The spectacular rise in executive compensation in recent years has not just drawn shareholder attention; it has drawn attention even from the common folk who often blame corporate greed and mismanagement for economic slowdowns.

Executive Compensation

Financial payment and non monetary benefits awarded to a firm’s executives including company presidents, chief executive officers (CEOs), chief financial officers (CFOs), vice presidents, directors, and other upper-level managers.

In general terms, executive compensation system in any company has two dimensions:

• Level of Compensation – this is the most critical aspect as it determines the quality of workers that a company attracts.
• Composition of Pay – cash, equity and any other in-kind benefits, retirement savings, perks such as cars, utility bills, club memberships etc.

1. Cash Compensation – sum of all standard cash salary compensation that the executive receives for the year. It is mostly this element which is alleged of being excessive by shareholders since it is the easiest to asses.
2. Option Grants – all stock (or other convertible security) options granted to the executive; this information includes strike prices and expiration dates.
3. Long-Term Incentive Plans (LTIPs) – long-term incentive plans include any form of compensation which is tied to the performance of the executive and is usually discretionary in nature. This element is (in general) in the form of a one of payment and often appears exaggerated.
4. Retirement Packages – these are packages given to executives after they retire from the company.
5. Executive Perks – any other perks given to executives, including the use of a private jet, travel reimbursements, utility bills and other rewards.

How much is too much – The big Executive Compensation debate

Should compensation be linked to performance? If yes, whose performance – that of the company or that of the executive? 8 out of 10 times, shareholders get angry when fat reward figures are disclosed on the ground that the “particular executive did a great job despite bad economic environment” or “the executive had to work much harder (read 23 out of 24 hours) for most of the year due to heightened competition or launch of new products or markets”.

Shareholder Interest

In 100% cases, it is claimed (by the management) that executive compensation is tied to the performance of the company and is aligned with shareholder interest. The decisions made by these executives factor in the company’s risk exposure, growth prospects, and reputation. The company must find the best talent in the market to take such important decisions. To a great extent this is true. Everything has a price and talent is no exception. The best talent goes to the highest bidder. Below I will try to address this issue and put forward an argument which is fast gaining support from most quarters.

India’s 10 Highest Paid Executives

Source: http://www.rediff.com/business/report/pix-special-indias-10-highest-paid-ceos/20140910.htm

The remuneration figures above are based on what is reported in the balance sheet of the company. There could be other factors which may increase the in-hand remuneration, as discussed in the 5 points above.

Pay Vs. Performance of Company

Lehman Brothers CEO Richard Fuld was paid more than $500 million from 1999 to 2007 and Countrywide Financial head Angelo Mozilo collected more than $400 million in the same period. While later it was found that they were both involved in betting on extremely risky subprime mortgages which led to the demise of Lehman, during that period (i.e. between 1999-2007) they sure made their organisations incredibly profitable. Was their pay justified?

On the other hand, Vikram Pandit, CEO of Citigroup, taking responsibility of Citigroup’s performance during and after the subprime crisis of 2008 agreed to work for a salary of  U.S. $1 / year and without any bonus until Citigroup became a profitable company. Not to mention that these were the toughest years to be an employee at a financial firm, let alone the CEO of Citigroup. That an executive’s compensation should be based on the performance of the company and not his personal performance is easier said than done.

Consider two things here:

1. How well the company does financially should naturally be relative to its past performance. A company making 10% net loss (on gross sales) for 5 consecutive years suddenly breaks even for 2 years may be considered outstanding performance but a whole host of other factors may have a bearing on such turnaround. To judge the individual efforts of an employee may be next to impossible.
2. If a company were to say that we will not pay as well or at all until we become profitable, it may find it hard to attract good talent. This is why the general rule is that if earnings go up (or if losses decrease), the CEO’s pay package will go up, too. This may be healthy as it provides executives with the incentive to perform well to increase their personal wealth.

Best Practice Standard on Executive Compensation

1. In some cases, executives are given pay hike and bonuses even when the company performance is falling. This should be a complete NO. While nobody should second guess the decision of the board of directors i.e. the business judgement rule, let no one justify that to turn the company profitable in future, we must take losses now and award the CEO highly for doing so.
2. Have a structure where compensation is linked to profitability. In case profitability is likely to come at a later stage in the best judgement of the management – grant options to be exercised later on the happening of certain things or upon management’s achieving certain targets.

• Avoid peer comparison and pay higher or lower than peers – Peer comparison is the root cause of all problem. Instead of comparing one executive to his or her industry peer, reward them based on how much better or worst they do for their own firm. No two people perform the same way nor are they ever aligned towards same end goals.

1. Pay package of top management should ideally not be based on the basis of the companies they have served previously but it should be based on the performance of the current company – how their decisions/judgement helps the company in achieving new heights – TO BE PAID WHEN THE COMPANY DOES ACHIEVE THOSE HEIGHTS @ a 10% premium.

A Word to Investors

Executive compensation is a very important issue and investors should look at this aspect carefully before making the decision to buy shares in a company. All companies disclose these figures in their financial statements. While an improperly compensated executive can cost shareholders money, the bigger problem is one of making sure that money is not being siphoned out of the company in the form of exorbitant salaries.

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Rajat Sharma

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