HR 202 Chapter 14

1. Compensation
Chapter 14
Compensation of Special Groups
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Who Are Special Groups?
Groups that receive special treatment.
• Either in the form of add-on packages not received by other
employees.
• In the form of compensation components unique in the organization.
Special groups share two characteristics.
• They tend to be strategically important to the company.
• Their positions tend to have built-in conflict arising from different
factions placing incompatible demands on members of the group.
Special groups include:
• Supervisors, top management, boards of directors, scientists and
engineers, sales personnel, and contingent workers.

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Supervisors
The challenge in compensating supervisors centers on equity.
• Incentives are needed to entice nonexempt employees to accept the
challenges of being a supervisor.
Supervisor jobs are often exempt from overtime pay.
Strategies to attract workers into supervisory jobs include:
• Provide a 5-30% differential from the top-paid subordinate.
• Pay for scheduled overtime.
• There is an increased use of variable pay.

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Corporate Directors
A board of directors provides strategic decision-making advice.
• 8-11 individuals from both inside and outside the company.
Due to attention to CEO pay and concerns about impartiality,
companies are filling boards with outside directors.
• Perceived as less probe to bias than internal directors.
• Internal members used to “rubber stamp” the CEO’s decision process.
• Now a director faces highly charged analysis of many things, including CEO
compensation.
• There is considerable risk as stockholders may sue directors.
In exchange for assuming this risk, directors are well paid.
• Typically $260,000 for working 30-40 hours per month.

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Executives
In the 500 largest companies, average CEO pay is $12.7 million
and the highest paid executives make much more.
CEO pay is larger in large companies.
• Average CEO pay in S&P SmallCap 600 is $3.5 million.
• CEO pay to median employee compensation is also larger.
How do people respond to these pay levels and CEO pay ratio?
• 74% of average Americans feel CEOs are overpaid and should make no
more than 6 times the pay of an average worker.
• Respondents thought CEOs should receive 0.5% bonus if the value of
their company rose by $100 million.
• In a survey of company directors, only 18% disapproved of CEO pay.
• Those respondents felt the CEO deserved 1.5% if the firm’s value
increased by $100 million.

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Exhibit 14.2: Highest Paid Executives

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CEO Pay and Company Performance
Research suggests CEO pay and company performance are
strongly aligned.
• The pay-performance relationship is often not optimally studied.
• After correcting, the authors found strong relationships between CEO
return and total shareholder return.
• In some cases, what looks like a lack of alignment probably is not.
There is concern over CEO pay structure leading to bad behavior.
• Heavy use of bonuses and stock-based compensation may lead to
taking too large of risks.
• The Dodd-Frank Wall Street Reform and Consumer Protection Act:
• Improves accountability and transparency in the financial system.
• Proposes to end “too big to fail” and ending bailouts.
• Aims to protect consumers from abusive financial services practices.

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Exhibit 14.3: CEO Return and Shareholder
Return

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CEO Pay and Shareholders
The Dodd-Frank Act requires shareholders vote on the
compensation plan for its five highest paid executives.
• The vote is nonbinding but 97-99% of votes approve executive pay.
A “no” vote is seen as a public relations disaster.
• Most often the plan is overhauled to obtain stockholder approval.
• Exceptions are companies still run by their original founders.
The Institutional Shareholder Services (ISS) evaluates pay plans
and recommends plan approval 90% of the time.
• ISS evaluates on pay for performance.
• They evaluate on problematic pay practices.
• They also evaluate the compensation committee’s communication and
responsiveness.

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Components of an Executive Pay Package
Base salary
Short-term (annual) incentives
or bonuses.
Long-term incentives.
Benefits.
Perquisites.
Base salary only accounted for
9.6% of CEO pay in 2016.
Long- and short-term
incentives accounted for 75%
and was 7.8 times salary.
The ratio of CEO to worker pay
of 302 is a bit of “apples to
oranges” comparison.
But CEO pay in large
companies has grown faster
than worker pay.

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Executive Base Salary
Job evaluation still play a role in determining base pay but other
sources are much more important.
• The compensation committee is usually a subset of the board.
A common approach of compensation committees is to identify
competitors and set pay level between the best and worst.
• Where a CEO falls in this range depends on many factors.
• CEOs likely to be raided generally have higher compensation.
• Larger companies hit the high end of the range.

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Executive Pay – Annual Incentives / Bonuses
Short-term incentive plans play a major role in executive pay.
The FV Cook annual survey of the top 250 companies reports:
• 83% have non-discretionary plans, all using financial measures.
• Commonly profit, revenue, and cash flow.
• Non-financial measures were used in 52% of plans.
• Strategic, individual or discretionary measures.
• Payouts were weighted heavier to financial measures.
Bonuses have become a smaller portion of executive pay.
• The time horizons have shifted and bonuses reward short-term
results, not necessarily desirable for long-term consequences.
Companies tailor plans to their own objectives and strategies.

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Exhibit 14.7: Annual Incentive Plan for Top Five
Executives, Ford Motor Company
Jump to long image description.

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Exhibit 14.8: Annual Incentive Plan for Top Five
Executives, Ford Motor Company, Quality
Measures

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Executive Pay – Long-term Incentives
The FW Cook survey shows performance awards are the most
used long-term incentive for executives in the top 250 companies.
The FW Cook data from 2008 showed that the majority of
companies used stock options/stock appreciation rights (SAR).
• The drop in popularity is due to bodies like ISS taking the stance that
service-vesting stock options are performance-based equity.
• The drop is also due to the change in accounting treatment of stock
options from “intrinsic value” to “fair value.”
The Black-Scholes options pricing model helps determine value.
• Volatile stocks with low dividends return the highest value.

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Exhibit 14.11: Effect of Volatility and Dividend
Rate on Option Value

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Long-Term Incentives and Performance
One concern with stock options is they may not link performance.
• Executives may exercise their options in a rising market which does not
reflect on any specific actions of their own.
• In a falling market, stock options are under water and may be re-issued.
• Executives may “game the system” through a large stock buyback.
No denying that executive decisions impact corporate success.
• Linking compensation to stock price effectively motivates success.
• Performance awards are the most important incentive program.
• FW Cook shows that total shareholder return (TSR) is the most common
measure of performance in relation to that of competitors.
• The next most common measures were profit, capital, efficiency, and
revenue with nonfinancial measures used less often.

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Executive Benefits and Perquisites
Beyond the typical benefits, many executives also receive:
• Additional life insurance.
• Exclusions from deductibles for health-related costs.
• Supplementary pension income exceeding ERISA maximum limits.
ERISA and tax code restrict benefits too far above other workers.
• Plans may have to cover 80% of employees, provide determinable
benefits, or meet vesting and nondiscrimination requirements.
Tax and regulatory agencies require a value on “perks.”
• If the CEO of the Shaw group dies, the company will pay his family $18
million for him to not compete against Shaw for two years.
• 7% of Fortune 500 firms give cash allowances, averaging $32,000.
• A personal car, and driver.

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Why the Interest in Executive Compensation?
One issue is income inequality in the U.S. and other countries.
Executive pay in almost every other country is lower than in the
U.S. who has a disproportionate share of S&P 500 companies.
The difference in pay between a CEO and the average worker has
exploded with a differential of 302:1.
Why do pay committees recommend these amounts of pay?
• The committee and Board represent shareholder interests and CEO
pay is a major cost but pales to the difference in shareholder returns.
• Executive compensation reflects changes in the market.
• Though critics are vocal, there is strong evidence of a strong pay-for-
performance link in the pay of executives.

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Explaining Executive Compensation
One explanation involves social comparisons.
• Executive salaries bear a consistent relative relationship to
compensation of lower-level employees.
• Critics point out the gradual increase in the spread between
executives’ compensation and average salaries of people they employ.
A second approach focuses on explaining the level of wages.
• CEO worth should correspond to some measure of company success.
• Or CEO salaries are tied to labor markets and competitor pay levels.
• Some say social responsibility should be a measure of company value.

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Executive Pay – Agency Theory
A third view, called agency theory, includes political motivations.
• One variant says CEOs are self-protective and make decisions to
solidify their positions and maximize personal rewards.
• Behavioral agency theory suggests CEO are risky to accumulate future
wealth, and conservative to protect current wealth.
As evidence of self-motivated behavior, consider that CEO pay
increases in all scenarios.
• If the CEO is truly underpaid, if the CEO is not underpaid and the
company is doing well, or even doing poorly.
Agency theory argues that compensation should ensure that the
best interests of stockholders is in mind when making decisions.
• Almost all companies tie performance to incentive plans.

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Scientists and Engineers
Firms hiring scientists and engineers, classified as professionals,
struggle to figure out what pay should be.
• For the first few years after graduation, an engineer’s knowledge is a
valuable resource but gradually, the knowledge becomes obsolete.
Because salaries plateau, many make career changes such as
moving into management or updating their knowledge.
• Some companies use the dual-career ladder providing two ways of
progressing, either the managerial or the professional track.
A second problem centers on the question of equity.
• Maturity curves reflect the years of experience in the labor market.
Organizations develop perks to satisfy the needs of professionals.
• Flexible schedules, large offices, campus-like facilities, and lavish
athletic facilities.

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Sales Forces
To meet the needs of the complex environment between the
customers and the organization, the sales job has morphed.
• The job can be outsourced and called either indirect sales force or
manufacturing reps or even independent reps.
• In-house sales jobs can be broken down by inside or outside reps.
Interacting in the field with customers requires high initiative
and has low supervision for extended periods of time.
• Standard compensation is not designed for this so there is more
reliance on incentive pay tied to individual performance.
• If the product is in high demand, the compensation mix is mostly base
salary with a small incentive component.
• If sales ability is important, the size of the incentive component
increases.

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Designing a Sales Compensation Plan
Six major factors influence the design of pay packages.
• The nature of people who enter the sales profession.
• Salespeople rank pay significantly higher than five other forms of reward.
• Organizational strategy.
• Market maturity.
• Companies should adapt compensation to sales patterns as the product
matures – focusing on customer satisfaction and retention.
• Competitor practices.
• External competitiveness is essential.
• Economic environment.
• Sales forces expand during good economic times and constrict during
recessive environments.
• The product to be sold.

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Sales Pay Plans and Organizational Strategy
A sales compensation plan should link desired behaviors to
organizational strategy.
Salespeople should know when to stress customer service and
when to stress volume sales.
• If you want to motivate aggressive sales behavior, a straight
commission-based incentive plan will focus sales efforts.
• Each measure of performance corresponds to a business goal.
Generally, there are two types of compensation plans.
• Unit rate plans differ by the amount they pay for each unit of sales.
• Commissions are either flat, ramped, declining, or pooled.
• Add-on plans focus sales staff on specific types of sales with extra
incentives for each sale of that line.

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Sales Pay Plans and Product Sold
The product or service influences design of a compensation plan.
• Products with high barriers to entry need compensation with a large
base-pay component, minimizing risk.
• Products with low barriers to entry use a higher incentive component.
Figuring out the sales target is a major challenge.
• Too easy a target results in undeserved compensation and impossible
targets can be demotivating.
A second challenge is accurately forecasting expected sales.
Most jobs do not fit straight salary or straight commission so
combination plans capture the best of both plans.
Salespeople famously find loopholes in sales incentive plans and
“milk” them for personal profit.

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Contingent Workers
Contingent workers are anyone hired through a temp agency,
anyone on an on-call basis, or independent contractors.
• Those in the first two categories generally earn less than traditional
workers and those in the latter category earn more.
Why the move to contingent workers?
• It may signal a permanent change in the way business is done.
• Temp workers afford a level of flexibility.
A major compensation challenge centers on equity.
• Some companies consider contingent workers as a pool of candidates.
• Others champion the idea of boundary-less careers.
There are also high-paid “gig” workers who work on demand.

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End of Chapter 14.