Executives Compensation Tereza Bůžková Tereza Bůžková Veronika Holá Veronika Holá Jakub Mikolášek Jakub Mikolášek

Introduction Historic Development Historic Development Optimal contracting x Managerial Power Optimal contracting x Managerial Power Types of Compensation Types of Compensation Camouflage Camouflage Optimal compensation packages Optimal compensation packages

Historic Development Executive pay relative to average wages in the US

Widening gap-reasons (1) Share Options Share Options – to make managers think like owners – rising bull market increased share value

Widening gap-reasons (2) Share options Share options Higher Fluctuation of CEOs Higher Fluctuation of CEOs – Tendency to search executives outside the company company – underbidding

Widening gap-reasons (3) Share options Share options Higher fluctuation of CEOs Higher fluctuation of CEOs Increase of average firm’s size Increase of average firm’s size – higher responsibility resulting in higher wages

Widening gap-reasons (4) Share options Share options Higher fluctuation of CEOs Higher fluctuation of CEOs Increase of average firm’s size Increase of average firm’s size Consultancy services Consultancy services – consultants create compensations packages – companies want to pay their managers at or above average above average

Theoretical Background Separation of ownership and control Separation of ownership and control → agency problem Owners Maximize shareholder value Managers – – extract high rents – – ensure stable income – – gain prestige  Need for incentives  Compensation Packages

Managerial Power Compensation may be influenced by managers Reasons: BOD election BOD election Directors lack the independent information Directors lack the independent information Superior insider information Superior insider information Interpersonal connections Interpersonal connections

Managerial Power (continued) When it is likely to be high? Weak or inefficient BOD Weak or inefficient BOD – BOD is too large – CEO = chairman of the board No big outside shareholder No big outside shareholder → No enhanced monitoring or external power → No enhanced monitoring or external power Anti-takeover provisions Anti-takeover provisions → The manager’s position more secure

Market-based incentives Threat of Takeover Threat of Takeover – in case of substantial underperformance underperformance

Market-based incentives Threat of Takeover – Generally very costly Threat of Takeover – Generally very costly – in case of substantial underperformance underperformance Entrenchment Entrenchment – staggered board – poison pills etc… – golden parachutes FAILURE

Equity-based Incentives Links compensation to performance ≈ stock price Target equity ownership level Target equity ownership level Options Options

Equity-based Incentives FAILURE Links compensation to performance ≈ stock price – Stock price linked rather with market development Target equity ownership level Target equity ownership level – Usually very low requirements – No punishment if breached Options Options – No appropriate decrease in cash compensation – Option whirlpool

Careful Manager Outrage costs – Embarrassment (negative media coverage etc.) – Shareholder disappointment → reduction of salary or firing out or takeover Compensation Consultants – – underbidding

Preferred Compensation Direct (cash) compensation Direct (cash) compensation → ? Outrage costs ? Other benefits Other benefits – (e.g. in UK about 30% of total compensation) Options Options – convenient for both s-holders and COE

Preferred Compensation (continued) Camouflage (Stealth Compensation) Retirement rents Retirement rents Loans ( since 2002 prohibited in US by SOA ) Loans ( since 2002 prohibited in US by SOA ) – Often forgiven (at least in part) Goodbye payments Goodbye payments – Sometimes beneficial even for s-holders

„Optimal“ Compensation Options Exercise price indexation Exercise price indexation Limited cashing-out Limited cashing-outEquity Target ownership plans Target ownership plans Performance targets Compensation linked to adj. Stock price, EPS,… Compensation linked to adj. Stock price, EPS,…

Sources: Literature: Bebchuck, L. A., Fried, J. M., (2003): Executive compensation as an Agency problem, The journal of Economic Perspectives, Vol 17, No 3 Bebchuck, L. A., Fried, J. M., (2003): Executive compensation as an Agency problem, The journal of Economic Perspectives, Vol 17, No 3 Barlett, L.R., Grant, J.H., Miller, T.I., (1999): Personality Differences and Executive Compensation, Eastern Economic Journal, Volume XVI, No. 3, July-September 1999 Barlett, L.R., Grant, J.H., Miller, T.I., (1999): Personality Differences and Executive Compensation, Eastern Economic Journal, Volume XVI, No. 3, July-September 1999 Bolton, P., Scheinkman, J., Xiong, W.: Pay for Short Term Performance: Executive Compensation in Speculative Markets, NBER Working Paper Series, Working Paper Bolton, P., Scheinkman, J., Xiong, W.: Pay for Short Term Performance: Executive Compensation in Speculative Markets, NBER Working Paper Series, Working Paper Kubo, K., (2002): The Determinants ot Executive Compensation in Japan and the UK: Agency Hypothesis or Joint Determination Hypothesis?, CEI Working Paper Series, No Kubo, K., (2002): The Determinants ot Executive Compensation in Japan and the UK: Agency Hypothesis or Joint Determination Hypothesis?, CEI Working Paper Series, No The Economist, January 20th 2007 The Economist, January 20th 2007

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