Executive Compensation Professor Srividya Iyengar

Coverage Classification of Executive Compensation Calibration of Exec. Compensation to Performance Theories of Exec.Compensation Principles of Executive Compensation Factors affecting Executive Compensation Models of Executive Compensation Different Criteria for Exec. Compensation Process of Setting Executive Compensation Legal Environment for Exec. Comp in India

Performance Linked Compensation Perquisites Base Compensation Terminal Benefits Classification of Executive Compensation

Calibration of Exec. Compensation to Performance High High Pay / Low Performance High Pay / High Performance Low Pay / Low Performance Low Pay / High Performance Pay Low Performance High Low

Theories of Executive Compensation Agency theory, Actions and Model Tournament theory Social comparison theory Balance sheet approach HQ-based pay Golden handcuffs Competency based pay Golden Parachutes Cafeteria plan

Agency Theory Principals (shareholder)s 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; The efforts put in by an executive is sometimes difficult to observe i.e., it is not tangible. And intangible efforts are difficult to quantify and reward

Sequence of actions Step 1 Step 2 Step 3 Step 4 Step 5 Step 6 Shareholders create a contract having or not the condition of awarding incentives Step 1 Step 2 Step 3 Step 4 Step 5 Step 6 Executives acceptance or non acceptance Shareholders pay for work provided including incentives Executives decide on quantity and quality of work they want Shareholders (through the BOD) evaluate results Executives handle a work

ORGANIZATIONAL OUTCOMES CONTROL STRUCTURES UPON THE AGENT Model of Agency Theory AGENCY PROBLEM AGENCY COST ORGANIZATIONAL OUTCOMES Conflict arising out of separation of Ownership & Management Interest Divergence: Shareholder’s self- interest Executive’s self-interest Information asymmetry Moral Hazard Adverse Selection Empire Building tendencies Collusive agreement b/w executive and supervisor / employees Performance Risk Diversification Acquisition Sale of Firm Executive Compensation CONTROL STRUCTURES UPON THE AGENT Shareholder’s Remedies Monitoring Incentives Bonding Writing of contracts

Principles of Executive Compensation Attracting and retaining executive talent Upholding shareholders interest Performance based compensation Effective compensation committee Executives to shareholders Compliance of law Transparent disclosure

Factors affecting Executive Compensation Changing nature of work Investors confidence Fostering right executive behaviours Attracting & retaining high performing executives Governance Effective benchmarking Factors Affecting Executive Compensation

Models of Executive Compensation Optimal Contracting Model EC is designed to reduce agency cost Market for managerial talent, capital, product and corporate control-preclude executives from earning excessive compensation Arms length bargaining

Contd… Managerial Power Model Executive’s ability to manipulate the compensation Set their compensation as shareholders are diffused and uninterested in corporate governance, generally preferring liquidity to control Executive have considerable influence including The power of the CEO over appointment of directors The ability of the CEO to reward cooperative directors Social and psychological influences Cognitive biases of directors tat come from being CEO’s Time and information barriers most directors face to making an informed and reasoned decision about compensation Not negotiated at arm’s length

Different criteria Exec. Compensation Strategy Role or Position Individual characteristics Performance Behaviour Size Market Peer compensation

Process of Setting Executive Compensation Market for Managerial Talent Engagement of compensation consultants Pay for Performance To Link EC with organizational performance Corporate Governance Mechanism to scrutinize EC Board of Directors Shareholders decide EC Government Regulations U/S 198 of The Companies Act 1956 Setting Executive Compensation

Legal Environment for Exe. Comp in India Boothalingam Committee Compensation differential between lowest and highest salary was in the range of 1:10 Suggested for setting up National Pay Commission for fixing executive compensation Sachar Committee Role of government in regulating executive compensation should be reduced Universal norms to be prescribed for everyone to follow Shareholders should be taking a decision on executive compensation