Executive Compensation: Linking Pay to Performance

Introduction: The Executive Compensation Debate

Executive compensation has attracted serious debate and criticism in recent years, particularly following the major fraud scandals that rocked the American corporate world. It is one thing to see executives awarded what many describe as obscene pay packages, but it is even more troubling to witness their inability to justify such heavy remuneration with strong performance. When senior executives and CEOs took home the largest share of profits and bonuses — on top of their fixed salaries — most companies justified these arrangements with arguments about motivation, turnover, and retention. The prevailing belief was that paying executives more kept them motivated and driven to achieve targets, thereby reducing turnover risk. However, this traditional logic no longer satisfies stakeholders, who are now pushing for efforts to tie pay directly to performance.

According to Baek and Pagan (2002), questions persist about whether higher executive compensation actually improves performance: "The escalating cost of executive compensation packages has been of interest to researchers during the last decade. The median top executive compensation in S&P 500 companies has increased from a little over $1 million in 1990 to around $2.5 million in 1996. Moreover, the portion of total pay based on stocks and options also increased from 30% to 50% during the same period." This trend was not limited to the United States. Exorbitant increases in executive compensation were also witnessed in Canada, where a 2004 survey revealed that "Canada's top executives received an average increase in bonuses of 30% in 2003; at the same time, their base salaries increased by 6.3%. Moreover, the same survey revealed that, including all forms of compensation, CEOs took home an average of about 8.3% more in 2003 than in 2002."

An average executive compensation plan includes "an annual salary, an annual incentive bonus pegged to short-term corporate performance, a long-term incentive program typically structured around the issuance of stock options, and a nonqualified deferred compensation program which supplements qualified retirement plan benefits." The costs associated with maintaining lavish executive lifestyles and compensation packages have prompted a significant outcry from the public in general, and from stakeholders in particular.

Components and Rising Costs of Executive Pay

Ironically, executive salaries continue to rise while other employees' wages see no substantial increase. Beyond the fixed salary — which is typically far higher for executives than for other staff — the benefits and perks associated with senior-level positions have also come under severe criticism. Researchers note that benefits tend to rise in step with fixed salaries so that they reflect the executive's status. Studies reveal that while perks are directly connected with a senior executive's stature, there is little logical justification for granting enormous benefits to those who could easily afford to purchase such services with their existing fixed salaries: "Benefits, like salary, reflect the position of executives. If their total compensation is higher than for all other groups of employees, then benefit provision should be correspondingly higher. There is a kind of logic to this explanation. But there is also a kind of antilogic, too. Providing benefits to those most able to purchase such services themselves would appear to go against common sense" (Hodgson, 2004).

Every firm has a compensation committee that determines the pay scale for each group of employees. This committee may be composed of non-management staff and independent accountants who advise the firm on appropriate compensation levels. The stock options program was long regarded as a critical method of aligning executive interests with those of shareholders. The reasoning was that requiring executives to participate in stock ownership would give them a personal stake in the firm's success, motivating stronger performance while reassuring shareholders.

Stock Options and the Governance Crisis

However, this program attracted immense criticism when it emerged that some CEOs were involved in insider trading and were cashing in stock options before share prices fell. As one analysis noted: "During the late 1990s, companies issued millions — and in the U.S., billions — of dollars worth of stock options, hoping to motivate their employees. Those days are likely over, for a variety of reasons, including shareholder concerns about the ever-increasing dilution due to the issuance of options and new accounting rules requiring companies to expense options. In addition, studies have shown that the accounting cost of stock options exceeds employees' perceived value of those options. Finally, there has been a crisis in governance that has caused a reexamination of corporate accounting standards. No wonder some feel that stock options are dead in the water" (Murrill & Caputo, 2004).

Conclusion

Compensation committees are now increasingly depending on the expertise of CPAs in designing suitable compensation packages. They can help committees establish performance milestones for executives, upon achievement of which their compensation would increase. Benefits and bonuses must be increased in accordance with performance and achievement. The broader goal is to move away from compensation structures that reward seniority and status alone, and toward systems grounded in measurable, long-term corporate success — satisfying not only executives but also the shareholders and stakeholders who ultimately bear the costs of excessive pay.