Chapter 10 The Resource Service

Chapter 10

Executive Compensation


Chapter 10 Executive Compensation


10.2 Are Incentive Contracts Necessary?
• No: Fama (1980)
– Forces of reputation on managerial labour market enough to
motivate manager to work hard
– Assumes managerial labour market works well

• Yes: Wolfson (1985)
– Forces of reputation help to motivate manager, but incentive
contract still needed
– Suggests that managerial labour markets do not work fully
well
– See Supp. slides for details


10.3 The BCE Compensation Plan
• Components of senior management compensation
– Salary
– Short-term incentive awards
• Cash bonus or deferred share units, based on
attainment of financial targets (e.g., EPS ) & new business
development,
• Individual contribution (based on a third performance
measure: creativity & initiative)

– More suitable for less senior managers?


10.3 The BCE Compensation Plan
(continued)
• Compensation components, cont’d.
– Stock options, based on share price performance
– Executives required to hold BCE shares

• All compensation components except salary
increase alignment
– Since investors and managers both want firm to do
well


10.3 The BCE Compensation Plan
(continued)
• Revisions to compensation plan 2004
– Mid-term incentive plan (2 year)
– Reduced stock option awards
• Restricted share units instead

– Reasons for revisions
• To shorten manager decision horizon, but not too
short
• Improve BCE corporate governance credibility


10.4 Theory of Executive
Compensation

• Desirable properties of a performance measure
– Sensitivity
– Precision
– Generally, these properties have to be traded off

• Share price
– High in sensitivity, low in precision

• Net income
– Low in sensitivity, high in precision


10.4 Theory of Executive Compensation
(continued)
• How to increase sensitivity of net income
– Reduce recognition lag
• Net income “waits” until many aspects of
manager effort are realized
– R&D, advertising, legal & environmental
liabilities
– Capital expenditure programs

• Current value accounting reduces recognition
lag
– But decreases precision


10.4 Theory of Executive Compensation
(continued)

• How to increase sensitivity of net income,
cont’d.
– Full disclosure
• More difficult for manager to disguise shirking by earnings
management
• Enables compensation committee to better evaluate
earnings persistence


10.4 Theory of Executive Compensation
(continued)

• Two types of manager effort
– Short-run
– Long-run

• If net income congruent to payoff, mix of shortrun and long-run effort does not matter to
investor
– Each effort type equally effective in generating payoff


10.4 Theory of Executive Compensation
(continued)
• If net income not congruent to payoff (more
likely), effort mix does matter

– Firm owner may wish to control manager’s effort
mix (i.e., length of manager’s decision horizon)

10.4 Theory of Executive Compensation
(continued)
• Controlling length of manager decision
horizon
– Greater proportion of performance based on share
price relative to net income increases long-run
effort relative to short-run effort, and vice versa
– Recall BCE 2004 compensation plan revisions
• Why did BCE want to shorten decision horizon?


10.4.3 The Role of Risk in Executive
Compensation

• Risk goes both ways
– Downside risk: Compensation may be less than
expected
– Upside risk: Compensation may be more than
expected
• Source of compensation risk
– Lower performance measure precision → higher
risk
• Manager must bear some risk to motivate effort


10.4.3 The Role of Risk in Executive
Compensation (continued)

• Too little compensation risk
– Reduces effort incentive

• Too much compensation risk
– Manager avoids risky projects
– Excessive hedging

• Goal is to control compensation risk, not
eliminate it


10.4.3 The Role of Risk in Executive
Compensation (continued)

• Controlling compensation risk
– Relative Performance Evaluation

• Fine in theory, but hard to find in practice

– Bogey of compensation plan
• Controls downside risk

– Cap of compensation plan
• Controls upside risk

– Role of Board, compensation committee
– Role of conservative accounting
– Golden parachutes
• Eliminate too much risk?


10.5 Empirical Compensation Research

• Research suggesting efficient contracting
– Lambert & Larcker (1987)
• Cash compensation (salary + bonus) more highly correlated with
ROE than with return on shares
• Correlation higher as noise in NI lower
• Correlation lower for growth firms
• Higher weight on ROE in compensation plan when correlation
between ROE and return on shares low, and vice versa

– Indjejikian & Nanda (2002)
– Bushman, Indjejikian & Smith (1996)
– Baber, Kang & Kumar (1999)


10.6 Politics Of Executive
Compensation

• Is executive compensation too high?
– If so, suggests inefficient contracting
• Jensen & Murphy (1990)

– According to authors, not too high, but managers do not
bear enough risk--they need to hold more stock

– Does executive compensation ignore extraordinary
losses?
• What about extraordinary gains?
• Ignoring losses and including gains increases
compensation

Value of Shares and ESOs to
Manager Less than Cost to Firm
• Manager compensation not as high as some
believe
– Manager risk averse, cannot diversify share holdings
– Ability to sell shares and ESOs usually restricted
– Therefore, shares and ESOs worth less to manager than
their expense to firm
• Recall expense to firm based on opportunity cost


10.7 The Power Theory
• Power theory disputes efficient contracting
version of PAT
– Manager uses power in firm opportunistically, to
earn more than reservation utility

• Opportunism limited by “outrage”
• Devices to camouflage excessive compensation
– Compensation consultants
– Peer groups


The Power Theory in Action
• Late timing of ESO awards
– Another way to camouflage excessive compensation


Controlling Excessive Manager

Power over Compensation

• Good corporate governance needed

– Corporate governance helped by full disclosure
• To reduce ability of manager to cover up
shirking by earnings management
• To help identify persistent earnings
• To enable compensation committee to better tie
pay to performance
• To limit excessive compensation by full
disclosure of compensation amounts


Two Roles for Financial Reporting
for Executive Compensation

• To provide a performance measure for compensation
contracts
– But must compete with share price
• To inform the managerial labour market about
manager performance and value
– Reputation at least partially motivates effort
• Recall Fama/Wolfson arguments

– Reputation determines manager’s reservation
utility
• Both roles can be accomplished simultaneously

10.8 Social Significance of Well-Working
Managerial Labour Markets
• Full disclosure helps the managerial labour
market to work well

– Manager’s reservation utility (i.e., manager’s
market value) will then better reflect his/her ability
and effort

• Well-working managerial labour markets
encourage productivity and social welfare


10.9 Conclusions
• Financial accounting-based performance measures are an
important input into compensation contracts
– Full disclosure helps compensation committees tie pay to
performance, control manager power, and increase contract
efficiency

• Financial accounting-based performance measures can
improve the operation of managerial labour markets
– Full disclosure improves working of managerial labour
market
• But not to point where need for an incentive contract is
eliminated


Chapter 10 Supplement
Wolfson (1985) Study of Oil and Gas Limited

Partnerships