes. In other words, when the firm's performance is only mediocre, the share price will likely not rise above the exercise price of the stock options granted to the company's executives, and the true value of the executive remuneration will thus fall below what was expected ex ante. The opposite holds when the firm performs very well: the true value of executive remuneration will be higher than was expected ex ante, but this loss is compensated by a higher share price. Therefore, when taking into account all scenarios there‟s thus and equilibrium. The gain is that the firm does not have to pay more when it cannot bear the costs, and it does have to pay more when it can afford it.

Part of the reason why the use of stock options is less common in the Netherlands than e .g. in the United States is culture : `the United States, as a society, has historically been more tolerant of income inequality, especially if the inequality is driven by differences in effort , talent, or entrepreneurial risk taking' (Conyon and Murphy 2000). The Netherlands is a much more egalitarian society, not permuting too large a pay differentials, even when these are due to differences in effort or talent. Therefore, the use of stock options has been much more widespread in the United States than in the Netherlands . Bruce et al. (2005) show that a similar difference exists between the use of stock options and other remuneration items in Germany and the United Kingdom.

Often discussed are the stock-option plans. Accoring to Abowd and Kaplan (1999), managers are granted with a package of stock-options with a maturity date of five to ten years in this case. These remuneration components reward executives for long-term performance, which only can be measured after a number of years. Core et al. (2003) also point out another purpose of long-term incentives, the attraction and retention of executives. Executives that have optimistic beliefs in the future of the company can be attracted with good long-term incentive plans, on the other

(11)

11

hand executives that are already in place can be retained by offering restricted bonus plans. If the options can only be traded after three years, with the condition that the executive is still in place at that moment, than the result will be that he will becomes less likely to resign.

Long-term incentive plans also receive critique. When using stock-market returns as performance indicators managers are rewarded for gains that are not in their control. For instance, they are rewarded for a general rise in the economy (Core et al. (2003), Abowd, and Kaplan (1999), and Bebchuk and Fried (2005)), or are punished for a market-wide or industry-wide shock (Oyer, 2004). Core et al. suggest using a relative performance evaluation that compares firm performance to a benchmark. These measures are already used in the compensation packages, but the incentive tools (options and restricted stock) respond to the market. Ittner et al. (1997) mention the increase of non-financial performance measures in performance evaluation, this could include: market share, efficiency/productivity, product quality, customer satisfaction and employee satisfaction (Ittner et al., 1997, pp. 231-232). These measures would provoke more long-term performance while financial measures are focused on the short term. Incorporating these measures for long-term incentive plans and detaching the incentive plans from the share price would result in less noise in the incentive plans – meaning that the bonus plans are detached from general market influences and are more focused on the actual performance of the executive. Conversely, Ittner et al. also warn for the risk that non-financial measures are more easily to manipulate for managers than financial ones, since the former are not audited. Last but not least, earnings management can again be a problem with the use of long-term incentives.

1.4.3. Valuation

The option valuation method most often used is the Black-Scholes option pricing method. The result of this formula is the cost of the option to the company and not the value of the option to the executive. Since executives cannot trade in their options, nor are as diversified as outside investors, they are likely to value the options lower than outside directors. Intuitively, the valuation of the options to the executive-recipient will depend on the executive's risk aversion, his or her wealth, the fraction of that wealth invested in company stock, and the likelihood that the executive will remain with the company until the option is vested (Murphy, 1999). A model focused on the benefit of the stock option grant to the individual executive, will involve arbitrary estimations. Therefore, I will focus on the cost to the firm using the Black-Scholes option pricing method.

Stock granted to the executives is considered part of executive remuneration and is valued at the market price. Core, Wayne and Larcker (2003) argue that the main reason to provide the executives with equity incentives is the desire to link changes in executive wealth directly to changes in share price. As is the case with stock options, stocks might be worth less to the executive than to an outside investor, due to possible trade restrictions and because the executive

(12)

12

is likely to be less diversified. The focus, as it is for the option valuation, will be the cost to the firm, calculated by taking the number of stock granted and multiplying this with the price of the stock.

Within the remuneration item of stock options a distinction can be made between the stock options outstanding at year end, those granted over the year, and those exercised over the year. Options plans exist to give executives an incentive to take actions that are in the best interest of the company over the longer run. Because an executive can, to a certain extent, affect the payout from an option plan, he is likely to be affected in his action by the options that have been granted to him, both in the current year, and in former years . The options he has exercised in the current year, however, are unlikely to affect his decisions and behavior, as he already possesses the gains from them.

1.5. Other types of remuneration

The other remuneration granted to the executives consists of several components. The other forms of compensation named by Murphy (1998) are restricted stocks, term bonuses, long-term incentive plans (hereafter LTIP) and retirement plans, which will be discussed below.

1.5.1. Restricted stock

Restricted stock is ownership of stock, with some restrictions. The restriction often requires that a certain length of time passes by, or that a certain goal is achieved, before the stock can be sold. They also usually don‟t give any voting rights, but they pay dividends. In the case of restricted stock such as the investment shares, the manager is provided with an incentive over a longer period. If he is able to keep up the performance of the firm over a period of three years he benefits from it in two different ways. Firstly, his wealth increases due to an increase in the share price due to the fact that the firm doubles the number of stocks he possesses. Secondly, since performance is measured over a longer period of time, the use of earnings management is mitigated.

1.5.2. Long-term bonuses

A long-term bonus plan typically has the same structure as a short-term annual bonus plan does. However, the main difference is that the payout of a long-term bonus plan depends on company performance over a longer period of time, usually three to five years (Murphy, 1999). Long-term bonus plans are not very widely used, though when they are in place, they tend to represent considerable amounts of money. The problems inherent in short-term bonus plans also apply to long-term bonus plans, with the exception that long-term bonus plans avoid executives to have a very short-term focus. Long-term bonus plans serve the same purpose as short-term bonus plans,

(13)

13

though on the long run. Last but not least, since executives can influence the payout from such a plan by their own actions, they are likely to be affected by it.

1.5.3. Long-term incentive plans

Long-term incentive plans (LTIP) can be considered as bonus plans for many years instead of the one-year used by annual bonus plans . They are often based on rolling-average three or five-year cumulative performance. LTIP generally consist of stock and option grants, since this research focuses on the structure on executive remuneration, the LTIP is split up in stock and option grants.

Long-term incentive plans have a payout dependent upon company performance over a longer period of time and typically come in the form of what are called performance shares on restricted stock. Jensen et al. (2004) explain that restricted stock grants are `restricted' in the sense that the executives who receive them cannot sell or transfer the shares for a period of time, and will forfeit the shares if they leave the firm prior to vesting. Abowd and Kaplan (1999) describe restricted stock as an option to purchase stock at an exercise price of zero. Performance shares are essentially a promise for future delivery of shares, conditional on continued employment and on meeting various performance thresholds. Thus, restricted stock rewards executives for simply not leaving the company, while performance shares require both continued service for the company and the realization of certain performance criteria.

Hall and Murphy (2003) argue that long-term incentive plans involving actual shares have certain advantages over using stock options in providing incentives to executives. First, requiring executives to hold company stock provides relatively stable incentives regardless of the stock price, whereas with stock options the incentive value of options depends on the market value of the stock relative to the exercise price. In other words: when the share

price is sufficiently above the exercise price of the options, stock options provide the same incentives as restricted stock . When, however, the share price falls below the exercise price of the options, stock options start to lose value. Restricted stock does not suffer from this change in incentive value. Granting restricted stock rather than stock options also affects managerial incentives to engage in risky investments, as argued by Hall and Murphy (2003). Executives who hold restricted stock are directly affected by changes in the stock price resulting from their investments decisions. However, executives holding stock options are likely to engage in riskier investments when these options are sufficiently out of the money. Namely, when the risky investment has a good result both the shareholders and the executive gain, but when the risky investment results in losses, only the shareholders lose.

(14)

14

To conclude, a long-term incentive plan is intended to motivate executives to take those actions that are in the best long-run interest of the firm . Executives can be expected to act upon the incentives presented in a long-term incentive plan, as it is in their best interest to do so.

1.5.4. Retirement plans

In addition to companywide retirement programs, top managers often have supplemental retirement plans. These plans care for the payouts after retirement.

1.5.5. Pensions

Pensions are meant to provide for an income after retirement. In contrast with stock options, pensions are normally not dependent upon performance. However, the large amounts of money involved in pension plans may lead executives to act in the best interest of the company and to thus benefit firm performance.

A pension can be defined as an amount of money paid regularly by a government or company to somebody who is considered to be too old or too ill to work. In the context of executive remuneration, it is the money set aside to provide for payments after an executive's retirement. In general, all employees tend to be covered by some type of retirement pension plan. However, those in place for executives are typically much more generous and involve more than just monetary payments. Bebchuk and Fried (2004) argue that retirement benefits provided to executives can be divided into four main types: retirement pensions, deferred compensation, postretirement perks, and guaranteed consulting fees . These four types of remuneration are generally not sensitive to performance, and may therefore not contribute to company performance. However, given the often-large amounts of money involved, it is in the best interest of the executive to continue to work for the company in order to get as large a pension as possible. Moreover, the executive should act in the best interest of the company in order to be allowed to continue servicing the company. By looking at pensions this way, they may have a positive impact on firm performance.

1.5.6. Pensions as the ultimate form of delayed compensation

Pensions are according to the before mentioned Eaton and Rosen (1983), the ultimate form of delayed compensation. Delaying the payment gives the company time to gather more information about the function and performance of its executive, which results in a better and fairer compensation package (Eaton and Rosen, 1983). Delayed compensation is thus paid whenever information today is more expensive than information tomorrow. However, pensions are generally based on the same formula for every employee in the firm. So it does not provide a direct incentive to perform in the best interest of the shareholder, but it serves more like a

(15)

15

retention bonus. This is because the level of pension could depend on the number of years that a manager stays with the firm, the earnings while working at the firm etc. (Balsam, 2002). Besides pensions Eaton and Rosen (1983) mention deferred compensation. In the sample of Eaton and Rosen 15% of the total remuneration package consists of deferred compensation which can take a variety of forms.

After having gone through the most important parts of the executive remuneration plan a single red line can be distinguished, delaying payments in order to: obtain more accurate information about the performance of executives, provide incentives to the executives for the long- and short term, and reward executives for the performance in the past. Based on literature of Hall and Murphy (2003) I illustrated this in figure 2 below, where different remuneration components are placed along a timeline. It indicates for which performance managers are rewarded at different moments in time.

Figure 2 – Different remuneration components are used to reward top managers for past or current performance, or to provide an incentive for future performance. T is expressed in years, pension benefits are the ultimate form of deferred compensation and benefit the top manager at an unknown moment in the future.

Kay and Van Putten (2007, p.5) use the following clear and simple summary:

“The key is a proper mix of risks and rewards. Base pay provides a stable, competitive income.

Benefits attract and retain talent in a tight labor market. Annual incentives motivate short-term

behaviors and actions that drive long-term value creation. Long-term incentives (LTIs), in the

form of equity, encourage employees to maximize long-term

capital accumulation”….”The compensation package must address both the need for income and security and the opportunity to accumulate assets.”

(16)

16

2. What is the function of a reward system?

2.1. Objectives of remuneration

The 2005 annual report of Philips states that:

"The objective of the remuneration policy for members of the Board of Management (. . .) is ( . . .) to focus on improving the performance of the Company and enhancing the value of the Philips Group, to motivate and retain them, and to be able to attract other highly qualified executives to enter into Philips' service, when required."

According to Jensen et al. (2004), any remuneration package should serve three purposes: it should attract the right people at the lowest possible cost, it should retain these people at the lowest possible cost, and it should motivate people to take those actions that maximize long-run shareholder value and avoid those actions that lower value.

When designing an appropriate remuneration package that motivates people to put in maximum effort should take two things into account according to Crespí and Gispert (1998). Firstly, it should pay attention to the fact that managers and top managers are most often risk averse. Secondly, it should take into account that the package is constructed under circumstances of asymmetric information. Given these objectives and circumstances, a remuneration package is a complex construct balancing multiple objectives and requirements. It is in the nature of man to be risk averse to a certain extent. Holt and Laury (2002) demonstrate this. According to them subjects tend to be risk averse, both in situations with high and low stakes. People generally prefer not to take gambles, especially when their own wealth, health, etc. are at stake. Executives also tend to be risk averse, partly because they have their entire human capital tied up in a firm. When an executive takes a gamble and loses, not only does the company suffer, but so does his reputation.

Last but not least, remuneration plans are also seen as a solution to the agency problem. They should motivate people to take those actions that maximize long-run shareholder value and avoid those actions that lower value. Umanath et al. (1996) also mention a second purpose of executive remuneration, by using it as a signaling device to the executives. Whenever the principals has knowledge about the state of nature and expected outcomes, and the agent does not (an information asymmetry in the advantage of the principal), then the principal could signal this to the agent by increasing the variable amount of the remuneration plan while decreasing its fixed part.

2.2. The agency problem

The manager‟s task is to manage the firm on behalf of the shareholders. However we are not always sure that the management acts in the best interest of the shareholders. A manager can for

(17)

17

instance, engage in costly empire building just for his prestige, or make holiday flights by using the company‟s private jet. As Dalton and Kesner (1987) say: “...many corporate managements

often do not behave in a manner even remotely consistent with stockholder objectives.” (p. 34)

This can be traced back to the agency problem as discussed by Jensen and Meckling (1976), which is caused by the separation of ownership and control in the modern firm. If the owners (principals) and controllers (agents) are both value maximizers, conflicts of interest will arise. The shareholders interest is the maximization of firm value. In this way his personal wealth will increase due to the increase of the shares he holds. The interest of the manager is very similar to those of the shareholders: he also prefers an increase of his personal wealth. Both interests can be conflicting and ultimately harming the shareholder. Managers are able to increase their personal wealth by extracting value from the firm - pecuniary and non-pecuniary. A conflict of interests arises when the value extraction does not result in a swell of the value of the firm. To be more specific, this occurs when the value of the pecuniary or non-pecuniary extraction by the manager is larger than the surplus of firm value generated by them.

The basic problem here is the information asymmetry between the owners and the manager and the divergence of interest. The manager wants to maximize his personal utility, whereas outside investors want the value of the firm to be maximized. Outside investors try to achieve this by implementing measures to monitor the behavior of the manager. However, managerial behavior is not easily observable, and therefore monitoring alone will not suffice. Outside investors may also offer the manager a form of incentive payment that aligns the objectives of the manager with those of the investors. This can be achieved e .g. by linking pay to some objective and measurable form of performance.

In their article "The nature of plan", Jensen and Meckling (1994) argue that all individuals behave according to the REM Model: individuals are resourceful, evaluative, and maximizing. In practice this means that people care about almost everything (ranging from, say, culture to personal wealth), are willing to make tradeoffs or substitutions between the things they care about, always prefer more of something to less, have wants that cannot be

satiated, act as maximizers, and are creative in responding to changing circumstances and opportunities. This notion of the nature of man can help explain the existence of agency problems: people are not `perfect agents' seeking to maximize the overall public good; they rather try to maximize their personal utility. In an organizational setting this means that executives (or employees in general) cannot be expected to always act in the best interest of the company as a whole. Whenever an executive finds an opportunity to maximize his personal utility by, say, using the corporate airplane more often than strictly necessary he will do so, without taking into account that this behavior harms the overall interest of the company. If this executive, however, is offered a remuneration package that links pay to performance he will likely substitute his time spent in the corporate airplane for extra effort in

(18)

18

doing what he was hired for, and in this way maximize his pay and act in the best interest of the company. Incentive pay appeals to the human desire to maximize, and thus yields the desired outcome for the company.

In the following section, I will discuss how these different types of compensation help solve the agency problem, which of them are most efficient and which ones actually serve different goals.

3. Are there any risks involved in a top managers reward system?

3.1. Agency problem and other issues in base salaries

As discussed in chapter 2, base salary is a fixed amount of money, meaning that it doesn‟t change with firm performance. The top manager is therefore likely to take his base salary as a given, and will not be affected by any of his actions. Base salary is a key ingredient in the top managers remuneration package, and other ingredients are often based on a percentage of base salary. As explained earlier, Balsams (2002) mentioned in his definition of base salary: base salary can be affected by performance, as good performance can lead to higher salary future periods. Therefore, base salary does play a role in the agency problem, and stimulate managers to overcome it.

As discussed before, agency problems are caused mainly by moral hazard. Importantly, base salary is highly sensitive to moral hazard problems. Fixed remuneration namely carries agency issues with it, and is the very reason that other types of remuneration were implanted in the total remuneration package of top managers.

Since the level of base salary is independent of performance or effort, there exists an incentive for executives to shirk, to not give their very best for the company. In order to alleviate this problem, variable, performance-related types of remuneration were introduced. Given the risk-averse nature of executives in general and the occurrence of events beyond the control of the executives, variable remuneration cannot be the only type of remuneration used. In spite of the inherent agency problems associated with fixed base salaries, they are a necessary precondition to attract the right executives. The level of base salary and other types of remuneration are often determined with the help of compensation consultants. While these consultants may play a useful role in this process, they can also help in camouflaging rents (Bebchuk and Fried, 2003) . The incentives of compensation consultants and the evidence regarding their use suggest that these consultants are often used to justify executive pay rather than to optimize it. This is a problem inherent in the pay-setting process for all types of remuneration, not just for setting the base salary.

3.2. Agency problem and other issues in annual bonus plans

To recall, an annual bonus plan rewards managers for their performance over the past year. Therefore, it can be considered as a short-term bonus which is a variable part of top manager remuneration. Short-term bonus plans are in place to make pay related to performance, and thereby alleviate the agency problem of having solely fixed remuneration. However, short-term

(19)

19

bonus plans come with their own agency problems. By taking a look at figure 1, which shows a graphical representation of a typical short-term bonus plan, the most important agency problems become clear. It is only within the boundaries of the so-called incentive zone that a pay-performance relationship exists. In terms of bonus received, it makes no difference for an executive to miss the performance threshold by a lot instead of a little (Jensen et al., 2004). This implies that as soon as executives notice they will not make the performance threshold at the end of the year, they no longer have an incentive to give their best, and they will likely throttle down, thereby harming shareholders' interests. At the other end of the incentive zone, a comparable situation takes place. Once the performance cap is reached, even higher performance will not result in a higher bonus. This creates another incentive for top managers to stop putting in their effort, which harm shareholders‟ interests.

In the end, the existence of this incentive zone may lead to a form of income smoothing whereby effort and earnings are artificially transferred to the next period where they will again have an effect on the amount of short-term bonus received. The above-mentioned problem can be alleviated by implementing a linear pay-performance relationship as represented in figure 2 below. Here, all extra effort pays off are in the form of extra remuneration, and there is no cap on what can be earned. Furthermore, the executive under this remuneration plan is punished if he performs very poorly. This also has an impact on the income-smoothing problem discussed below.

(20)

20

Agency problems may also arise from the type of performance standards that are used. According to Murphy (2001) the distinction here between internally determined and externally determined standards is important. Performance standards can be classified as internally determined when executives can take actions that may affect the standard in a current or future year. Of the above-mentioned performance standards the `budget', `prior year' and `discretionary' standards can be labeled internally determined .`Peer group', `timeless' and `cost of capital' standards are externally determined, as executives cannot really affect them. Murphy (2001) predicts that internally determined standards will affect managerial behavior, because managers understand that their actions this year will affect next year's performance target. He indeed finds that income smoothing takes place in companies with internally determined performance standards, but not in companies with externally determined standards. Murphy also finds that bonuses are significantly more volatile for executives in companies with externally determined performance standards than in companies with internal standards. This is the case because top managers in companies with internal standards face no incentive (or even a disincentive) to reach results that would exceed their bonus cap.

For externally determined standards there often is no bonus cap, leading executives to put in as much effort as possible: all extra effort will pay off. The use of certain performance measures, especially accounting measures, may also be problematic (Murphy, 1999). Firstly, as is pointed out in most accounting books, accounting measures are backward looking and have a short-run focus. When short-term bonuses are based on accounting measures, this may lead executives to avoid actions that reduce current year profitability but improve future profitability. Short-term bonuses are maximized, but long-run shareholder interests are harmed. Secondly, accounting profits can be manipulated in various ways. There exists evidence that managers indeed choose accounting policies, and thus manipulate reported profits, to maximize their expected compensation (see e .g. Crespí et al. (2002), Leone and Rock (2002) and Guidry et al . 1999). Short-term bonuses, like stock options (discussed below), are meant to reward executives for their performance . Executives, however, may also reap the benefits of a rising stock price that is due to factors beyond their control (Bebchuk and Fried (2004). During a time of general economic growth stock prices tend to rise, even when a specific company does not perform particularly well in comparison with its competitors. Executives of such a company then benefit from general market conditions, while doing nothing to improve the position of the company.

3.3. Agency problem and other issues in long term incentive plans

To recall from chapter 2, long-term incentive plans (LTIP) can be considered as bonus plans for many years instead of the one-year used by annual bonus plans. They are often based on rolling-average three or five-year cumulative performance. LTIP generally consist of stock and option grants. Furthermore, even in some cases of pension plans, the performance of the company plays a role in the future payments. Therefore, I will discuss in this section mainly stock options and their relation to the agency problem, since this covers the main problem and benefits present in long term incentive plans.

(21)

21

One of the reasons why stock options are granted to executives is to mitigate the problems associated with executive risk aversion (Hall and Murphy, 2003). Stock options are used to induce managers to undertake profitable investment opportunities that come at some risk. An unintended consequence of granting stock options, however, may be that executives will engage in investment opportunities that come at too high a risk. Since the value of options increases with stock-price volatility (see e.g. Ross et al. (2002)), executives who have been granted options have an incentive to engage in riskier investments (Murphy, 1999). In this way, they are not only gambling with their own wealth, but also with the personal wealth of their company's shareholders.

Another issue is that stock option plans do not always provide incentives in a way that is most efficient and cost-effective to the company. To date, nearly all stock options are granted without being indexed to e .g. the average industry performance (see e .g. Hall and Murphy

2003). This means that executives can benefit from increases in the stock price which are due solely to market and sector trends beyond their control (Bebchuk and Fried 2004, 2003). While options were meant to give incentives for outstanding effort and performance, executives are thus able to gain by chance. And as the market tends to increase over time, the expected value of future market changes to executives is positive (Bebchuk and Fried, 2004). Baker et al . (1988) rightly point out that in the opposite situation of a downward market trend executives should not be insulated from outside factors if they can take actions that reduce the firm's exposure to losses from such sources. In other words: if the market trend is downward, but the executives take no actions to let company results go down by less than the market rate, they should feel the consequences of their lack of action.

Options are often not valued by executives at their true value, because of their uncertain payoff and the risk-averse nature of top managers. This results in more options being granted than their true value would justify (Jensen et al. 2004 and Hall and Murphy, 2003), and can thus be called inefficient compensation (Core et al. 2003). Apart from their risk-averse nature, top managers also value options at less than their true value because they are generally forbidden to sell or trade their options and to hedge their risks from holding the option. Moreover, in contrast to outside investors, executives are typically not well diversified, as both their physical and their human capital are to a very large degree tied up in the firm (Conyon and Murphy, 2002). This also leads them to value the options granted to them at less than their true value.

The previous problem is exacerbated by the so-called perceived-cost argument. From an economic point of view options of course have value, and are thus not free to grant. In the past, however, executives often seemed to believe that granting options was costless, as under many accounting regimes the cost of granting options did not have to be expensed (see e .g .Hall and Murphy, 2003). In this way, accounting profits were not affected, and executives could, mistakenly, believe granting options was free. Today, however, this perceived-cost argument no

(22)

22

longer holds. With the adoption of the new International Financial Reporting Standards (IFRS), companies are required to reflect in their financial statements the effects of share-based payments including executive stock options. This means that share-based payments should be recorded in the financial statements at their fair value at grant date. The IASB (International Accounting Standards Board - the board that has laid down the IF'RS) offers several methods for determining the fair value, but the main point is that companies are obliged to present information about the fair value of their stock option plans, and that they thus can no longer maintain not to understand the cost of granting options

Jensen et al. (2004) and Jensen (2001b) point out that stock option plans may teach executives that the cost of capital is zero. Jensen et al. (2004) also point out that stock options cannot give optimal incentives as the executives have no `skin in the game'. As was pointed out in an earlier section, if an option does not end up in the money, the executive does not lose any of his personal wealth. Had the executive been granted actual shares, or had he been obliged to own shares bought from his personal wealth, he would have suffered from a lack of share appreciation (or downright depreciation), and he would have thus been more inclined to maximize the share price by his actions (Jensen and Murphy 1990b) .

Another issue is that of option repricing. In an option repricing, the exercise price of the option is adjusted, most often in a downward direction following a share-price decline. A common justification for an option repricing after the share price of a company has declined is that executives options in that case have lost their incentive value: if the share price declines to a level sufficiently below the exercise price, the executive perceives he will have little

chance of exercising his options and they thus their lose value (Murphy, 1999) .

There are two conflicting views on option repricing. On the one hand, option repricing can be interpreted as rewarding an executive for failing policies. On the other hand, option repricing can be a motivation for executives to engage in risky investment opportunities . Given the risk-averse nature of executives, they would generally prefer to forgo investment opportunities with an uncertain payout, though economic rationality would dictate them to engage in them. By offering an option repricing, a kind of `safety net' is offered to the executive, taking away part of his risk aversion to the benefit of the company.

An additional problem is that of the situation of asymmetric information between the executives who have been granted stock options and other investors (Duffhues, 2000).

Because executives are by definition insiders and thus have access to information that is not (yet) available to outside investors, they can benefit from this inside knowledge by e .g . selling their options before bad news is made public. Though this type of insider trading is illegal, there exists evidence that executive's sale of stock options is timed to the publication of certain types of news (Bettis et al.,1999). Paul (1992) shows that whenever there is a situation of asymmetric

(23)

23

information between executives and shareholders and stock-based compensation is part of an executive's total remuneration, the firm will be governed in an inefficient way and the share price will not reflect the true value of the firm.

A final problem is that of overvalued equity (Jensen et al., 2004). Granting stock options provide top managers with an incentive to raise the company's share price, as well as incentive to make the share price as high as possible. In the short run this may not seem much of a problem as both the option-holding executive and the shareholders benefit from a very high share price. However, in the long run the equity of the company will become overvalued: it no longer reflects the underlying value of the company. Once this happens and is recognized by the market the company will face immense problems, as it cannot deliver the performance the market expects on the basis of the share price. Consequently, the share price will collapse, and all parties involved will suffer.

(24)

24

Conclusion

In the current economic times top manager remuneration has become a renewed topic of discussion. While in the near past state funds were needed to save key firms in our economy, recent news about huge bonuses and other components of top manager remuneration granted in the same firms makes people mesmerized at first sight and spreads fast. Yet the remuneration packages serve three important purposes: it should attract the right people at the lowest possible cost, it should retain these people at the lowest possible cost, and it should motivate people to take those actions that maximize long-run shareholder value and avoid those actions that lower value. Therefore, remuneration plans are also seen as a solution to the agency problem. However, in order for a remuneration plan to be effective, it should match short-term and long-term goals well, such that managers will take into account both time perspectives.

When we take a closer look at remuneration schemes, we realize that every single ingredient of top manager remuneration has its own rational. The basic ingredients in a top managers reward system include base salary, an annual bonus, stock options and retirement plans. Each of them has their own benefits and risks, and place in time.

Base salary is still one of the most basic and important types of remuneration in the package for top managers. It‟s a fixed amount of money that doesn‟t change with performance. As a consequence, it‟s likely that a top manager takes his base salary as a given. Therefore, it doesn‟t motivate him to perform well. It is meant mainly for attracting top managers and compensating them for the risks in the variable parts of their remuneration, part of which is beyond the executive's control. Importantly, most other ingredients of top manager remuneration schemes are tied to base salary levels. A downside of base salary is that it‟s subject to moral hazard, which is one of the main causes of agency problems.

In contrast, an annual bonus plan does reward managers for performance. It‟s a short-term bonus that is paid only if a pre-determined performance threshold is reached, and can increase in the incentive zone as company performance increases. As a consequence, equity incentives are often used to encourage risk-averse managers to pursue valuable but uncertain risky investment opportunities. Annual bonus plans also have their own agency problems. Namely, it‟s only within the boundaries of the so-called incentive zone that a pay-performance relationship exists. Stock options, on the other hand, are focused on long run performance. Importantly, stock options are a way to solve the agency problem by providing a direct link between managerial rewards and share price appreciation. Consequently, the interest of agents and principals are matched. Moreover, stock options may offer numerous other benefits such as tax advantages and flexibility in the costs of labor. Yet the effort to raise the share price can also lead to overvaluation and a collapse of the share price. Another issue is that stock option plans do not always provide incentives in a way that is most efficient and cost-effective to the company.

(25)

25

Last but not least, retirement plans care for the payouts after retirement and are thus focused on the very long run. Pensions are a form of delayed compensation. Delaying the payment gives the company time to gather more information about the function and performance of its executive, which results in a better and fairer compensation package. Moreover, the executive should act in the best interest of the company in order to be allowed to continue servicing the company. By looking at pensions this way, they may have a positive impact on firm performance.

(26)

26

Reference list

Balsam, s. (2002) An Introduction to Executive Compensation. Academic Press, San Diego Bebchuk, L. & Fried, J. (2004) Pay without performance. Harvard University Press, Cambridge Crespí, R. and Gispert, C. (1998), "Board remuneration, performance, and corporate

governance in large Spanish companies", working paper version December 1998

Core, J.E., Wayne, R.G. & Larcker, D.F. (2003) Executive equity compensation and incentives: A survey.

Core et al. (2003) "Performance standards in incentive contracts", Journal of Accounting and Economics, vol. 30, no. 3, 245-27 8

Dalton, D., and Kesner, I. (1987) Composition and CEO Duality in Boards of Directors: An International Perspective. Journal of International Business Studies, Vol. 18, No. 3, pp. 33-42 Duffhues, P., & Kabir, R. (2008). Is the pay-performance relationship always positive? Journal

of multi-national financial management, 18 (1), 45-60.

Eaton, J., and Rosen, H. (1983) Agency, Delayed Compensation, and the Structure of Executive Remuneration. The Journal of Finance, Vol. 38, No. 5, pp. 1489-1505

Hall, B .J . and Murphy, K .J . (2003), "The trouble with stock options", Journal of Economic Perspectives, vol. 17, no . 3, 49-70

Holt and Laury (2002) Board Models in Europe - Recent Developments of Internal

Corporate Governance Structures in Germany, the United Kingdom, France, and Italy. Law

Working Paper Nº. 18/2002

Jensen, M.C. (2001), "Value maximisation, stakeholder theory, and the corporate objective function", European Financial Management, vol. 7, no. 3, 297-317 (a)

Jensen, M.C. and Meckling, W.H. (1976), "Theory of the firm: Managerial behaviour, agency costs and ownership structure", Journal of Financial Economics, vol. 3, no. 4, 306-360

Jensen, M .C . and Murphy, K.J . (1990), "Performance pay and top-management incenlives', Journal of Political Economy, vol. 98, no. 2, 225-264 (a)

(27)

27

how", Harvard Business Review, vol. 68, no. 3, 138-153 (b)

Kaplan, S .N. and Zingales, L. (1997), "Do investment cash-flow sensitivities provide useful measures of financing constraints?", Quarterly Journal of Economics, vol. 112, no . 1, 169-215 Main, B. (1991) Top Executive Pay and Performance. Managerial and Decision Economics, Vol. 12, No. 3, pp. 219-229

Main, B. (1993) Pay in the Boardroom: Practices and Procedures. Personnel Review, Vol. 22, No. 7, pp. 3-14

Masson, R.T. (1971), "Executive motivations, earnings, and consequent equity performance", Journal of Political Economy, vol. 79, no. 6, 1278-1292

Murphy, K.J . (2001), "Performance standards in incentive contracts", Journal of Accounting and Economics, vol . 30, no . 3, 245-27 8

Murphy, K.J. (1999), "Executive compensation", in ed. O. Ashenfelter and D. Card, Handbook of Labor Economics, vol. 3, Elsevier Science, North Holland

Murphy, K .J . (1985), "Corporate performance and managerial remuneration. An empirical analysis", Journal of Accounting and Economics, vol. 7, no. 1-3, l 1-42

Ofek, Eli 8c David Yermack. 2000 . Taking stock: Equity-based compensation and the

evolution of managerial ownership, Journal of Finance 55, 1367-1384.

Umanath, N., Ray, M., and Campbell, T. (1996) The Effect of Uncertainty and information Asymmetry on the structure of Compensation Contracts: A Test of Competing Models.

Management Science, Vol. 42, No. 6, 868 - 874.

Yermack, D . (2004), "Remuneration, retention, and reputation incentives for outside directors", Journal of Finance, vol. 59, no. 5, 2281-2308