Executive Compensation

Executive employees, such as chief executive officers (CEOs), chief financial officers (CFOs), company presidents, and other upper level managers are often compensated differently than those at lower levels of an organization. Executive compensation consists of base salary, bonuses, long-term incentives, benefits, and perquisites. Total executive compensation has increased dramatically during the past decade, leading to concerns about pay equity and ethics. As the gap between pay at lower and higher levels of corporations widens, CEOs and other executives are increasingly perceived as overcompensated.

TYPES OF EXECUTIVE COMPENSATION

There are several different types of executive compensation that are used to reward corporate executives for their job performance. The underlying purpose of executive compensation is to increase the corporation's profits by motivating executives to make good decisions about the direction of the company; however, compensation packages are determined by a variety of factors, both internal and external.

Base Salary of Executives. Base salary is the regular annual salary of the executive. While job evaluation is typically used to set employee pay in organizations, executive base salary levels are often more influenced by the opinion of the compensation committee (which consists of some or all of the members of the company's board of directors), which is often dependent on information from salary surveys of similar companies. Typically, pay of CEOs and other executives is set to be competitive with other executive salaries in the market and thus may be very high in comparison to the pay of employees in their own company. According to the Mercer Human Resource Consulting 2006 CEO Compensation Survey, the median CEO base salary was $995,000 in 2006. However, that same study also

noted that CEO salary is typically only about one-sixth (15% to 16%) of a CEO's total compensation.

Recent data also shows that salaries for executives typically rise more quickly than salaries for other employees. According to the Mercer survey, CEO compensation increased by 7.1 percent in both 2005 and 2006 while exempt employee salaries increased by only 3.6 percent and 3.7 percent respectively; in 2004, CEO compensation increased 14.5 percent while salaries rose only 3.4 percent.

Executive Bonuses. In addition to a base salary, most executives receive variable pay, a compensation that fluctuates according to some level of performance. The use of compensation beyond base salary is intended to motivate executives to reach certain organizational performance goals, for example, specific profit levels, and reward them for reaching these goals. One very popular type of variable pay is the executive bonus, which is a one-time payment tied to some short-term performance goal. The bonus may be based on any number of performance outcomes, ranging from judgments of executive performance by the board of directors, to levels of company profits or market share. Nearly all executives now receive some sort of bonus as a part of their compensation package. The Mercer survey cited above notes that in 2006, CEO bonuses were 26 percent of a CEO's total compensation, an increase from 16 percent in 2002.

Long-term Incentives. In recent decades, long-term incentives (LTIs) have become important for rewarding the performance of executives, and they now make up over half of total executive compensation. Incentives are rewards that are linked to specific long-term goals of the organization. The most common long-term incentive is the stock option, which either gives the executive free company stock or allows him or her to purchase company stock at a reduced price for a period of time. These stocks become more valuable as the company improves financially; therefore, ownership of stock is intended to encourage the executive to make the organization more profitable. Executives can then sell these stocks at a later time when they have appreciated in value, therefore providing compensation beyond the employee's tenure with the organization. However, company failures—in which unethical accounting practices and artificial inflation of stock prices caused lower-level employees to lose investments in company stock—have raised concerns about the ethics of granting large numbers of stock options to executives.

Executive Benefits and Perquisites. Benefits for executive-level employees are also likely to be different than those offered to lower-level employees. Executives will often receive high levels of typical company fringe benefits, like health insurance, life insurance, and pension plans. Additionally, some executives may also have a contract for large severance packages, paying cash and stock options to a CEO fired from a company. Many executives negotiate generous severance packages at the time of hire, so that even if they are unable to deliver upon promises to the company, they can collect compensation upon exit.

Executive perquisites, or “perks,” are special benefits and services for executives and other top employees of companies. Perks may be things such as a car service, an executive dining room, special parking, membership in clubs, and other such amenities. It is customary for many U.S. executives to receive perks as a part of their total compensation. Some of these perks, like car service or a company airplane, may serve to improve an executive's ability to do his or her job. Additionally, some perks bring with them a certain level of status (for example, company-paid membership to an exclusive country club that is appealing to executive employees).

PAY EQUITY

High-profile media reports on executive compensation that followed in the wake of the corporate scandals throughout the 2000s raised consciousness about the issue of pay equity. Both employees and stockholders became increasingly aware of the wide disparity between executive compensation and pay for all other employees, particularly when CEOs of corporations involved in scandals or financial distress were reported to have received millions of dollars in bonuses, stock options, and pensions. (For example, Freddie Mac CEO, Richard Syron, received $14.5 million in 2007; $2.2 million of this amount was a “performance bonus.”) Many critics argue that executive pay is far too high, and that these pay rates invite ethical problems.

Pay equity, or the fairness of pay, can be evaluated both internally and externally. These ideas are based on equity theory, a theory of motivation. Equity theory, briefly, indicates that a person examines what he brings to a job (inputs) and what he receives from a job (outcomes) and compares that to a reference person, evaluating the other person's inputs and outcomes. An employee might determine that she brings a certain level of education, experience, and effort to her job and that those inputs result in a certain level of salary and benefits. She would then compare this relationship to the education, experience, and effort, and the subsequent salary and benefits of another person. If these ratios are not equal, then the employee will feel unfairly treated. If this employee determines that her inputs are far greater than her counterpart's inputs, but their pay is the same, this employee will feel unfairly compensated.

External equity is the assessment of the fairness of pay in similar jobs in different organizations. Executives

who compare their pay to executives in other similar firms are making an assessment of external equity. External equity can be determined through market pay surveys, in which companies share information about the pay and benefits in their jobs. Additionally, the pay levels of executives may be public knowledge, either in company publications to shareholders or in trade organizations. If an executive is compensated highly as compared to others in similar companies, he or she is likely to feel positively about this situation; however, executives who are compensated at a lower rate than comparable executives in other companies may attempt to have their salary raised or may look for another position.

Internal equity is an assessment of the fairness of pay in different jobs within the same organization. Executives and employees compare their inputs and their pay to one another's to determine if they are fairly treated. Internal equity is often referred to as pay structure, and there are two types of pay structure: egalitarian and hierarchical. In egalitarian pay structures, the range of pay from the lowest paid employee to the highest paid employee is not very big; there are not large differences in pay. Egalitarian structures tend to be preferred by the lower-paid employees, because they feel that executive pay is not too high. However, executives may become dissatisfied in organizations with egalitarian pay structures, because they feel that their pay may not be commensurate with their skills or job duties. Hierarchical pay structures, conversely, have a fairly wide range of pay between the lowest and highest paid employees. In hierarchical pay structures, upper-level employees are likely to be paid very high salaries, which they are likely to find satisfying. However, in hierarchical structures, employees in low-level jobs may feel unfairly treated because of their relatively lower pay rate.

The pay level of U.S. executives is very high as compared to the pay of executives in other countries, as compared to pay of U.S. executives in the past, and as compared to U.S. employees at lower levels of the organization. Currently, U.S. executives earn about 400 times the pay of the lowest paid workers in their own companies. In Europe and Asia, the pay of executives is about 10 times that of the lowest paid worker. Additionally, many U.S. executives have generous stock option or severance packages that increase the value of their compensation.

EVALUATING PAY EQUITY

With increasing attention focused on the issue of pay equity, corporate boards and stockholders are more concerned than ever about evaluating pay equity. To examine the fairness of executive pay, several factors must be assessed. First, the executive pay package should be responsible to shareholders, which means that it is not so high that it detracts from company profits or that its incentives discourage unethical influence of stock prices. One result of recent attention to issues of pay equity has been an increase in the linkage between long-term incentives and performance. The Mercer Survey cited above indicates that LTIs for CEOs are increasingly performance-based, with performance-shares making up 31 percent of the LTI mix in 2006 (up from 21% in 2005) and stock options dropping from 52 percent to 46 percent of the total. This marks a drastic change from 2002, when stock options made up 76 percent of CEO LTI pay.

Another factor in evaluating pay equity concerns the competitiveness of pay packages with those of other similar organizations so that executives can be recruited, rewarded, and retained successfully. If a pay package is not competitive, there may be motivation problems or turnover. Additionally, executive pay should fit with the company's strategy so that it encourages overall company success. This is particularly relevant in regards to short-term bonuses and long-term incentives which can be used to steer the performance of the executive and the organization. Finally, compensation for executives must be in compliance with regulations. There are a number of laws regarding retirement plans, stock options, and other compensation components that must be followed when designing executive pay plans.

ETHICAL CONCERNS WITH EXECUTIVE COMPENSATION

The base salary, bonuses, incentives, and benefits for executives have raised serious questions about the ethical implications of such pay. One concern about the high pay level for American executives is that they may encourage executives to make business decisions that benefit themselves rather than the organization in order to meet performance goals necessary to receive incentive pay. This is particularly likely if incentives are short-term in nature. For example, an executive may drive up short-term profits that cannot be sustained, only to collect a large bonus and leave the company before long-term financial problems are revealed.

A second concern with the ethics of high executive pay is the use of stock options as an incentive. Recent evidence of illegal practices in some high-profile American companies has prompted the enactment of the Sarbanes-Oxley Act of 2002. This act prevents executives of companies from keeping profits or bonuses acquired from selling company stock if they have misled the public about the financial health of the company to increase stock price.

Finally, some question the ethics of the high level of executive pay when lower-level employee pay has not risen at the same rate. There is a continually widening gap in compensation in different levels of organizations;

for instance, the Mercer study determined that CEOs enjoyed bonuses of 162 percent of salary in 2006, while other studies indicate that typical clerical and technical staff earn approximately 5 percent of salary as an annual bonus. Although some argue that executive level positions deserve high rates of pay due to the nature of the job and the high level of responsibility involved, others argue that the gap in executive versus typical employee pay has widened so dramatically that employees are under-compensated and may even be tempted to engage in unethical behavior, such as stealing from the company.

RESPONSIBLE EXECUTIVE COMPENSATION

The post-Sarbanes-Oxley world has seen an increasing push for responsible executive pay. This trend continues to gain momentum with new rules requiring companies to make disclosures about the nature and value of executive compensation packages. Stockholders have been particularly concerned with ensuring that executive compensation grows only as shareholder returns grow. Recent data indicates that this has in fact been happening. As the Mercer Survey notes, “While the median change in CEO total direct compensation (salary, bonus and long-term incentives) was 8.9 percent, corporate net income increased by 14.4 percent, up from 13 percent in 2005, and total shareholder return was 15.1 percent, more than double the 6.8 percent return in 2005. Companies heard the message that pay has to be linked to performance.” It remains to be seen whether there will be sustained attention on this issue.

SEE ALSO Corporate Governance; Ethics; Human Resource Management

BIBLIOGRAPHY

Chingos, Peter T., ed. Responsible Executive Compensation for a New Era of Accountability. Hoboken, N.J.: John Wiley & Sons, Inc., 2004.

“Executive Pay Trends: Looking Forward and Back.” Journal of Deferred Compensation 10, no. 1 (2004): 24–35.

Martocchio, Joseph J. Strategic Compensation: A Human Resource Management Approach 5th ed. Upper Saddle River, NJ: Pearson Prentice Hall, 2008.

“Mercer issues annual study of CEO compensation at large US firms.” Mercer Consulting 9 April 2007. Available from: http://www.mercer.com/pressrelease/details.jhtml/dynamic/idContent/1263210.

Milkovich, George T., and Jerry M. Newman. Compensation. 9th ed. New York: McGraw-Hill Irwin, 2007.