Copyright © 2009 by Pearson Education Canada Chapter 10 Executive Compensation

Copyright © 2009 by Pearson Education Canada Chapter 10 Executive Compensation

Copyright © 2009 by Pearson Education Canada 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 Yes: Wolfson (1985) –Forces of reputation help to motivate manager, but incentive contract still needed –Suggests that managerial labour markets do not work fully well –See Supp. slides for details

Copyright © 2009 by Pearson Education Canada The BCE Compensation Plan Components of senior management compensation –Salary –Short-term incentive awards Cash bonus or deferred share units, based on attainment of financial targets (e.g., EPS ) & new business development, Individual contribution (based on a third performance measure: creativity & initiative) –More suitable for less senior managers? »Continued

Copyright © 2009 by Pearson Education Canada Compensation components, cont’d. –Stock options, based on share price performance –Executives required to hold BCE shares All compensation components except salary increase alignment –Since investors and managers both want firm to do well »Continued 10.3 The BCE Compensation Plan (continued)

Copyright © 2009 by Pearson Education Canada Revisions to compensation plan 2004 –Mid-term incentive plan (2 year) –Reduced stock option awards Restricted share units instead –Reasons for revisions To shorten manager decision horizon, but not too short Improve BCE corporate governance credibility 10.3 The BCE Compensation Plan (continued)

Copyright © 2009 by Pearson Education Canada Theory of Executive Compensation Desirable properties of a performance measure –Sensitivity –Precision –Generally, these properties have to be traded off Share price –High in sensitivity, low in precision Net income –Low in sensitivity, high in precision »Continued

Copyright © 2009 by Pearson Education Canada Theory of Executive Compensation (continued) How to increase sensitivity of net income –Reduce recognition lag Net income “waits” until many aspects of manager effort are realized –R&D, advertising, legal & environmental liabilities –Capital expenditure programs Current value accounting reduces recognition lag –But decreases precision »Continued

Copyright © 2009 by Pearson Education Canada Theory of Executive Compensation (continued) How to increase sensitivity of net income, cont’d. –Full disclosure More difficult for manager to disguise shirking by earnings management Enables compensation committee to better evaluate earnings persistence »Continued

Copyright © 2009 by Pearson Education Canada Theory of Executive Compensation (continued) Two types of manager effort –Short-run –Long-run If net income congruent to payoff, mix of short-run and long-run effort does not matter to investor –Each effort type equally effective in generating payoff »Continued

Copyright © 2009 by Pearson Education Canada Theory of Executive Compensation (continued) If net income not congruent to payoff (more likely), effort mix does matter –Firm owner may wish to control manager’s effort mix (i.e., length of manager’s decision horizon) »Continued

Copyright © 2009 by Pearson Education Canada Theory of Executive Compensation (continued) Controlling length of manager decision horizon –Greater proportion of performance based on share price relative to net income increases long-run effort relative to short-run effort, and vice versa –Recall BCE 2004 compensation plan revisions Why did BCE want to shorten decision horizon?

Copyright © 2009 by Pearson Education Canada The Role of Risk in Executive Compensation Risk goes both ways –Downside risk: Compensation may be less than expected –Upside risk: Compensation may be more than expected Source of compensation risk –Lower performance measure precision → higher risk Manager must bear some risk to motivate effort »Continued

Copyright © 2009 by Pearson Education Canada The Role of Risk in Executive Compensation (continued) Too little compensation risk –Reduces effort incentive Too much compensation risk –Manager avoids risky projects –Excessive hedging Goal is to control compensation risk, not eliminate it »Continued

Copyright © 2009 by Pearson Education Canada The Role of Risk in Executive Compensation (continued) Controlling compensation risk –Relative Performance Evaluation Fine in theory, but hard to find in practice –Bogey of compensation plan Controls downside risk –Cap of compensation plan Controls upside risk –Role of Board, compensation committee –Role of conservative accounting –Golden parachutes Eliminate too much risk?

Copyright © 2009 by Pearson Education Canada Empirical Compensation Research Research suggesting efficient contracting –Lambert & Larcker (1987) Cash compensation (salary + bonus) more highly correlated with ROE than with return on shares Correlation higher as noise in NI lower Correlation lower for growth firms Higher weight on ROE in compensation plan when correlation between ROE and return on shares low, and vice versa –Indjejikian & Nanda (2002) –Bushman, Indjejikian & Smith (1996) –Baber, Kang & Kumar (1999)

Copyright © 2009 by Pearson Education Canada Politics Of Executive Compensation Is executive compensation too high? –If so, suggests inefficient contracting Jensen & Murphy (1990) –According to authors, not too high, but managers do not bear enough risk--they need to hold more stock –Does executive compensation ignore extraordinary losses? What about extraordinary gains? Ignoring losses and including gains increases compensation

Copyright © 2009 by Pearson Education Canada Value of Shares and ESOs to Manager Less than Cost to Firm Manager compensation not as high as some believe –Manager risk averse, cannot diversify share holdings –Ability to sell shares and ESOs usually restricted –Therefore, shares and ESOs worth less to manager than their expense to firm Recall expense to firm based on opportunity cost

Copyright © 2009 by Pearson Education Canada The Power Theory Power theory disputes efficient contracting version of PAT –Manager uses power in firm opportunistically, to earn more than reservation utility Opportunism limited by “outrage” Devices to camouflage excessive compensation –Compensation consultants –Peer groups

Copyright © 2009 by Pearson Education Canada The Power Theory in Action Late timing of ESO awards –Another way to camouflage excessive compensation

Copyright © 2009 by Pearson Education Canada Controlling Excessive Manager Power over Compensation Good corporate governance needed –Corporate governance helped by full disclosure To reduce ability of manager to cover up shirking by earnings management To help identify persistent earnings To enable compensation committee to better tie pay to performance To limit excessive compensation by full disclosure of compensation amounts

Copyright © 2009 by Pearson Education Canada Two Roles for Financial Reporting for Executive Compensation To provide a performance measure for compensation contracts –But must compete with share price To inform the managerial labour market about manager performance and value –Reputation at least partially motivates effort Recall Fama/Wolfson arguments –Reputation determines manager’s reservation utility Both roles can be accomplished simultaneously

Copyright © 2009 by Pearson Education Canada Social Significance of Well- Working Managerial Labour Markets Full disclosure helps the managerial labour market to work well –Manager’s reservation utility (i.e., manager’s market value) will then better reflect his/her ability and effort Well-working managerial labour markets encourage productivity and social welfare

Copyright © 2009 by Pearson Education Canada Conclusions Financial accounting-based performance measures are an important input into compensation contracts –Full disclosure helps compensation committees tie pay to performance, control manager power, and increase contract efficiency Financial accounting-based performance measures can improve the operation of managerial labour markets –Full disclosure improves working of managerial labour market But not to point where need for an incentive contract is eliminated