Executive Compensation

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Description of Executive Compensation. Explanation.




Definition Executive Compensation. Description

Executive Compensation (EC) is dealing with the pay or remuneration of directors, officers, and executives of a firm in return for fulfilling their often complex, strenuous and important duties. EC should be considered as one, though important, mechanism of Corporate Governance.

Executive CompensationComponents of Board Remuneration / Executive Compensation Categories

The following main remuneration types or categories can be distinguished:

  • Fixed (base) components:
    • Salary
      • Often benchmarked by comparing the salary with a reference group (peer group) of similar companies.
    • Perquisites (paid expenses), including:
      • Retirement plan
      • Health insurance
      • Limousine with chauffeur
      • Private usage of company buildings
      • Private usage of company airplane
      • Private usage of company boat
      • Loans with a low interest rate
      • Luxurious office furnishings
      • Personal security
      • Memberships (golf club)
      • Removal expenses
      • Compensation for personal tax advice
      • Various other allowances
    • Insurance (e.g. Directors and Officers Liability Insurance)
    • Welcome Scheme
    • Exit Scheme
  • Variable (pay per performance) components:
    • Short-term Incentives
      • Bonuses
        • Mostly paid at end of book year.
        • Based on performance criteria that have been established beforehand:
        • The minimum and maximum size of the bonus can be some percentage of the fixed salary (for example from 0% - 250% of the target performance)
        • Mostly a tiered bonus system is used, meaning that there has to be some minimal performance before any bonus will be paid and that higher performances are paid progressively.
        • Payment can be in cash, shares or options
    • Long-term Incentives
      • Call Options
        • These give the executive the right to buy a certain amount of shares against a predetermined strike price (typically the actual share price at the moment of giving the call options.
        • The length of the option contract can vary. Typically 10 years. After this period the options have no value.
        • If at some point in the future the share price exceeds the strike price, then the executive may exercise his options.
        • Often there is a non-exercise period (vesting restriction) during which the options may not yet be exercised. For example 3 years.
      • Shares
        • Ordinary shares: the executive receives some number of ordinary shares.
        • Time Vested Restricted Stock: often there is a restriction that the executive has to wait a number of years (10) before he receives the shares, or before he may sell them.
        • Performance Restricted Stock: a form of restricted stock in which the executive only receives the shares if he achieves some target (such as some level of stock prices increase plus dividends over a number of years).
        • Stock Appreciation Rights: the executive receives in cash the difference between the stock price at the end of the period minus the stock price at the beginning of the period.

Pay per Performance?

  • Proponents of stock options claim variable pay (and in particular options) align the interests of the executives with those from the shareholders, thus diminishing the agency problem.
  • Critics claim that stock options contribute to accounting manipulation (earnings management) and gaming (taking excessive risk). This effect is strongest if the value of the variable pay is extremely high and if the performance criteria are not sophisticated enough.
  • A problem with variable executive pay (in particular with options) is that there is no 'bonus malus'. There is only a potential up-side gain (if the stock price goes up) for the executive, but no downside risk: if the stock price goes down, the option simply isn't exercised.
  • The performance criteria are sometimes adjusted during the period to compensate the board in case of unfavorable circumstances.
  • Likewise, sometimes bonuses are rewarded even if the performance criteria have not been met.
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