Executive compensation has received attention due to high visibility, perceived unfairness, and importance. A good corporate governance rating signals that the board prioritizes shareholders over the CEO. Executive pay packages can motivate strategic decisions that benefit shareholders or reinforce the wrong choices. Recent environmental changes like shareholder activism, Sarbanes-Oxley, and SEC disclosures are affecting CEO risk and compensation. Managing risk involves stock options, pay-for-performance, and golden parachute provisions. The risk environment should influence executive contract design.

1. Executive Compensation:
Something Old, Something
New
Gary Skarr, SPHR, CCP
October 23, 2008
Executive Forum
Hot Topic
Executive compensation has been a hot
HR topic because of:
High visibility
Frequently perceived unfairness (particularly
in North America)
Importance
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2. Corporate Governance Rating
A good corporate governance rating sends
a signal to potential investors that the firm
is a better investment because
presumably the board of that firm is
working for shareholders as opposed to
cozying up to the CEO
Executive Compensation
Package
Can either be a motivational tool
encouraging executives to pursue
strategic decisions that are in the best
interest of shareholders or it can be
designed to reinforce the wrong strategic
choices
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3. The CEO Pay Package
Two out of three CEOs have seen their
pay go up in the last couple of years
Only a small percentage of the differences
in pay among CEOs could be explained by
differences in the performance of their
firms
CEOs who were making more money
were also running larger companies
What Does Pay Mean?
Large pay packages are flagged as a sign
of weak boards that are too cozy with
management and not looking out for
shareholders
Low ratings signal that the board is
ineffective in monitoring the CEO which
can in turn hurt the firm’s stock price
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4. The Role of Risk in the Executive
Compensation Contract
Employment risk - the possibility that the
executive will be terminated either due to
unsatisfactory performance or due to
change in control
Compensation risk - the potential
unpredictability in the executive’s future
pay represented mainly by the proportion
of stock options in the total pay package
The Role of Risk in the Executive
Compensation Contract
Continued
Business risk - the uncertainty surrounding
the firm’s competitive environment
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5. Components of the Pay Package
Fixed pay – salary and benefits
Typically smaller than variable pay
Firms can only write off one million dollars in
fixed pay
Most companies top off salaries at about one
million dollars
Components of the Pay Package
Continued
Variable pay – bonuses and stock options
Draw the CEO’s attention to performance
results and can serve to align the goals of the
company and its shareholders with the
personal goals of the executive
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6. Recent Environmental Changes
Affecting CEO Risk
Shareholder activism
Sarbanes-Oxley Act (SOX)
SEC disclosures
Shareholder Activism
Proxy resolutions sponsored by union and
public pension funds, aimed at cutting
CEO pay, are winning extraordinary
victories
If shareholder activism keeps spreading it
will ignite a good amount of reform
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7. The Sarbanes-Oxley Act
(SOX)
SOX holds the new generation of CEOs
personally accountable for their
companies' financial statements
Some worry that SOX forces CEOs to
place more focus on the internal control
environment and the short term as
opposed to focusing on the long term
SEC Disclosures
The SEC voted on an expansion in
disclosure requirements for executive pay
including:
The dollar value of every benefit that
executives derived from their employment
Companies should report the extent to which
executives sell shares given to them as
variable pay
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8. SEC Disclosures Continued
Additional SEC disclosures include:
Companies should disclose not just the
amounts paid but also the criteria based upon
which those bonuses were awarded
Companies should annually disclose the
dollar value of the package that each
executive will receive upon exit in the case of
a change in control, termination or retirement
Managing Executive Risk
Stock options
Pay for performance
Change-in-control provisions
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9. Stock Options
Stock options are the right to purchase
stock at a predetermined price
Restricted stock is a right granted to
purchase during a specified period, at the
market price on the date of the option, a
specified number of shares
Stock Options Continued
Restricted stock is replacing stock options
in executive benefits packages due to
changes in accounting standards
Restricted stock is not as tied to
organizational performance as stock
options
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10. Pay for Performance
Tying executive compensation to specific
performance guidelines can be
counterproductive
CEO performance should be tied to
broader metrics that go well beyond
financial measures such as leadership and
innovation
Pay for Performance
Continued
SOX provisions increase business risk for
CEOs leading to risk averse business
strategies
Link pay to performance very loosely and
motivate them with restricted stock options
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11. Change in Control Provisions to
Manage Employment Risk
Golden parachute clauses have increased
in popularity
Golden parachutes are payments in the
form of cash, an acceleration of vesting or
other benefit that occurs in connection with
a change in the ownership or control of a
company's stock or assets
Golden Parachute Provisions
Typical golden parachute provisions
include:
a lump-sum payment equal to typically three
times the base salary plus bonus
accelerated vesting of deferred compensation
and supplemental executive retirement plan
(SERP) benefits
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12. Golden Parachute Provisions
Continued
Additional golden parachute provisions
include:
Additional age and service credit during the
severance period (typically three years) for
purposes of pension calculation
Accelerated vesting of equity awards
Linking Pay to Performance
Individuals in positive contexts can
become risk averse while individuals in
negative contexts can become risk
seeking
An ideal level of risk needs to be
determined for the executive and the
extent that pay is tied to performance
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13. The Risk Environment
Firms operating in highly competitive,
high-risk environments need to pay more
to attract and retain high quality executives
than firms operating in low risk
environments
The Risk Environment Continued
The proportion of variable pay needs to be
balanced by the potential to earn more
money
Total pay should be highest in settings
where risk is greatest for the CEO such as
high technology firms or family controlled
firms
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14. CEO Pay in High Technology
Firms
High technology firms need to reward
CEOs by using multiple performance
criteria including:
Financial indicators
Emphasis on innovation
Support of basic research
CEO Pay in Family Firms
Family firms differ from non family firms in
two major ways:
Executives who are members of the family
exhibit a greater desire to retain control of the
firm stemming from a strong personal
attachment
Employment and compensation risk is highly
concentrated in the firm
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15. CEO Contracts in the Family
Business
Contracts should be more transactional
with specific performance provisions for
family CEOs
Contracts should be more relational for
CEOs outside of the family to protect them
from unfair judgment
Conclusion
There are a wide variety of ways to design
CEO contracts
The provisions of these contracts can
impact the firm performance
The environment in which the firm
operates should influence the CEO
contract
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