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Chapter 10

Executive Compensation

Overview

Concept of executive compensation plan (10.1)


Is it necessary? (10.2)
Compensation plan a real world case (10.3)
Theories (10.4) and empirical evidence (10.5)
supporting efficient contracting on compensation
10.4.1 Sensitivity vs. Precision
10.4.3 Controlling compensation risk

Theories and empirical evidence not supporting


efficient contracting on compensation
Politics of executive compensation (10.6)
Power theory (10.7)

Conclusion (10.8; 10.9)

Review of
Efficient Contracting Theory
Agent-Principle Conflict
Managers, like investors, are rational
Act toward self-interest, risk-averse, effort-averse

=> May not have same goals as owners and investors


Describes moral hazard problem of information
asymmetry
Principal wants agent to work hard, but
Principal cannot observe agent effort
Agent may shirk on effort
If no exams, how hard will students work?

What would owner do in fear of manager shirk? (note


manager efforts and ability are not directly observable)
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What Would Owner Do


In Fear of Manager Shirk?

Not hire the manager


Hire the manager and let it be
Owner rents firm to manager
Monitoring manager effort
Direct monitoring
Indirect monitoring
e.g. executive compensation plan
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10.1 Executive Compensation Plan


An executive compensation plan is
an agency contract between the firm and its
manager
that attempts to align the interests of owners and
managers
to achieve efficient contracting between the two

by basing the managers compensation on one


or more measures of the managers
performance in operating the firm
Also called incentive contracts
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10.2 Are Incentive Contracts


Necessary?
No: Fama (1980)
Forces of reputation on managerial labour market
enough to motivate manager to work hard
Assumes managerial labour market works well (i.e.
efficient)

Yes: Wolfson (1985)


Provide empirical evidence that forces of reputation
help reduce but do not eliminate manager shirking
Thus compensation contracts are still needed

Suggests that managerial labour markets do not


work fully well

10.3 RBC Compensation Plan (2009)


- Group Discussion (p.407-408)
1) What consists of compensation in RBCs plan
before proposed change in 2009?
a) For each component of compensation in RBCs plan,
what performance measures and relative performance
measures are used? Assess the appropriateness of each
performance measure
b) Discuss merits and limitations of the plan

2) What are proposed changes in 2009 to the plan?


Why such changes?

Performance and Relative


Performance Measures
Performance measures
Generally multiple measures
Must be jointly observable
Can be categorized into
Financial measures
Annual net income growth, ROE, etc.

Non-financial measures
Internal peer/executive evaluations; personal goals;
management initiatives; etc.

Relative performance measures


Relative to industry, segment, peer, and
individual performance

1) Components of Compensation
Salary
Short-term incentives
Cash
Or if elected, deferred share units
Provide flexibility to executives to convert short-term
incentives to mid-term incentives

Mid-term incentives
3-year deferred share units

Long-term incentives
10-year ESO, vesting at 25% per year for first 4 years
Must hold specific amount of shares (e.g. shares worth
8 times salary, for the president and CEO)
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1a) Performance Measures


Short-term
Business segment
Net income growth, return on equity (ROE)

Individual bonus
Overall bank and segment performance, relative to targets and
peer group
Non-financial performance measures (personal goals, etc.)

Mid-term
Share price performance over the previous 3 years,
relative to peer group
Conditioned on achievement of target ROE (20%)

Long-term
Set share price on the ESO award date (i.e. price at year
0) as exercise price
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Relative Performance Measures


Adjustable in relative to industry, segment,
peer, and individual performance
Median value of a peer group in similar firms
Top third (15% increase)
Bottom third (15% decrease)
etc.

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1b) Merits and Limitations


of the Plan

Discussion: how to decide if a compensation


plan is good or bad?
Note a compensation contract is a mix of incentive,
risk and labor market efficiency considerations, and is
subject to mutual agreement
Also note a contract may be rigid and incomplete
A good plan should consider
Tradeoff btw precision vs. sensitivity (10.4.1)
Controlling compensation risk (10.4.3)
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Limitations of the Plan


(Theory in Practice 10.1)
Share prices do not fully reflect the risk inherent in
the firm
Hence may not be an objective performance measure

Most important firm decisions are made at the top


Lower-level managers who do not make such decisions
suffer form the decline in share value

Competent managers may leave the firm


If the incentive contract does not or lower its expected
utility

etc.
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2) Proposed Changes to the Plan

Proposed changes to existing plan


Increase the deferral of bonus payments
Greater weight on individual non-financial
performance measures
Increase required executive stock holdings
Claw back bonus if fraud or misconduct

Why the changes?


Effect on manager decision horizon
To have managers focus more on long term

Effect on manager compensation risk


To better align risk of managers with the firm
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10.4.1 Sensitivity vs. Precision


Share price (as a performance measure)
High in sensitivity, low in precision

Net income ((as a performance measure)


Low in sensitivity, high in precision

Sensitivity
The closer the measure to true manager
efforts, the more sensitive the measure is

Precision
The less noise contained in the measure, the
more precise the measure is
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10.4.1 Sensitivity vs. Precision


How to decide the relative proportion of
net income and stock price in a
compensation plan?
Depends on various factors
Short-term vs. long-term horizon?
Investment opportunities?
etc.

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10.4.1 Sensitivity vs. Precision


How to increase sensitivity of net income
Reduce recognition lag
Net income waits until many aspects of
manager effort are realized
R&D, advertising, environment liabilities

Current value accounting reduces recognition lag


At the cost of precision

Full disclosure
More difficult for manager to disguise shirking by
earnings management
Enables compensation committee to better
evaluate earnings persistence
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10.4.3 Controlling
Compensation Risk
Managers are rational
The more risk managers bear on a project, the higher
compensation they expect

Compensation risk
The risk that the compensation is more or less than
expected
Either way will result in lower manager effort

How to control compensation risk?


Compensation should be aligned with the actions taken by
managers

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Controlling compensation risk


Relative performance evaluation (RPE)
Whether the manager performance beats
industry/peer performance
Sounds fair but may be sometimes problematic

Bogey/Cap of compensation plan


Role of conservative accounting
Role of Compensation Committee
Too biased toward managers?

Stock options (ESO)


No downside risk
Earnings management?

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10.5 Empirical Compensation


Research
A number of studies provide evidence of efficient
contracting
Efficient contracting
The compensation contract is efficient, i.e. correctly reflects
managers efforts and controls compensation risks

Lambert & Larcker (1987), Hemmer and Labro (2009), Banker


et al. (2013), etc.

Counter evidence exist (Section 10.6; 10.7)


e.g. golden parachute; power theory

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10.6 Politics of
Executive Compensation
Is executive compensation too high?
If so, suggests inefficient contracting
Ignore extraordinary losses (Jensen & Murphy 1990)
Managers do not bear enough risk
Solution: have managers hold more stock

What about extraordinary gains?

Golden parachutes
Excessive retirement package

Power theory (10.7)

Counter-evidence (next slide)


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Is Executive Compensation
Too High?
Counter evidence: Gayle & Miller 2009
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Suggests managers are not overpaid


The increased manager compensation is due to
increased firm size and increased compensation
risk

Managers are risk averse, but they cannot diversify share


holdings
Managers ability to sell shares and ESOs usually
restricted
Therefore, shares and ESOs worth less to manager than
their expense to firm

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10.7 The Power Theory


Power theory disputes efficient contracting
version of PAT
Manager has excessive power in the firm and
uses such power opportunistically, to earn more
than reservation utility
The source of manager power is the ability of the
CEO to influence the BODs
Core, Holthausen and Larcker (1999): the weaker the
corporate governance, the more excessive the
executive compensation is.

Devices to camouflage excessive compensation


and outrage
Compensation consultants, peer groups, etc.
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Power Theory (Contd)


How to control excessive manager power
over compensation?
Good corporate governance
Full disclosure
Regulation
Compensation discussion and analysis
Increased disclosures of risk management
Limit tax deductibility of compensation

Say on pay
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10.8 Managerial Labor Markets


The social significance of managerial
labor markets that work well
Quality of manager effort important to
social welfare
Motivation of effort requires informative
performance measures
Encourages efficient tradeoff between
sensitivity and precision
Encouraged by full disclosure
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10.9 Conclusions
Financial reporting plays two important roles in
motivating manager effort
Provides a performance measure input into
compensation contracts
helps compensation committees tie pay to
performance, control manager power, and increase
contract efficiency

Improves working of managerial labor markets


Full disclosure helps labour market evaluate manager
performance and establish reputation

Motivating manager performance and improving the


working of managerial labor market equally
important to social welfare as improving operation
of capital market
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