1. 1
Management Compensation
JEM100 - Corporate Governance
Doc. MPhil. Ondřej Schneider, Ph.D., McKinsey Chair
Prof. Ing. Michal Mejstřík, CSc
12/11/2007

Jana Procházková

Julia Neue

Robert Warren

Tony Mikes

2. 2

Outline
− Introduction to Management Compensation
− Comparison between Managerial and
Executive Compensation

Chevron case example
− Principal Agent Problem
− Mitigating Principal Agent problems
− Concluding remarks

3. 3
Introduction to Management
Compensation
Specifications of managerial work
very difficult to describe – various types of task on day to
day bases
− internal role

directing an organizational unit
(leadership)
− external role

developing relationships outside the
organization

4. 4
Levels of management

Managerial compensation follows the
hierarchical structure of an organization
− Top management
− 1-5 % of the organization’s workforce
− Developing goals and strategies to keep the organization effective
− Concerned with the problems extending years in the future
− Responsible for the total operation (CEO and executive VPs)
− the owners through the board of directors see them as the trustees of
their sources
− their compensation is connected with the success of the organization
as a whole as well as their own
− indeed, it has been found that managerial system which did not focus
on critical organization outcomes were ineffective (Schuster,
Management Compensation)

5. 5
Levels of management
− Lower management
− first – line mangers = supervise the work of non-managerial
employees
− compensated as a percentage of wage of the people they supervise
− Middle management
− a larger number of managers
− information channel between top managers and supervisors
− specific function in the organization and coordinate other functions in
the organization
− compensation related to the function being managed, managerial
surveys
− decrease over the past years in order to reduce bureaucracy

6. 6
Difference between 'Management'
and 'Executive'

Management group

Executive group

exists within the management group

“top”, “president”, “vise-president”, “chief”

differentiated position within the organization
In many international locations and within small to medium-sized
North American firms, the terms „managers“ and „executives“
are used interchangeably

However

7. 7
Difference between 'Management'
and 'Executive'

in U.S large publicly traded corporations two
separate spheres
Executive body
Management Body

8. 8
Components of managerial
compensation
− base pay,
− bonuses (short term incentives),
− capital appreciation plans (long term
incentives),
− deferred compensation and benefits
(including perquisites/perks).

9. 9
Aspects of compensation plans
− commitment
− managers associate themselves with the organization
− difficult to turn off the job even in their leisure time
− decision making
− core of managerial work
− particularly broad framework of decision-making under uncertainty
− primarily conceptual decision-making
− orientation
− focus on getting the job done in the organization
− power needs
− enjoy controlling a situation and having a strong influence on the
outcome of events
− the idea of status
− managers spend an enormous amount of time at work
− have heavy responsibility

10. 10
Other ways to determine the level of
pay
− Management by objective

based on individual definition of performance

measurable standards are developed by the
manager himself and his supervisor

performance is evaluated towards the objectives at
the end of a period by both parties jointly

drawbacks

hold managers to the objective that are out of date
in case the world is too dynamic

11. 11
Other ways to determine the level of
pay
− Pay for performance

It has been found that the perception would lead to
higher pay is more important than the fact
− Generally, there is nearly no relation between pay and performance
with managers measured from a sample of 600 middle- and lower-
level managers.
− However, those who were the most highly motivated felt that pay was
important to them and that good performance would lead to higher
wage

In many cases it is hard for the managers to see
the connection between performance and pay
− rewards are deferred
− the goals are not clearly expressed

It cannot be taken for granted that paying for
performance is worth doing

12. 12
Bonus standards – short term
incentives
− a manager receives a bonus because some
standard was met in the past period

organizational (productivity, cost saving)

job related (job outcomes, performance of
particular activities)

usually paid in cash

based upon the base pay of the managers
− e.g. assume that the organization wished to maintain a minimum
return on assets of 10 percent. The managers may receive 20 percent
of base pay if the organization achieves a 10 percent return on assets
and an additional 5 percent of base pay for each 5 percent increase in
return on assets over 10 percent.

13. 13
Long term incentives – stock options

Is used to tie the managers to the long term
success of the organization

primarily motivates top management

granting managers the right to become a part
of shareholders

ownership and control come closer together

14. 14
Stock Option Possibilities

Stock Option Plan

managers are offered stock at a set price

Stock Appreciation Rights (SAR)

work like stock options but the managers do not
have to buy the stock

the manager receives from the organization the
difference between the current market value of the
stock and the stated option value of the stock

however, the amount of possible gain is limited

15. 15
Stock Option Possibilities

Restricted stock plans

the manager is granted a certain number of shares
of stock as a bonus but may not sell those shares
until certain conditions have been met (such as
certain performance, employment for certain
years)

Phantom Stock plans

In these plans the manager is awarded units that
represent shares of stock. These units typically
mature at some time, ordinarily four to six years.
At maturity the manager is paid the then-current
value of the stock or the difference between the
original value and current value.

16. 16
Stock Option Possibilities

Performance share plans

the manager is granted performance units that
represent shares of common stock. He or she
earns these shares through the performance of the
organization.

17. 17
Issues with stock options

Managers may be inclined to inflate the
value of the company so as to inflate the
value of their stocks options.
− Enron
− Apple Computer
− WorldCom
− Global Crossing

18. 18
Deferred compensation

Retirement benefits

Golden parachutes

provides pay and benefits to an executive after
being terminated due to a merger or acquisition
− reasons for doing so

limit the risk of unforeseen events

business expenses

Perks

designed to satisfy special needs of the managers,
especially top managers

may include a car, entertainment expenses, and
club memberships.

services such as free medical examinations, low-
cost loans, and financial or legal counseling

19. 19
Comparison between management
and Executive Compensation
Annual salary comparison table
Data in national currencies:
County Position Low Average High Bonus %
CEO 187 603 239 778 479 557 37,3
CFO 93 359 133 848 440 238 22,4
CEO 367 466 469 665 939 331 37,7
CFO 182 874 262 185 862 351 22,4
CEO 3 925 703 5 017 514 10 035 028 37,3
CFO 1 953 747 2 801 071 9 213 003 22,4
GreatBritain
Germany
CzechRepublic
Source of data: www.salaryexpert.com - salary calculator

20. 20
Comparison between management
and Executive Compensation
Annual salary comparison table
Data in EURO:
County Position Low Average High Bonus %
CEO 265 083 338 806 677 614 37,3
CFO 131 916 189 127 622 056 22,4
CEO 367 466 469 665 939 331 37,7
CFO 182 874 262 185 862 351 22,4
CEO 144 375 184 528 369 057 37,3
CFO 71 853 103 015 338 825 22,4
GreatBritain
Germany
CzechRepublic
Source of data: www.salaryexpert.com - salary calculator

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Interesting note:
Pay rises in all circumstances

The CEO is truly underpaid. The consultant reports this
to the Compensation Committee, and the executive's
salary is increased.

The CEO is not underpaid and the company is doing
well. The consultant is asked to compare the
executive's salary to a set of companies who are known
to pay highly. The result is a recommendation to raise
the executive's pay.

The CEO is not underpaid and the company is not doing
well. The consultant finds management lamenting that
with these low wages, turnover is inevitable. The
consultant then suggests a raise to prevent turnover.

22. 22
Examples
Kmart
Webvan
Mattel Inc.
Former CEO Chuck Conaway filed the country's
largest retail bankruptcy, after which he (and
other Kmart executives) still received bonuses.
While Kmart laid off 22,000 workers without
severance pay, Conaway walked away with $9
million.
George Shaheen left the online grocery company
a few months before it closed its doors, taking a
severance package of $375,000 per year for life. (If
he dies, his wife still receives the compensation.)
While Jill Barad was at the reigns of Matel, the
stock price dropped 70%, but she still walked
away with over $10 million.
Source: Jennifer Dixon, "Departure of Kmart Chief Raises Questions about Severance Package," Detroit Free Press,
March 12, 2002.

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Executive pay compared to blue-
collar workers in the U.S.A.
Source: Business Week
Year CEO salarycompared to blue-collar worker
1980 42 times
1990 85 times
2000 531 times

24. 24
Differences in the pay of managers
and blue collar workers explained

5 Motivational models:
1. The equity model

if the manager is earning such high salary, his
contribution should be equally great

contradictions
2. The performance-motivation model

questions whether it is the manager or other
environmental factors that lead to results of the
company

25. 25
Differences in the pay of managers
and blue collar workers explained
3. Agency theory

managers – agents of the stockholders

in the general assumption, interest of the
shareholders and managers are the same, but in
practice not. Shareholders thus attempt to align
the interest of top management with their own by
designing attractive compensation packages
4. Tournament theory

promotion is viewed as tournament and the high
pay is the price of winning

26. 26
Differences in the pay of managers
and blue collar workers explained
5. Social comparison theory

people need to evaluate themselves in comparison
to others

thus managers of one company must be paid
similarly to managers of another

27. 27
How is pay established?

Board of Directors = Compensation
Committee

28. 28
Executive compensation
− The compensation of every employee is
decided by the company owners through the
board of directors and the management team
(or "management committee").
− There may be a 'personnel and compensation
committee' that deals specifically with labour
compensation.
− Employee compensation may be negotiated
with a workers union.
− Management team compensation is often left
to the company.

29. 29
Executive compensation

Five tools of compensation:

base salary

short-term incentives

long-term incentives (LTIP)

employee benefits

Perquisites

In a typical modern US corporation, the CEO
and other top executives are paid salary plus
short-term incentives or bonuses.

30. 30
Management compensation
Chevron management committee example:

The purpose of the Management Compensation Committee of
the Board of Directors of Chevron Corporation is:

1. To discharge the responsibilities of the Board of
Directors of the Corporation relating to
compensation of the Corporation’s executives;

2. To assist the Board of Directors in establishing
the appropriate incentive compensation and
equity-based plans and to administer such plans;

3. To produce an annual report on executive
compensation for inclusion in the Corporation’s
annual proxy statement; and

4. To perform such other duties and responsibilities
enumerated in and consistent with this Charter.

31. 38
Mitigating the Principal-Agent
problem

Managers have strong incentives to gamble
on risky projects that impose potentially
large losses on the firm's fixed claim holders.

Moral hazard :
− investment-risk choices made by
management are not readily observable by
depositors and regulators

32. 39
Firms response to threat by:

Altering top-management compensation as a
way of influencing managerial return and
risk-taking incentive

Bank lenders may impose measures (such as
imposing more restrictive loan covenants) to
protect their investments in troubled firms.

Senior managers' compensation may be tied
to the successful resolution of the firm's
bankruptcy or debt restructuring, or is based
on the value of payoffs to creditors.

From “CEO Compensation in Financially Distressed Firms: An Empirical Analysis” pg 456

33. 40
Firms response to threat by:

Replacing top managers:
− One-third of top management may be
replaced in a given year around default, and
those who remain often take substantial cuts
in their salary and bonus.

Average inside replacement CEO earned 35% less
than his or her predecessor.

Average outside replacement CEO earned 36%
more than the CEO he or she replaced.
− Outside replacement CEOs, who represent almost 60% of new CEO
hires, also typically receive large grants of stock options as part of
their compensation (to turn the company around).

34. 41
Firms response to threat by:

Deferred compensation:

Deferring part of the managements compensation
until the firm's financial restructuring was
completed.
− reduces legal fees and other costs that increase directly with the
amount of time that firms spend renegotiating their debt contracts.

firms respond to financial distress by

basing more of senior managers' compensation on
long-term stock-based performance measures,

cuts in their cash compensation (including
bonuses).

35. 42
Concluding remarks

The components of managerial
compensation are:
− base pay,
− bonuses (short term incentives),
− capital appreciation plans (long term
incentives),
− deferred compensation and benefits
(including perquisites/perks).

Principal – Agent Problems can be mitigated
through a variety of methods

36. 43
Sources:

http://www.eridlc.com/onlinetextbook/chpt20/text_main.htm

Schuster, Management Compensation

www.salaryexpert.com

Jennifer Dixon, "Departure of Kmart Chief Raises Questions about Severance Package,"
Detroit Free Press, March 12, 2002

Business Week

http://www.cnb.cz/www.cnb.cz/cz/financni_trhy/devizovy_trh/kurzy_devizoveho_trhu/prumerne_me

http://www.x-rates.com/

PLEASE PROVIDE FULL CITATIONS

37. 44

Hall, Brian J., Murphy,Kevin J. “The Trouble with Stock Options” Journal of Economic Perspectives. Vol.
17(3), Summer 2003

"A Theory of Bank Regulation and Management Compensation." The Review of financial
studies Spring 2000 Vol. 13, No. 1,

Chang, Chun. "Payout Policy, Capital Structure, and Compensation Contracts when
Managers Value Control" The Review of Financial Studies, Vol. 6, No. 4. (Winter, 1993)

Gilson, Stuart C., Vetsuypens, Michael R. "CEO Compensation in Financially Distressed
Firms: An Empirical Analysis." The Journal of Finance, Vol. 48, No. 2. (Jun., 1993)

Hadlock, Charles J., Lumer, Gerald B. "Compensation, Turnover, and Top Management
Incentives: Historical Evidence" The Journal of Business, Vol. 70, No. 2. (Apr., 1997)

http://news.bbc.co.uk/1/hi/business/5131990.stm