1. STRATEGIC COMPENSATION A Human Resource Management Approach Chapter 12: Compensating Executives Copyright © 2015 Pearson Education, Inc.12-1

2. Learning Objectives 1.Explain the difference between executive pay with pay for nonexecutives. 2.List the main components of executive compensation packages. 3.Discuss with examples the principles and processes of setting executive compensation, including the key players and the theoretical explanations for setting executive compensation. Copyright © 2015 Pearson Education, Inc.12-2

3. Learning Objectives 4.Summarize the executive compensation disclosure rules and the reasons why they have been established. 5.Concisely present the “say on pay” practice. 6.Briefly explain the executive compensation controversy as it relates to whether U.S. executives are paid too much. Copyright © 2015 Pearson Education, Inc.12-3

4. Learning Objective 1 Explain the difference between executive pay with pay for nonexecutives. Copyright © 2015 Pearson Education, Inc.12-4

5. Key Employees Copyright © 2015 Pearson Education, Inc.12-5

6. Who Are Executives? To understand the main difference, it is essential to define what we mean by executives The Internal Revenue Service (IRS) recognizes two groups of employees who play a major role in a company’s policy decisions: highly compensated employees and key employees Copyright © 2015 Pearson Education, Inc. 12-6

7. Who Are Executives? Key employees are used by the IRS to determine the necessity of top-heavy provisions in employer-sponsored qualified retirement plans that cover most nonexecutive employees Highly compensated employees are used by the IRS for nondiscrimination rules in employer- sponsored health insurance benefits Copyright © 2015 Pearson Education, Inc. 12-7

8. Key Employees The term key employee means an employee who at any time during the year is: A 5% owner of the company A 1% owner having an annual compensation of more than $165,000 An officer having an annual compensation greater than $165,000 in 2013 Copyright © 2015 Pearson Education, Inc. 12-8

9. Highly Compensated Employee The IRS defines a highly compensated employee as one of the following during the current year or preceding year: A 5% owner at any time during the year or the preceding year For the preceding year had compensation from the employer in excess of $115,000 in 2013 If the employer elects the application of this clause for a plan year, was in the top paid group of employees for the preceding year Copyright © 2015 Pearson Education, Inc. 12-9

10. The Main Difference Executive compensation has both core and employee benefits elements, much like compensation packages for other employees One noteworthy feature distinguishes executive compensation packages from nonexecutive compensation packages Executive compensation packages emphasize long-term or deferred rewards over short-term rewards Copyright © 2015 Pearson Education, Inc. 12-10

11. Learning Objective 2 List the main components of executive compensation packages. Copyright © 2015 Pearson Education, Inc.12-11

12. Executive Compensation Components Current or annual core compensation Deferred core compensation: stock compensation Deferred core compensation: golden parachutes and platinum parachutes Enhanced protection program Benefits and perquisites Clawback provisions Copyright © 2015 Pearson Education, Inc. 12-12

13. Components of Current Core Compensation Two components Annual base pay Bonuses Copyright © 2015 Pearson Education, Inc.12-13

14. Annual Base Pay Fixed element of annual cash compensations CEO jobs do not fall within formal pay structures -CEOs’ work is highly complex and unpredictable -Setting CEO compensation differs from the rational processes to build market-competitive structures Copyright © 2015 Pearson Education, Inc.12-14

15. Bonus Types Discretionary: awarded on an objective basis Performance-contingent: based on the attainment of specific performance criteria Predetermined allocation: based on a fixed formula Target plan: ties bonuses to executives’ performance Copyright © 2015 Pearson Education, Inc. 12-15

16. Stock Plans Incentive stock options Nonstatutory stock options Restricted stock Phantom stock Discount stock options Stock appreciation Copyright © 2015 Pearson Education, Inc. 12-16

17. Stock Terminology Stock options: stocks purchased at a designated price for a specific time Stock grants: a company offers stock to employees Exercise of stock grants: purchase of stock Disposition: sale of stock Fair market value: average stock price on the NYSE Copyright © 2015 Pearson Education, Inc. 12-17

18. Incentive Stock Stock purchased in the future for current price Capital gains are: -The difference between the purchase price and the stock option price -Taxed at the time of disposition Copyright © 2015 Pearson Education, Inc. 12-18

19. Nonstatutory Stock Options Company awards stock at discounted price No favorable tax treatment Taxes paid on difference between the discounted price and the fair market value at the time stock was granted Copyright © 2015 Pearson Education, Inc. 12-19

20. Restricted Stock Awarded at discounted price Ownership of stock in 5 to10 years Must sell stock back at same price if they leave early Taxes paid at end of restriction period Copyright © 2015 Pearson Education, Inc. 12-20

21. Phantom Stock Bonus in the form of the equivalent of either the value of company shares or the increase in that value over a period of time Executives must be employee for 5 to 20 years Executives must retire from company Capital gains paid at retirement Copyright © 2015 Pearson Education, Inc. 12-21

22. Discount Stock Option Plans Options granted at rates far below fair market value on the date it’s granted Executive receives benefit equal to difference between exercise price and fair market value Copyright © 2015 Pearson Education, Inc. 12-22

23. Stock Appreciation Rights Executive never has to exercise stock rights to receive income Income from difference between stock value when granted and the value at end of period Executive gets to keep the stock Income taxed when rights exercised Copyright © 2015 Pearson Education, Inc. 12-23

24. Golden Parachutes Provides executives pay and benefit following termination due to ownership change or corporate takeover (merger or combining of two separate companies) Anheuser-Busch  U.S. beer brewing company InBev  Belgium beer brewing company InBev purchased Anheuser-Busch Income and benefits for 1 to 5 years Treated as a business expense Copyright © 2015 Pearson Education, Inc. 12-24

25. Platinum Parachutes Lucrative awards that compensate departing executives with: -Severance pay -Continuation of company benefits -Stock options Given in order to avoid legal battles or critical press reports Copyright © 2015 Pearson Education, Inc. 12-25

26. Clawback Provisions Allow board of directors to take back performance-based compensation when performance goals were not achieved –These provisions becoming more common –Ex: Wilmington Trust Corporation rescinded more than $1.8 million from Chief Executive Donald Foley Copyright © 2015 Pearson Education, Inc.12-26

27. Executive Employee Benefits Employee benefits represents an additional key component of executive compensation packages: –Enhanced benefits –Common perquisites Copyright © 2015 Pearson Education, Inc.12-27

28. Enhanced Benefits Supplemental life insurance: increases the value of executives’ estates bequeathed to designated beneficiaries (usually family members) upon their deaths, as well as provides executive with preferred tax treatments Supplemental retirement: restores benefits restricted under qualified plans Perquisites: cover a broad range of benefits, from free lunches to the free use of corporate jets Copyright © 2015 Pearson Education, Inc. 12-28

29. Common Perquisites Company car Supplemental life insurance Legal services Recreational facilities Travel perks Copyright © 2015 Pearson Education, Inc. 12-29

30. Common Perquisites A survey revealed –Fewer companies are offering perks to their CEOs  89.8% in 2009, 77.6% in 2010 –Most common perks offered in 2010  31.7% supplemental life insurance, 30.7% company cars, 26.1% country club memberships Copyright © 2015 Pearson Education, Inc. 12-30

31. Learning Objective 3 Discuss with examples the principles and processes of setting executive compensation, including the key players and the theoretical explanations for setting executive compensation Copyright © 2015 Pearson Education, Inc.12-31

32. Key Players Compensation consultants Board of directors Compensation committees Copyright © 2015 Pearson Education, Inc. 12-32

33. Compensation Consultants Propose recommendations Develop packages based on strategic analysis -External market context -Internal factors Possible conflicts of interest Copyright © 2015 Pearson Education, Inc. 12-33

34. Board of Directors Represent shareholders’ interests Usually 15 members -CEOs and executives -Community leaders -Professionals Give final approval to recommendations Are compensated well for services Copyright © 2015 Pearson Education, Inc. 12-34

35. Compensation Committees Usually other board of directors’ members Major duties include: -Review consultants’ recommendations -Discuss assets and liabilities -Make final recommendations Copyright © 2015 Pearson Education, Inc. 12-35

36. Executive Compensation Theories Agency theory -Shareholders give control to executives Tournament theory -Managers compete for promotions Social comparison theory -Compensation compared to others Copyright © 2015 Pearson Education, Inc. 12-36

37. CEO Compensation as a Tournament Copyright © 2015 Pearson Education, Inc.12-37

38. Learning Objective 4 Summarize the executive compensation disclosure rules and the reasons why they have been established. Copyright © 2015 Pearson Education, Inc.12-38

39. Disclosure Rules Governed by Securities and Exchange Commission (SEC) Securities Exchange Act of 1934 -Amended in 1992 and 1993 Major objectives -Clarify disclosure of compensation to CEO and top executives -Increase board of directors’ accountability Copyright © 2015 Pearson Education, Inc. 12-39

40. SEC Disclosure Requirements Stock option and appreciation rights Long-term incentive plans Pension plan Stock performance comparison Compensation committee report Directors’ compensation Employment contracts and golden parachutes Copyright © 2015 Pearson Education, Inc. 12-40

41. Summary Compensation Table Compensation for CEO and four top-paid executives over three-year period Disclosure of annual compensation –Salary and bonuses Disclosure of long-term compensation All other compensation Copyright © 2015 Pearson Education, Inc. 12-41

42. Learning Objective 5 Concisely present the “say on pay” practice. Copyright © 2015 Pearson Education, Inc.12-42

43. Say on Pay President Barack Obama signed the Wall Street Reform and Consumer Protection Act of 2010 Also referred to as the Dodd-Frank Act Companies that trade on public exchanges must comply with three major provisions Copyright © 2015 Pearson Education, Inc.12-43

44. Say on Pay (cont’d) 1.Requires say on pay: gives company shareholders the right to vote yes or no on executive compensation proposals 2.Details independence requirements for compensation committee members and their advisers 3.Companies disclose the circumstances under which an executive would benefit from a golden parachute arrangement Copyright © 2015 Pearson Education, Inc.12-44

45. Learning Objective 6 Briefly explain the executive compensation controversy as it relates to whether U.S. executives are paid too much. Copyright © 2015 Pearson Education, Inc.12-45

46. Are U.S. Executives Paid Too Much? Comparison between executive compensation and other work groups Strategic questions: Is pay for performance? Ethical considerations: Is executive compensation fair? Internal competitiveness Copyright © 2015 Pearson Education, Inc.12-46

47. Comparison between Executive Compensation and Other Work Groups Median annual earnings for all civilian U.S. workers was $45,790 in 2012 Least paid nonexecutive—shampooers at $18,600 Highest paid nonexecutive— anesthesiologists at $232,830 Typical annual salary and bonus for chief executives was about $3.5 million in 2011 Copyright © 2015 Pearson Education, Inc.12-47

48. Nonexecutive Annual Pay, 2012 Copyright © 2015 Pearson Education, Inc.12-48

49. Strategic Questions: Is Pay for Performance? Difficult to say yes or no Evidence is mixed based on decades of academic research There are complex forces beyond the control of CEOs (ex. economy, government regulation) Copyright © 2015 Pearson Education, Inc.12-49

50. Corporate Performance Measures Size Growth Profitability Capital markets Liquidity Leverage Copyright © 2015 Pearson Education, Inc. 12-50

51. Main Considerations in Executive Compensation Company’s ability to attract and retain top executives Income disparity between executives and nonexecutive employees Layoffs of thousands of nonexecutive employees Copyright © 2015 Pearson Education, Inc. 12-51

52. Layoff Reasons Global competition Reduction in demand Technological advances Mergers and acquisitions Relocating production plants overseas Economic recessions Copyright © 2015 Pearson Education, Inc. 12-52

53. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2015 Pearson Education, Inc.12-53