Executive Incentives PDF

CORPORATE GOVERNANCE HENRIK NILSSON (SSE)[email protected] Is executive pay out of control? https://www.youtube.com/watch?v=eAo3UfsNgbg Executive Incentives Executive Compensation: Outline 2 Recap of Agency theory Potential Managerial Temptations Types of Executive Compensation Does Incent...

CORPORATE GOVERNANCE HENRIK NILSSON (SSE)[email protected] Is executive pay out of control? https://www.youtube.com/watch?v=eAo3UfsNgbg Executive Incentives Executive Compensation: Outline 2 Recap of Agency theory Potential Managerial Temptations Types of Executive Compensation Does Incentive-based Compensation Work in General? Potential “Incentive” problems with Incentive-based Compensation Theories explaining CEO compensation International Perspective-CEO Compensation Around the World Recapitulation: Agency Theory 3      Separation of Ownership & Managerial Control: Basis of the modern corporation Shareholders purchase stock, becoming Residual Claimants Shareholders reduce risk efficiently by holding diversified portfolios. Professional managers contracted to provide decision-making. Modern public corporation form leads to efficient specialization of tasks.    Risk bearing by shareholders. Strategy development and decision-making by managers. Solution to potential principal – agent problems:  Monitoring and Incentives Agency Theory An agency relationship exists when: Agency Relationship Shareholders (Principals) Firm Owners Hire Managers (Agents) Decision Makers Risk Bearing Specialist (Principal) Managerial DecisionMaking Specialist (Agent) which creates 11-4 Framework for studying executive compensations 5 Main purpose of compensation plan 6  Provide the right incentives! 1. 2. 3. 4.   Attract the right people Retain the right people Motivate them to perform (consistent with corporate strategy and risk profile) and align their interest with the shareholders Discourage self-serving behavior (and excessive risk taking) Employer interested in: 1. Performance, 2. Retention, 3. Termination with minimal adverse impact financially and legally and 4 Post-employment protection (e.g non-competition agreements, invention protection) Employee interested in: 1. Compensation, Employment security and rights and flexible post-employment termination Potential Managerial Temptations 7 A good manager should put the needs of other stakeholders before his own. However, if shareholders and the board of directors cannot effectively monitor managers’ behavior, then managers may be tempted to put their needs first, even at the expense of shareholders. Examples of Self-serving Managerial Actions 8 Shirking (i.e. not working hard) Hiring friends Consuming excessive perquisites (perks) Building empires Taking no risks or chances to avoid being fired Taking excessive risk to earn large bonuses Having a short-run horizon if the managers is near retirement Excessive compensation (CEO-Chairman-Main Owner) Determining the Level of Compensation (Board of Directors) 9 In theory: 1. 2. 3. Determine how much value the company expects to create during a reasonable time horizon (for example, five years). Determine how much of this value should be attributable to the efforts of the CEO. Finally, determine what percentage of that value should be fairly offered to the CEO as compensation. In practice:  Determine compensation levels by benchmarking (remuneration committee and the compensation consultant). 10 Types of Executive Compensation (Short term incentives, STI) Base Salary Fixed comp paid to an executive for services rendered Provides security and predictable income for daily needs of the individual In many countries (like US) a small percentage of overall total compensation. However, since target annual and long-term incentives are often expressed as a percentage of salary, changes in salary resonate through the compensation package (see, e.g. RB case) The base salary is usually determined through the benchmarking method (i.e., comparing to similar size firms). 11 Types of Executive Compensation (Short term incentives, STI) Bonus Compensation earned and paid based upon achievement of performance goals over a one-year period Motivate performance and align executive with company’s short-term performance objectives Opportunities for CEO and senior executives are often defined as a percentage of base salary Selected performance metrics should focus and drive performance Common performance measures: 1. Earnings, 2. Revenue, 3. Cash flow. 4 strategic goals. Leverage: Minimum (low level of performance, payout= 25-50%) ; mean/expected (expected/budgeted level of performance, Payout = 100% of target); Maximum (exceptional performance, 150-300% of target) 12 Types of Executive Compensation (Long-term incentives, LTI) • Long-term incentives are awards earned and paid based upon achievement of goals over a period exceeding one year • Goals may be based on stock price or business performance • Typically equity based • Purpose/objectives • Align executive and shareholder interests • Attract, retain and motivate • Focus participants on critical performance criteria • Provide competitive pay opportunities based on performance (pay-for-performance) • Create wealth 13 Types of Executive Compensation (Long-term incentives, LTI) 1. Stock Grants: An alternative form of long-term incentive compensation that avoids some governance failures (incentive failures). • Restricted stock • Grant of shares that are restricted in terms of transferability and subjected to time-based vesting. • Does not have asymmetric incentives (Does not go to zero when stock price falls) • Performance shares • Stock awards granted only after specified financial and nonfinancial targets are met during a three- to five-year time period. • Saving share program (co-investment programs) • Incentive program that requires an initial investment. The investment later provides additional shares (sometimes performance shares) as a reward in the form of matching shares. Types of Executive Compensation (Long-term incentives, LTI) 14 2. Stock Options (and similar contracts) • Stock options are believed to align managers’ goals with shareholders’ goals (increase in value as the stock price increases). • Stock options have asymmetric incentives (“all or nothing”) • Stock options can lead to increased risk taking by managers (options increase in value with stock-price volatility). • Time-based vesting requirements, options have deferred payoffs that encourage a focus on long-term results. • Performance-vested options (accounting performance, stock performance, non-financial performance metrics) Desirable features of option programs 15  Pros:     Allignment with shareholders: Options increase in value as the stock price increases (implement risky investments with positive NPV). Because of vesting requirements, options have deferred payoffs that encourage a focus on long-term results Fixed expense in the income statement (valued at grant date and then amortized (expensed) over the vesting period. Cons:    Not always performance based (i.e not tied to companies financial performance) Dilution (number of shares are increasing) Expense recognized even if option expires worthless Other Compensation 16 Perquisites: Club membership, financial advisors, luxury cars and chauffeurs, personal use of company aircraft, loans below market rate, etc. Retirement compensation (Defined Contribution Plans vs Defined Benefit Plans) Severance pay (Golden Handshakes, separation pay that is awarded to retiring or fired CEOs). Decline in severance multiples over time Perks represents a diminishing portion of total compensation for executives Level of shareholder distaste seems to be far in excess of value of benefits delivered. Common perks support health and productivity Important Governance Policies 17 Share ownership guidelines Require that executives hold a certain number of shares Required value is most often defined as a multiple of base salary Clawbacks Gives companies the right to “clawback” incentive compensation awards paid to executives if performance upon which those awards was based is later found to be erroneous. Different regulation/legislation in different countries but most companies implement their own policies (clauses in compensation conracts) CEO pay ratio Requires disclosure of the median total annual compensation of all employees and the ratio of the employee median to CEO total comp. (US) 18 Determining the Level of Compensation (Board of Directors) In theory: 1. Determine how much value the company expects to create during a reasonable time horizon (for example, five years). 2. Determine how much of this value should be attributable to the efforts of the CEO. 3. Finally, determine what percentage of that value should be fairly offered to the CEO as compensation In practice, the compensation committe:  determines compensation levels by benchmarking.  Uses compensation consultants 19 Corporate Governance in Nokia, 2018 Executive ownership in Nokia, 2018 20 21 Compensation Strategy in Nokia (2018) The specifics of the executive comp program in Nokia (2018) 22 The specifics of the compensation program in Nokia (2018) 23 Motivation Details Actual compensation, 2018 24 25 “In 2018, we complied with the Finnish Corporate Governance Code, with the exception that we were not in full compliance with the recommendation 24 as our restricted share plans did not include performance criteria but were time-based only. The restricted shares vest in three equal tranches on the first, second and third anniversary of the award subject to continued employment with Nokia. Restricted Shares are and will be granted on a limited basis for exceptional purposes related to retention and recruitment to ensure Nokia is able to retain and recruit vital talent for the future success of the company.” 26 Jones et al. (2006)The Determinants of Stock Option Compensation: Evidence from Finl. 27 Jones et al. (2006) The Determinants of Stock Option Compensation: Evidence from Fin 28 29 Perquisites Variable Pay Canada Brazil Belgium Australia Kim et al 2010 Venezuela United States United Kingdom Taiwan Switzerland Sweden Spain South Korea Singapore Netherlands Mexico Japan Italy India Germany France China-Shanghai China-Hong Kong Fixed Pay Argentina Percent of Total Pay International Perspective-CEO Compensation Around the World 30 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 31 EY Finnish Executive Remuneration Report | 2016 | Do executives have incentives to perform? Measuring Incentives (Table 2 Frydman&Jenter, 2010) Fractional ownership 32 Frydman & Jenter (2010) Figure 1: Median Compensation of CEOs and Other Top Officers from 1936 to 2005 33 Does Incentive-based Compensation Work in General? Pay-for-Performance sensitivity  34 Ex post evidence: Do companies pay for performance? Edmans et al., 2017, Executive Compensation: A Survey of Theory and Evidence How do we know if the executive is getting the right pay? 35 Pay = CEO ability + Cost of effort + Incentive risk premium + excess pay Source: Core&Guy, 2010 “Is pay to high and are incentives too low? A wealth-based conracting framework Theories explaining CEO compensation: Rent extraction or competitive pay? 36    Managerial power hypothesis:  Weak corporate governance allow CEOs to (at least partly) determine their own pay. Managment talent hypothesis:  CEO pay is the efficient result of increasing demand for CEO effort or scarce managerial talent. Technology change hypothesis:  Changes in firms’ characteristics, technologies, and product markets over the last 30 years have increased the effect of CEO effort and talent on firm value, and therefore also the optimal levels of incentives and pay. Theories explaining CEO compensation: Rent extraction or competitive pay? 37   Managerial general skills hypothesis:  A shift in the type of skills demanded by firms from firm specific to general managerial skills. Such a shift intensifies the competition for talent, improves the outside options of executives, and allows managers to capture a larger fraction of their firms’ rents. The monitoring hypothesis  Growth in CEO pay is the result of stricter corporate governance and improved monitoring of CEOs by boards and large shareholders. , If CEO job stability is negatively affected by an increase in monitoring intensity, firms optimally respond by increasing the level of CEO pay. Potential “Incentive” Problems in practice with Incentive-based Compensation 38 Problems with Accounting-Based Incentives (e.g. Bonuses based on accounting performance Focus on short-term accounting results (forego costly research and development that might be beneficial to the firm) Accounting profits may be manipulated downwards after the target is reached Manipulate accounting results upwards in order to achieve targets. Problems with Stock Option Incentives 39 CEOs might forego increasing dividends in favor of using the cash to try to increase the stock price (excessive risk-taking in short run) CEOs might pick a too risky business strategy (long-run) Stock options may be too far underwater to motivate the manager effectively CEOs may try to do what they can to time stock price movements to match the time horizons of their stock options Market factors cause changes in stock price that are not the result of the executive’s individual effort. Repricing previously issued options may let options lose their effectiveness 40 Main Findings 41      At a macro level, the inclusion of ESG metrics in compensation contracts is more common in countries that are generally perceived to be ESG sensitive, including the possibility that some form of ESG reporting is already mandatory in these countries. At the firm level, aside from size and volatility, the practice of ESG Pay is associated with firms that have publicly issued environmental commitments. We also find that ESG Pay is associated with more independent boards with a higher percentage of female members and, notably with the presence of institutional investors. Firms that link ESG performance to executive compensation receive on average more favorable ESG scores from outside rating agencies. Results show a decrease in carbon emissions in cases in which the contract includes a measure specifically related to emissions. Results show no positive association with financial outcomes, such as return on assets, and even show a decrease in stock returns after the adoption of ESG Pay. Summary 42 Stock and option incentives are believed to solve agency-problem However, whether or not the incentives work results in much debate (pay-for-performance vs. excessive compensation) If incentive compensation is perfect, then no monitors are needed. BUT: Behavioral biases might prevent efficient contracting (assumes rational behavior). Incentives measured in terms of ownership/total wealth seem to effect performance 43 Purpose of the paper • • To explore the cross-sectional determinants of a new measure of executive incentives, that is, ownership value relative to total wealth (PPE) To explore whether the PPE measure of incentives is related to firm performance Motivation • Fractional ownership as a measure of incentives is problematic, because Firms differ in size • CEOs’ differ in their wealth Observed performance effects of incentives • Incentives should be positively related to firm performance, or • Incentives should NOT be positively related to firm performance • • • • Optimal incentives differ across firms/industries Optimal contracting CEO’s total wealth elasticity and firm performance Perf it / it 1  Incentives it  Control _ Variables it  Annual _ Dummies  Industry _ Dummies   it Perfit/it+1 – 1) One-year ahead accounting performance measured as ROA Incentivesit – PPE_Grossit, PPE_Netit based both on market and book value of CEO holdings. Control variables: Sizeit – the natural logarithm of total assets Debt-to-assetit – debt-to-asset ratio Volatilityit – firm’s idiosyncratic volatility, measured as a standard deviation of residuals from the market model regression of daily returns over preceding 36 months NPRit – net purchasing ratio of a CEO ROAit – Current return on assets 48 Short on the accounting for Stock Options Options and Accounting No accounting expense for the firm before 2005, only economic cost to the firm (shareholders). Stock option’s favorable tax treatment for executives. Nowadays IFRS 2 and FAS 123(R) takes into account the value of the option at grant date and amortize that value during the life of the option or vesting period.