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Management Compensation

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Management Compensation JEM100 - Corporate Governance Doc. MPhil. Ond ej Schneider, Ph.D., McKinsey Chair Prof. Ing. Michal Mejst k, CSc 12/11/2007 – PowerPoint PPT presentation

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Title: Management Compensation


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

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
Introduction to Management CompensationSpecificat
ions 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
Levels of management
  • Managerial compensation follows the hierarchical
    structure of an organization
  • Top management
  • 1-5 of the organizations 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
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
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
Difference between 'Management' and 'Executive'
  • in U.S large publicly traded corporations two
    separate spheres
  • Executive body
  • Management Body

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
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
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
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
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
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
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
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
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
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
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
Comparison between management and Executive
Compensation
Source of data www.salaryexpert.com - salary
calculator
20
Comparison between management and Executive
Compensation
Source of data www.salaryexpert.com - salary
calculator
21
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
Examples
23
Executive pay compared to blue-collar workers in
the U.S.A.
  • Source Business Week

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
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
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
How is pay established?
  • Board of Directors Compensation Committee

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
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
Management compensationChevron 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 Corporations 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 Corporations
    annual proxy statement and
  • 4. To perform such other duties and
    responsibilities enumerated in and consistent
    with this Charter.

31
Executive Compensation Plans
  • The Committee shall
  • a) Administer the executive compensation plans of
    the Corporation
  • b) Maintain sole discretionary authority to
    interpret provisions of the executive
    compensation plans
  • c) Establish all rules necessary or appropriate
    for implementing and conducting the executive
    compensation plans
  • and

32
Executive Compensation Plans
  • d) Determine, as applicable in connection with
    the Corporations executive compensation plans
    such matters as eligibility for participation
    the amount and timing of benefits persons to
    receive awards the amount, form and other
    conditions of awards the manner and form of
    deferral elections the creation and issuance of
    rights or options entitling holders thereof to
    purchase stock from the Corporation or when
    appropriate authorize the purchase by the
    Corporation of its stock for allocation to the
    accounts of persons to whom such shares have been
    awarded
  • e) Administer existing grants under legacy
    executive compensation plans assumed by the
    Corporation and

33
Executive Compensation Plans
  • f) Administer other executive compensation plans
    that may be adopted from time to time
  • g) Recommend incentive-compensation plans and
    policies and equity-based plans and policies to
    the Board of Directors
  • h) Provide necessary approval to qualify for
    exemptions as may be established by the
    Securities and Exchange Commission under section
    16 of the Securities Exchange Act of 1934
  • i) Provide necessary determinations in connection
    with executive compensation to qualify for tax
    deductions in excess of limitations under section
    162(m) of the Internal Revenue Code
    and

34
Executive Compensation Plans
  • j) Approve equity compensation plans not subject
    to stockholder approval under applicable listing
    standards.
  • k) The Committee shall produce the annual report
    on executive compensation for the Corporations
    proxy statement.
  • l) The Committee shall perform such other
    activities and functions related to executive
    compensation as may be assigned from time to time
    by the Board of Directors, including, but not
    limited to preparing or causing to be prepared
    any reports or other disclosure required with
    respect to the Committee by any applicable proxy
    or other rules of the Securities and Exchange
    Commission or any applicable listing standards.

35
Principal - Agent Problem
  • The management (Agent) follows other interests
    than shareholders (Principal).

36
Principal Agent problem in LBOs LBO
Leveraged buy out
  • Less investors no free riders
  • Better monitoring
  • Higher pressure on management because of capital
    structure
  • No unnecessary investments from Free Cash Flow
  • Better business strategies
  • High influence of a third party the creditor

37
Incentives based managerial compensation in
LBOs
  • Low fixed salaries
  • Equity holdings
  • Stock- based compensation
  • Discipline of debt
  • Increased monitoring from the LBO association

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

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

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).

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).

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

43
Sources
  • http//www.eridlc.com/onlinetextbook/chpt20/text_m
    ain.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/devi
    zovy_trh/kurzy_devizoveho_trhu/prumerne_mena.jsp?m
    enaUSD
  • http//www.x-rates.com/
  • PLEASE PROVIDE FULL CITATIONS

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
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