Executive compensation plans are consistent with agency ...



An executive compensation plan is an agency contract between the firm and its manager that attempts to align the interests of owners and managers. Although these compensation plans are consistent with agency theory predictions, they are far more complex because they involve a mix of incentive, risk, and decision horizon considerations.

Managers are assumed to be risk adverse but unlike investors they cannot diversify their compensation risk. Consequently, executive compensation plans are designed to control risk while still maintaining effort motivation.

Some of the risk-reducing approaches are:

• Having more than one performance measure

• Adding a threshold level of performance in the bonus plan (ie a bogey)

• Making available stock options that lower the downside risk

• Having a compensation committee for the review of compensation for the manager

• Using relative performance evaluation (RPE)

One major problem with compensation contract design is that the full impact on net income of current manager effort is usually not observable in time to form the basis of incentive contract. The payoff observability problem is even greater if we recognize that manager effort is a set of activities, rather than a single activity. Some of these activities have longer-run implications than others do. Given these problems of using current net income as a payoff measure, we can see why share price might be a better measure. With efficient securities markets, share prices will “properly reflect” all that is know about prospective payoffs from current manager actions. Share price includes the information content of net income itself. However, share price is affected by economy-wide events such as interest rate changes, which impose risks beyond those inherent in the firm. Also, the presence of noise traders means that share prices do not perfectly aggregate public information. Therefore, the use of share price as a payoff measure may impose excess risk on managers. To the extent that net income is relatively insensitive to economy-wide factors and to noise trading, the inclusion of both share price and net income in the compensation contract is important in attaining an efficient contract. Moreover, the relative proportion of stock price-based and net income-based payoff measures in the compensation plan is also important in attaining an efficient contract and having desirable risk-reduction properties for management.

Another approach in reducing compensation risk is to add a bogey to the bonus plan. A bogey exempts the manager from paying the firm if it should suffer a loss. This reduces the manager’s downside risk. Stock options also reduce the manager’s downside risk since the lowest they will be worth is zero. Fear of personal bankruptcy is not the best way to motivate a manger to work hard; the reason being that the manager may adopt only safe operating and investment strategies whereas shareholders’ interests may be better served by riskier ones. Therefore, limitation of downside risk is important. But, it works both ways, since downside risk is limited, upside risk should also be limited; otherwise the manager would opt for operating and investment strategies that are far too risky for the shareholders’ best interests. For this reason, compensation plans should impose both caps on incentive remuneration as well as bogeys.

A further risk-reducing approach is to filter the manager’s incentive pay through a compensation committee. By doing this the committee can take exceptional circumstances into account that a bonus formula could not. And as a result, reduces the manager’s compensation risk.

The final approach in reducing compensation risk is the use of a relative performance evaluation. RPE is a process of setting bonuses or other incentive awards in relation to the average performance of other firms in the industry. Therefore, the systematic or common industry risk will be filtered out of the compensation plan, especially if the number of firms in the industry is large. As a result, RPE is more highly correlated with manager effort than net income itself and therefore less risky. However, there is no strong evidence in support of this approach. One reason being, basing compensation on both share price and net income accomplishes a similar result of that of an RPE.

The theory of executive compensation suggests that the relative proportions of share-price-based and net-income-based incentives are critical in the attainment of an efficient compensation contract.

Lambert and Larcker (1987) (LL) studied the relationship between managers’ cash compensation and firm performance. They found that the relative proportions of accounting-based and market-based compensation vary as the theory predicts. In particular they found:

• ROE more highly related to cash compensation than return on shares.

• The above relationship was strengthened when net income was less noisy relative to return on shares because as a result net income better reflected manager effort.

• The above relationship for growth firms’ tended to be lower. The reason being historical-cost-based net income tends particularly to lag behind the real economic performance of a growth firm.

Consequentially, the LL study provides empirical evidence consistent with agency theory.

Executive compensation attracts political controversy due to the large amount of compensation that is often involved. Some argue that executives as a group are overpaid, pointing to low sensitivity of executive compensation to firm performance, especially when performance is poor. Where others argue that executives are not overpaid, pointing out that the amount of compensation received is very small relative to the shareholder values created and that managers cannot diversify away their compensation risk.

Regulators have reacted to this controversy by requiring increased disclosure of executive compensation, on the grounds that the managerial labour markets and the shareholders of individual firms can act if pay becomes excessive.

Jensen and Murphy (1990) (JM) reported that CEO’s were not overpaid, but that their compensation was far too unrelated to performance. They found that over time, the variability of CEO’s and regular workers’ compensations were almost the same. They based this finding on the fact that CEO’s did not bear enough risk to motivate good performance.

The role of monitoring manager performance, thereby enabling efficient compensation contracts, is as important to society as the role of communicating useful information to investors. Executive compensation plans are important to accountants because it improves the proper operation of managerial labour markets and motivates productivity, which is just as important as improving the proper operation of capital markets and the efficient allocation of scare capital in the economy.

Quiz

Q1 In a perfectly efficient managerial labour market incentive contracts are not beneficial in reducing moral hazard. True or False

Q2 An executive compensation plan is:

a) A compensation plan designed to ensure that executives are rewarded fairly for their effort.

b) What executives receive upon retiring from the firm. Also know as a golden handshake.

c) A way of increasing the wage of executives without having to spend the companies money.

d) A method of compensation created with the purpose of aligning the interests of the managers with the owners.

e) A way of ensuring that managers get paid way more than anyone else.

Q3 If the labour markets were perfectly efficient, who would get paid the most in the current period?

a) A manager who had a great year last year, and has been doing well in the current quarter.

b) A manager who did badly last year but should do better in the future.

c) A manager who is doing very well in the current period, but had a very disappointing year, last year.

d) A manager who has lost his job and is collecting EI.

e) If labour markets were perfectly efficient everyone should be paid equally.

Q4 As the seniority of managers increases incentive awards become more:

a) qualitative

b) quantitative

c) both increase equally

d) none of the above

Q5 The mix of short- and long-term incentive components in an executive compensation plan is important. True or False

Q6 The threshold level of performance before incentive compensation becomes payable is called a cap. True or False

Q7 Why is the payoff from manager effort usually not observable in time to form the sole basis of an incentive contract?

1) Share price is a better measure of manager performance.

2) Accounting profit often lags the exertion of manager effort.

3) Losses on credit sales for the period have to be estimated.

4) Managers often have a short-run decision horizon.

Q8 The Theory of Executive compensation states that:

a) Net income alone is a better payoff measure

b) Share price alone is a better payoff measure

c) Net income and share price together are better payoff measures

d) Neither net income or share price are good payoff measures

Q9 Which of the following statements is/are true with regards to compensation contracts:

a) Share price is sensitive to economy-wide events

b) Share price is sensitive to noise traders

c) Net income is sensitive to economy-wide events

d) Net income is sensitive to noise traders

e) a) and b)

f) c) and d)

Q10 The LL study provides empirical evidence consistent with agency theory.

True or False

Q11 Executive compensation plans are designed to control the decision horizon considerations but not compensation risk. True or False

Q12 Share price as a payoff measure in compensation contracts reduces the risk on managers.

True or False

Q13 Using an RPE for management compensation reduces the systematic risk managers are subject to in their compensation plan.

True or False

Q15 In order to have the most efficient compensation plan one must look to reduce manager’s downside risk only. True or False

Q16 The Jensen and Murphy study reported that CEO’s were overpaid and that their compensation was far too unrelated to performance.

True or False

Q17 Executive compensation attracts political controversy because of the large amount of campaign donations made by executives.

Q18 An executive contract is an application of the agency theory.

True or False

Q19 There are only two measures of performance in an executive contract: Share price and Net Income. True or False

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