Alternative Approaches to Executive Compensation - Essay Example

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Alternative Approaches to Executive Compensation Shareholders have no control in some publicly traded companies. This gives the managers a lot of substantial power…
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Alternative Approaches to Executive Compensation
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Summary Affiliation Alternative Approaches to Executive Compensation Shareholders have no control in some publicly traded companies.
This gives the managers a lot of substantial power
Managers may use this power to serve their interests
There are two ways of linking executive competition and agency problem, which include the optimal contracting approach and the managerial power approach.
Limitations of Optimal Contracting
Agency problem experienced by managers
CEO can influence the nomination process for the board directors
The directors may never challenge the CEO’s pay, as they may want to please the CEO.
Market forces are not strong enough to assure optimal contracting outcomes
Failure of maximizing the shareholder value
Directors’ interest in the firm is nominal and therefore may not be serious with the company management.
Some agreements of the directors may be affected by market forces especially those affecting capital.
Managerial power approach
The Managerial power approach gives managers an opportunity to camouflage especially when extracting rent,
The approach may lead to the use of structures unfavorable to the firm performance and managerial incentives.
The compensation arrangement design depends on the perception of the outsiders
The managerial power approach may influence the relationship between power and pay without considering performance
The CEO’s compensation may be influenced by transparency and salience disclosure.
Power and Camouflage at Work
Practices explained by power camouflage include
Power Pay Relationship
Pay is higher in if managers have higher power
The board is ineffective
There is a small outside shareholder
Fewer institutional shareholders
Managers are protected by antitakeover arrangements
Managers with antitakeover policy compensate themselves more
Compensation consultants
Employed to provide advice on executive compensation
May increase their incentive to please the CEO
Used to justify executive pay instead of optimizing it
Provides compensation data, which favors the CEO
Stealth Compensation
This is where a firm may use camouflaging practices to enable them to pay the executives large sums of money.
Payments include deferred compensation
Loan forgiveness and consultation contracts
Use of executive loans with favorable interest rates
Golden goodbyes
A practice in which the board pays the outgoing CEO gratuity or benefits not counted as compensation contracts
Given even hen executives depart due to low performance
The gratuities are influenced by the management
Suboptimal Pay Structures
Suboptimal Pay Structures include
The pay without performance
Executives receive huge pay to increase the value of shareholders
Increased equity-based compensation
May involve very large amounts of compensation to executives
Option Plans, that fail to Filter Out Windfalls
Stock option plans fail to filter out stock price rises
Reduced windfall option plans may filter out some stock price increase.
Using the market-wide index and vesting may help in filtering
At-the Money Options
Another Sub optimal pay structure in which the executive is paid with the current market price without considering other factors such as inflation and their length of contract.
The exercise price is above the current market price
Are the most favorable to managers
Managers’ freedom to unwind Equity Incentives
Another challenge of the optimal contracting approach where managers sell their shares
The action may force the company to give them new incentives.
Unwinding weakens the managers’ incentives
Managers have the freedom of determining when to unwind
The Perceived Cost Explanation
Directors perceive conventional options to be or to grant or cheap
Directors may overlook the costs of options to shareholders
Inadequate information is one cause of misperceptions

Cost to Shareholders
The excess amount that the executive receive to compensate their power increases the costs on the firm’s shareholders.
The executive is only interested in the compensation schemes, which can camouflage their extraction of rent.
The power of management and extraction of rent influences the compensation of the executives.
The executive compensation design is always influenced by the managerial power especially in the firms in which control and ownership are separate.
Bebchuk, L. A., & Fried, J. M. (2004). Executive compensation as an agency problem. Journal of Economics Perspectives, 117(2). Read More
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