What Is Executive Compensation - Essay Example

CEO Compensation Introduction Executive compensation is the compensation provided to the higher ity of the corporate organisation in the form of cash or bonus. Besides, it also includes other large variety of payments, within the company. In most of the organisation, the corporate governance serves as the crucial mechanism regarding the policy to provide improved control over the executive compensation. In the today’s business scenario, compensation of the higher authorities or executives, including the Chief Executive Officers (CEOs) and other officers are generally based on the growth and performance of the business and on the market pay scale or similar position. During the time of peek economy the company has to endure extra remuneration and compensation for the CEOs. Moreover, there is always deliberate discussion over the compensation policy, especially during the time of poor company performance and financial crisis (Balsam, 2002). In this regard, the aim of the paper is to examine the effect in the executive compensation regardless of the poor performance of the company with the help of various economic theories and the empirical evidence. Discussion According to Bertrand & Mullainathan (2001) the remuneration of the CEOs in an organisation is based on the principle of the economic agency model. In accordance with this model, the firm owners act as the principal and the hired CEOs are the agents acting on behalf of the owner. The authors argued the fact that the shareholder pays a key role in the organisation in designing the remuneration system of CEO’s in order to maximise the value of the organisation. Moreover, the article examines the fact weather the CEOs are paid on the basis of luck or not. Luck represents changes in the performance of the company, which are beyond the control of CEOs. These three measures include the changes in the pricing trend, firm performance, and year-on-year dissimilarity in the organisational performance. The finding of the evidence revealed that in the different scenario the CEOs pay is significant to luck. Additionally, it has been revealed that in the organisation the payment is largely affected by the luck not with the performance. Pay for the luck has large influence over the discretionary components, including compensation, salary, and bonus structure. It has been determined from the study that mode of the corporate governance plays a crucial role that significantly influences the CEOs remuneration (Bertrand & Mullainathan, 2001). Moreover, the principle of agency model sometime helps the organisation in setting the compensation of the CEOs with other option, this other option generally includes gift (Walton, 2010). Apart from this, there are certain irregular practices followed in most of the organisation which involved providing additional benefits to executive even if they do nothing. In this context, it is important for the organisation to recognise an appropriate reward structures, mostly for the company directors as well as the higher executives. Moreover, it is ascertained that organisation needs to build a proper approach to determine the marginal productive of the executives in the business organisation (Productivity Commission Inquiry Report, 2009). However, it is significantly difficult task for the shareholders to observe the marginal productivity of an individual. It is very difficult for them to proper compensation plan for the executive performance as the determination of the compensation also requires considering the experience and value of CEO, which tend to increase with respect of time regardless to the poor performance of the company (Bertrand & Mullainathan, 2001). Jensen & Murphy (1990) notified that the conflict between the interest of shareholders and CEO is common principal agent problem in the current business practice. Lack of information about CEO’s activities and opportunity investment tasks are the main reason behind the conflicting situation. The study has undergone the analysis of the relationship between the performance pay and CEO incentive structure of different organisations. The finding of the study revealed that the relationship between the shareholder and the CEO wealth is limited and significant changes have been identified in the last five decades. Moreover, with the increase in the $1000 changes in the wealth of the shareholders is anticipated to increase the salary and bonus structure by 2%. Whereas, on the other hand, it led to 30% increase in the salary of CEO with the same. The findings of the evidence advocate that the organisation is lagging behind providing the proper pay-for-performance compensation to the CEOs. Moreover, the political scenario both inside the organisation and public sector organisation are the key reason behind the larger pay-off in the organisation for exceptional performance. In this regard the economists are having long recognition for the agency cost that are incurred in the principal- gent relationship and provide an ingenious solution and suggestion to minimise such cost to the organisation. The agency cost is generally incurred for a CEO who acts as an agent for any particular company (Abowd, & Kaplan, 1999). Moreover, when the CEO bears significant portion of cost but receive all the benefit for serving his/her. Additionally, to reduce such practices organisation can increase the agency ownership stake into the final output of the business that helps to ensure that they are bearing high productivity to ensure their cost. According the study, the main reason behind the growing compensation of the CEOs in respect of the poor financial performances of the company is associated with the method through, which the wealth of the CEO is calculated in the today’s business practices. The general mode of calculating the changes in the CEOs wealth is illustrated below: Changes in CEO wealth = total pay + PV [change in (salary + bonus)] Correspondingly, the finding of the research also reveals that in the short run the shareholder compensation is directly propositional to the firm performance and share valuation, but in the long run with a decrease in value of money, the compensation and salary structure of the CEOs also increases. Nevertheless, despite the poor performance, an organisation, it has to bear the cost of CEO qualitative affords towards the organisational (Jensen & Murphy, 1990). Core & Guay (2010) argued in their paper that the pay of CEO are generally higher, but has witnessed significant growth in the executive compensation after the period of 1970s due to similar growth in the stock market activities of the company. In this regards the economic theory advocates that the big corporate houses are facing serious problem in managing their existing operation with the pool of current state of man powers, which lead to hiring more talented and highly qualified CEO. Thus, the growth in the executive compensation is argued to be important to meet the demand of CEO’s (Gabaix & Landier, 2008). Moreover, it has also been revealed in the study that during the year 2005, the total pay provided to the top 5 CEOs was around $50 billion. Whereas, total market capitalization of this firm was around $20 trillion, which is in comparison to assets is around 2% and 20% of profits. It was also argued that multi-national corporation is very complex to manage than other business format. Thus, the fees of executive is claimed to increase with the passage of time. Moreover, in this regards the human capital theory of managerial reveals the individual characteristics and quality of the executive plays an important role in predicting future scenario of the businesses, which is again not measure with the value of money. CEO emphasise through calculation of the possible of return on organisational investment. Thus, the amount that the organisation needs to compensate to the executive at any underline situation is determined through how executive is valuable for the firm. Moreover, government and regulatory bodies are continuously engaged in providing significant regulation to strengthen the compensation system for CEOs. For example ‘Troubled Asset Relief Program’ (TARP) instituted standards in order to regulate the compensation practices of the firms, which get government assistance. In respect of having the proper control over the CEO companies needs key measure through creating an independent committee, reducing the perquisites and most also concerned towards the change in control payment system. The study in this context also identified that firms uses the severance or change-in-control system of payment to compensate the CEOs which are mostly designed to reduce the risk of overpaying the CEOs in the financial difficulties through retaining the best talents. Moreover, the US executive’s compensation system is highly based on the equity performance than the executives of any other country. Nevertheless, particularly in the context of the US executive, there are not any empirical evidences regarding the US executives revealing the incident of overpaid during the poor performance of a company (Core & Guay, 2010). Conclusion For the foregoing discussion and analysis of evidences and economical models, it can be comprehended that CEOs play an important role in the organization and are from background with different knowledge and needs, which provoke the organisation to compensate them during the time of poor performance. In this respect, the organization is required to formulate policies and measures with the intention of ensuring that the CEOs are remunerated in accordance with the performance rather than their importance in an organisation. Moreover, the development of proper compensation policies through the proper corporate governance practice along with independent members of board committee responsible for auditing the pay are few key measures to ensure the appropriateness in the executive compensation policies. References Abowd, J. M., & Kaplan, D. S. (1999). Executive compensation: Six questions that need answering. Journal of Economic Perspectives 13(4), 145-168. Balsam, S. (2002). An introduction to executive compensation. United States: Academic Press. Bertrand M., & Mullainathan, S. (2001). Are CEOs rewarded for luck? The ones without principals are. The Quarterly Journal of Economics, 116(3), 901-932. Core, J. E., & Guay, W. R. (2010). Is there a case for regulating executive pay in the financial services industry? University of Pennsylvania, 1-40. Gabaix, X., & Landier, A. (2008). Why Has CEO Pay Increased So Much? Quarterly Journal of Economics 123(1), 49–100. Jensen, M. C, & Murphy, K. J. (1990). Performance pay and top-management incentives. Journal of Political Economy, 98(2), 225-264. Productivity Commission Inquiry Report. (2009). Executive remuneration in Australia. Australian Government Productivity Commission, 49(19), 1-447. Walton, N. (2010). Crowding theory and executive compensation. Center in Law, Economics and Organization Research Paper Series, 1-25. Read More