CHAPTER 20: MANAGERIAL AND EXECUTIVE COMPENSATION

Overview: This chapter analyzes how top management's pay is determined. It examines base salary, short-term incentives (bonuses), long-term incentives (stock options), deferred compensation, benefits and perquisites.

Corresponding courses:

12 IRS Reasonable Executive Compensation
21 Managerial and Execuitve Compensation
22 Black-Scholes Valuations
42 Accumulated Earnings and Deferred Compensation

INTRODUCTION

Managerial employees represent the most common group to be identified as requiring special compensation programs. This is for a number of reasons.

2. Managers are a small part of the total number of employees in any organization but represent a disproportionately high percentage of total wage costs.

1. They are a group of vital importance to the operation of the organization, and it is important to attempt to individualize compensation for each manager, particularly each executive.

3. It is necessary to develop measures of individual performance that are tied to organizational performance, since it is of utmost importance that managers associate themselves with organizational success.

Within the management group (for our definition) exists the "executive group." Common to many position naming systems, these positions carry the lead title "Top", or "Vice President" (except in financial institutions), "President," "Chief" or other nomenclature that differentiates their position within an organization hierarchy. In many international locations and within small to medium-sized North American firms, the terms "managers" and "executives" are used interchangeably.

This is not the case for large U.S. publicly traded corporations. In these companies, "executive compensation" is a subject on to its own, although we concurrently cover it in this chapter. This executive group is of such importance and their compensation arrived at so differently from other employee groups that ERI has developed a special Executive Compensation Assessor software to analyze its pay practices.

Tax Treatment

Since executive compensation plans provide favorable tax treatment for both the executive and the organization, it is important to identify who is in this group of employees. The IRS provides two classification; Key Employees and Highly Paid Employees.

Key employees

The IRS definition of a key employee is:

• one of 10 employees owning the largest percentage of the company

• an employee owning more than 5% of the company

• an employee who earns more than $150,000 per year and owns 1% of the company

• the definition excludes anyone who earns less than $45,000 a year

Highly paid employees

The IRS definition of a highly paid employee is an:

• employee who owns 5% of the company

• employee earning $75,000 a year [this year or last year]

• employee who earned over $50,000 [this year or last] and is in the top 20% of all salaries paid to active employees

• officer who earned over 150% [last year or this year] of the dollar limit for annual additions to a defined contribution plan

MANAGERS: THE JOB AND THE PERSON

As a beginning point we will examine the nature of the managerial job and the characteristics of the people who occupy this role in organizations.

The Managerial Job

Presthus identified one of the basic patterns by which people accommodate themselves to working in organizations is to be upwardly-mobile. This person then associates his or her goals with those of the organization.¹ The major group of people in organizations who meet this description are its managers. This connection that these people make between themselves and the organization needs to be enhanced and encouraged through the compensation plan. This section will discuss the managerial role, the characteristics of managerial work, and the differences in levels of managerial work.

The Managerial Role

In a way, all managers are the people in the middle.² This emphasizes the fact that managers have to please a number of constituencies in order to get their work done. Broadly speaking, managers have an internal role and an external role.³ The internal role has to do with directing an organizational unit. In interpersonal terms, Katz sees this as a leadership function.⁴ The external role requires the manager to deal with people outside the organizational unit to accomplish the unit's work. This role is not as clearly defined as the internal role but involves developing relationships, gathering information, and deciding where the organization is going and how to get there. In this, the manager is often like the salesperson...on the margin of the organization. To the extent that this is the case, incentive plans would seem appropriate.

Mintzberg has elaborated further upon the manager, developing ten roles, divided into three categories: interpersonal roles, informational roles, and decisional roles.⁵ Each of these categories has roles that can be considered internally and externally oriented, as illustrated in the figure below.

Figure 18-1. The internal and external roles of the manager
Source: T. J, Atchison and W. W. Hill, Management Today, New York: Harcourt Brace Jovanovich, Inc., 1978, p. 7.

Externally, the manager represents the organization to the world, deals with the world, and decides the direction the organization needs to take. Internally, the manager directs organizational activity and allocates resources to accomplish goals. All this is central to the organization's success. Not all managerial jobs contain all ten roles equally, nor do all managers perform all roles equally. This leads to a great deal of variety in the definition of the managerial job, with the manager having a good deal of influence over the definition.

Characteristics of Managerial Work

Mintzberg goes on to point out that managerial activity has three basic characteristics: brevity, variety, and fragmentation. Managers deal with a great many things each day...sometimes a hundred or more...and these things cover a wide variety of topics. Managers are active people. They perform a large quantity of work and find it hard to leave it behind when they leave the office. In this they are like professionals. Further, managers are not able to concentrate their energies on a single project until it is completed; instead they jump from one thing to another all day long, leading to the feeling of fragmentation. This makes the job very ambiguous to the manager.

It is no wonder that Sayles finds that managers have a hard time describing what they do to others in meaningful terms and that what comes out sounds like a lot of little unconnected items.⁶ Thus, describing the managerial job can be very difficult, partly because the manager has trouble defining what he or she does and partly because it is hard to make sense of what is done. Developing useful job descriptions is difficult in this circumstance. Since most compensation programs need job descriptions for evaluation purposes, this problem may change the way managerial compensation is handled.

These characteristics of the managerial job are tied to the activities of managers just discussed. Since managerial jobs differ in the degree to which certain activities take place in the job, the characteristics also vary. For instance managerial jobs such as sales or marketing positions are more subject to brevity and fragmentation than some other managerial jobs.⁷

Levels of Managerial Work

Organizations are hierarchical, which is what creates the managerial role in the first place. Large organizations have a number of managerial levels. In fact, the organization chart is usually a chart of the managerial Jobs in the organization. Compensation plans for the managers in an organization generally follow this organizational hierarchy closely. The hierarchy contains three levels of managers: top management (executives), middle management, and lower management (supervisors).

Top Management. Executives are those at the top of the organizational hierarchy, usually the top 1-5 percent of the organization's work force.⁸ They look out of the organization to the environment. They are charged with developing the goals and strategies required to keep the organization effective. The owners, through the board of directors, see these people as the trustees of their resources. Thus compensation for this group is closely associated with the success of the organization as a whole.

Ordinarily, top management is responsible for the total operations of the organization (the CEO and executive VPs), a major segment of the organization (an-operating division with a set of products), or a major organizational function (such as finance). The results of these units are measurable, and it is usually assumed that these managers had a significant impact on these results and therefore should be rewarded on the basis of the results.

Lower Management. At the other end of the hierarchy are the supervisors. They are first-line managers. That is, they direct the work of non-managerial employees. This job is more internally oriented, in two ways. First, the supervisor is more intimately concerned with a small group of workers and the work of that unit. Second, although the supervisor's external contacts are outside the organizational unit, they are still within the organization itself. The pressures of the first-line supervisor are immediate and influence today's results, in considerable contrast with the top manager, who is concerned mostly with problems extending years into the future. Because supervisors are so close to their workers, the job comparison for first-line supervisors is often the worker in the organizational unit. Thus the supervisor's wages are some percentage over those of the workers. In fact a series of studies show that employees have a definite idea about the "appropriate" distance between organizational levels. Mahoney's review of these concepts and other studies indicates that about a 33 percent distance between organizational levels feels right to people.⁹ A study by one of the authors shows a lower differential at the supervisory level, closer to 20 percent.¹⁰

Middle Management. As the name implies, this consists of the organizational levels between the two so far discussed. These managers direct other managers and act as an information channel between top management and supervisors. Their perspective is ordinarily intermediate. They are usually responsible for a specific function in the organization and spend much of their time coordinating this function with other groups in the organization. A great number of the contacts of this group are lateral, so that getting work done is through means other than the use of authority.¹¹ This creates considerable ambiguity for the middle manager, a feeling that he or she is responsible but does not have the necessary control. These contacts make peer comparisons important for this group. Compensation for this group is often related to the function that is being managed, and since there are large enough numbers of managers, managerial wage surveys make sense. It should be noted that this group has decreased dramatically in the past twenty years as organizations have downsized and eliminated organizational levels to reduce bureaucracy.

Managerial Personality

It is difficult to identify any particular personality pattern as being common to managers. However, there are a number of aspects of managers relevant to the development of a compensation program for them that need to be explored. These are their commitment, decision orientation, and power needs.

Commitment. From the discussion thus far it should be clear that commitment is one thing managers have and organizations need. Managers associate themselves with the organization and spend a great deal of time at their work, usually up to 60 hours a week. But even if they are not formally working, managers find it is hard to turn off the job. They think about their jobs even when they are supposed to be at leisure. In terms of the membership model, these people have high inputs and will therefore expect high outcomes from the organization.

Decision Orientation. Managers are action-oriented. Mintzberg found that managers had a preference for live action and the use of verbal media.¹² This often gives them the appearance of being intuitive rather than analytical in their decision making.¹³ This is in contrast with why the professional, who is analytical, is valuable to the organization. The manager ensures that things keep moving and get done. Decisions are the heart of the manager's job.¹⁴ In a way this is what the manager is paid for. Certainly the time span of discretion, by which Jaques measures job level, implies that decisions are central to defining managerial jobs.¹⁵ Likewise, the Hay system of job evaluation, the one most commonly used to evaluate managerial jobs, focuses upon three aspects of decisions: know-how, problem solving, and accountability.¹⁶ So an orientation to decision making is probably useful in trying to evaluate managerial jobs and performance. Furthermore, both Kotter and Mintzberg find that being knowledgeable about the business and organization and having a wide set of contacts in order to collect information are important aspects of the manager's job.¹⁷

Managerial decision making is not like technical decision making. Katz points out that as managers move up the organizational hierarchy they need to have higher levels of conceptual skill. This skill requires the manager to think in terms of general trends rather than specifics and to be able to see the forest for the trees.¹⁸ This skill may be related to the idea of left-brain thinking.¹⁹ The point is that managers as they move up in the organization need to be able to think and make decisions using a much broader framework and be able to deal with high levels of uncertainty. These skills may be in very short supply within the society, creating demand higher than supply.²⁰

Power Needs. McClelland found that, unlike sales personnel, managers do not have a high achievement drive. This is not to say that they do not focus on accomplishing things or are not ambitious; they do and are.²¹ But they do not match McClelland's technical definition of achievement drive. What McClelland did find out about managers is that they have a high power need .²² They enjoy controlling a situation and having a strong influence on. the outcome of events. This desire for power can take two different forms, "power over" and "power to." The former is a personal definition of power that taps the unsavory aspects of the idea of power. The "power to" is a more institutional expression of power that focuses on getting the job done in the organization within the rules of the organization. Compensation programs for managers need to encourage this type of power drive.

This power aspect of the manager indicates that managers have and need considerable interpersonal skill. Most studies show that this is true.²³ Katz sees that this interpersonal skill takes on two forms, supervisory and peer. Supervisory skill has to do with the leadership of the people in the manager's organizational unit. Peer skill has to do with the myriad contacts the manager must engage in outside the organizational unit in order to get the work done.²⁴

Also connected to power is the idea of status. Managers spend a great deal of time on the job, are committed to the organization, and carry heavy responsibility. They must find it worth doing. Beyond the high wages, there are a number of other extrinsic and intrinsic rewards available to managers. The management job is held in esteem within the organization, if not in society as a whole. Also there is a hierarchy of managers in the organization, with those further up having more status than those lower down. The measure of status is most often reflected in the wages of the person. Thus, managerial compensation is a reflection not only of job worth but of the rank and status of the manager.

MANAGERIAL AND EXECUTIVE COMPENSATION SYSTEMS

Managerial, and particularly executive compensation have a number of components. Some of these components are the same as those for other compensation systems but are administered differently, while others are unique to managerial compensation. The components of managerial compensation are: base pay, bonuses (short term incentives), capital appreciation plans (long term incentives), deferred compensation and benefits (including perquisites).

Base Pay

Base pay of managers can represent as much as two thirds of their total compensation or as little as one third. The percentage tends to vary with organization level. The higher the level, the lower the percentage of total pay represented by base pay. The base pay of managers is set using the model developed in this book. However, there are some special considerations for management pay, so each of the three core decisions is examined in turn.

Wage level decision

The managerial group in the organization has a number of characteristics that affect the pay level decision in the direction of paying this group at or preferably above market. First, this group of jobs is very important to the organization. The people in these jobs...are highly skilled and replacement can be difficult. These factors would call for a wage level decision that emphasizes being at or above market in order to be able to recruit and retain these employees.

Tied to these factors is a second consideration, the sunk costs that the organization has in the manager. Ordinarily the manager is a person who has worked for the organization a number of years, and the odds are good the organization has spent considerable money in training this person as he or she has moved up the managerial ranks.

A third consideration that supports a high wage level decision is that this is a small group of employees. So even if wages are high for the group, their overall impact on total wage costs of the organization may be small.

Fourth, managers are in contact with the outside world a great deal. This means that they are more likely to be aware of the market rates for their jobs than other employee groups, and that other organizations would be more inclined to make them employment offers. Any group that is as important and visible, as is this group, will have to be paid competitively in order to hold down turnover. A final consideration that calls for an aggressive pay level decision is the relatively small supply of managers as compared with other employee groups.

A problem occurs in this aggressive stance toward the pay level for top executives. The pay for a particular year is established, at least partially, based upon either wage survey results or comparisons with specified executives from comparable companies. When setting the pay rate from these comparisons, the compensation committee ordinarily assumes that "their" executive is better than the average thus establishing his/her pay at a level above the average. If most companies do this the next year will produce a large raise in the average that is again exceeded in each successive year. The result is an inflation of executive pay.

The criteria used to determine wage level also differ somewhat from those used in the regular compensation program. In particular, organization size has been shown to be a major criterion in determining top management pay.²⁵

Organizational performance in the form of profit levels, sales, market share, and other measures are also criteria that are often used in deciding top-management pay. Middle-management pay criteria arc more likely to be influenced by internal organizational factors, particularly the organization chart and the salary of the top executive. The organization chart becomes a guide for determining the appropriate internal references...those at the same organizational level. The top executive's pay becomes a ceiling in the organization: all other managerial positions can be measured in terms of their percentage of that person's pay. This is a common way in which managerial pay is reported.²⁶

Pay ranges for the lowest managerial levels tend to be set as a percentage above those of the employees being supervised. This percentage increase seems to be fairly constant, averaging about 30 percent, but going to as high as 50%. This differential is supposed to reflect the complexity of the managerial task. Organizations can use both the top-down and bottom-up approaches but they may find that there is a compression problem, or the opposite, a gap in the grade levels. This is because the starting points at the top and at the bottom are using different criteria, so that where the results of these calculations come together there can be either a gap or an overlap.

These various criteria used for managerial jobs should not be interpreted to mean that market rates for managerial jobs cannot be obtained. In fact, there are many managerial wage surveys. These can be both general managerial surveys and industry-specific surveys.

Examples of executive pay surveys include:

• ERI's Listing of Executive Compensation Surveys

• Hay Associates: Point Survey

• Management Compensation Services (Hewitt Associates): Project 777 Survey

• Sibson and Co.: Management Compensation Survey

• Towers, Perrin, Foster and Crosby: Management Regression Analysis

• Watson Wyatt: Executive Compensation Service

Most industries, through their associations, also conduct and distribute managerial wage surveys. The advantage of these industry surveys is that they provide information on jobs that reflects the way organizations in the industry organize. For instance, banking surveys provide information on jobs such as loan officer and branch manager. Often these surveys will provide information on wages for the overall sample and use major breakdowns, such as geographical regions and size of organization. A problem with some of these data is the sample size. Since most times there is only one position for a particular job title per organization, if the sample is subdivided the number of positions included can become quite small and the data not as usable. The most comprehensive data on executive salaries can be found in ERI's Executive Compensation software.

Wage structure decision

The first consideration in the application of wage structure decisions to managerial employees is whether there should be a separate wage structure for managers or whether the top of the regular wage structure will be satisfactory. Many organizations have a separate wage structure for managerial employees. Some of these structures include more than just managers: they include other groups, particularly professionals. These wage structures often include all exempt employees. The main rationale for this separation of wage structures is that the pay-policy lines for exempt and nonexempt are so different that combining them leads to a false straightline function, the relationship between market wages and the job evaluation system being curvilinear in this case.

As indicated, managerial jobs tend to be difficult to describe, and thus although job descriptions are used for managers they often are not taken as seriously in determining wages. Management job descriptions are typically written in terms of broad functions, areas of responsibility, scope and impact of assignments, degree of accountability, and the extent and nature of supervision and influence involved. This is in contrast with the focus on tasks and activities performed in a standard job description. Since there is only one job incumbent in most managerial jobs, each job is unique and the impact of the manager on the nature of the job can be great. Properly developed managerial job descriptions are useful for organizational and personnel planning as much as they are for setting compensation.

In the 1950's organizations often had a different job evaluation plan for management. This was probably useful only in large organizations, given the cost of developing a separate system. Most organizations today utilize a rank-to-market plan (benchmark ranking), wherein the organization compares its jobs with one or more compensation surveys to determine if there is a good match. In this type of plan, the structure is designed first and then jobs slotted into appropriate ranges depending upon their market value.²⁷

The wage structure for managerial jobs is characterized by wide ranges and broad grades. Ranges are typically 50 to 60 percent wide, but 100 per cent is also quite common.²⁸ The arguments for this are (1) that the evaluation of managerial jobs is not as precise as it is for lower-level jobs and thus a broader range allows for variation, and (2) that there is more possible variation in performance of managerial jobs, so the use of wider ranges allows the organization to recognize this greater variation. Grades and ranges are more likely to be seen as guidelines in managerial compensation rather than as strict rules. The midpoint is important since it reflects the labor-market value. Minimums are less likely to be used, since rarely would a person who is minimally qualified be placed in the job. Maximums are not held to because the performance or value of a particular manager supersedes and exceeds the structure.²⁹

Wage system decision

Everything discussed so far has indicated that managers have more-than-average ability to affect their performance. Further, there are measures that can be used to determine this impact on the job. Therefore, pay for performance would seem to be highly appropriate for managerial positions. Most organizations indeed claim that they pay managers in terms of performance, both that of the individual and that of the organization.

If there is a difference between pay-for-performance systems for managers and those for other groups it lies in defining performance in organizational and not personal terms. This difference increases as the job moves toward the top of the organization. This is true for both basic wage increases and bonuses. This emphasis on organizational measures of success is functional since managers feel that organizational success is their success. But as in most pay-for-performance systems, the correct performance standards must be the focus of the system. Schuster found that those managerial pay systems that were ineffective were those that did not focus on critical organizational outcomes.³⁰

Management by objectives. Where an individual definition of performance in managerial jobs is developed it is most often done through management by objectives (MBO). The measurable standards are developed jointly by the manager and his or her supervisors. At the end of the time period, performance is evaluated by both parties in a joint meeting in terms. They consider how well the objectives were met. This system can work well where each party respects the other and does not play power games with the setting and evaluation of objectives.

There are two main problems in MBO from the standpoint of tying it into wage increases. The first is that there is not much comparability between individuals, so that judgments about how much one person should receive versus another are not clear. The second is that the world may be too dynamic to set objectives and have them mean anything in a month, much less six months. Thus, MBO may be restrictive and hold managers to objectives that are out of date.

Pay for performance. Two concerns with pay for performance for managers are:

1. Is pay contingent on performance?

1. Does it make any difference in performance when pay and performance are connected?

Lawler found almost no relation between pay and performance measures on a sample of 600 middle- and lower-level managers. However, those managers that were most highly motivated did exhibit two crucial attitudes. First, they felt that pay was important to them (the first condition in the performance-motivation model). Second, they did feel that good performance would lead to higher pay. So the perception is more important than the fact.

Lawler went on to explain why it is hard for managers to always see the performance-reward connection. First, many of the rewards are deferred, so that the time frame is too long. Second, the goals are not always clearly expressed, so the manager does not know what he or she or the organization needs to achieve. Third, the secrecy that surrounds pay increases reduces the knowledge that the individual manager has as to how he or she has done comparatively.³¹

The answer to the second concern may not be any more positive. In one of the few studies that examined an organization throughout a period of time in which a merit-pay system was installed, it was found that the system had no effect at all on organizational performance.³² Although there may be a number of explanations of these results, the fact is that we cannot take it for granted that paying for performance is worth doing.

Short-Term Incentives

Managerial incentives may be based on short-term or long-term performance. This section discusses short-term managerial bonuses.

The use of bonuses varies greatly with industry, but more than 50 percent of organizations have some sort of managerial bonus plan.³³ Those organizations with bonus plans tend to pay somewhat less in base pay than those without them. Bonus plans can be divided into immediate-cash plans and deferred plans. Since short-term plans are usually immediate-cash plans, they are covered here. Deferred plans are discussed in the next section on long-term incentives.

Bonus standards

The manager who receives a bonus receives it because some standard was met during the past time period, typically a year. As indicated, in pay for performance this standard may be either organizational or job-related.

The most common form of managerial bonus is based upon organizational profits. But there are a number of other possible organizational measures, such as sales, productivity, or cost savings of one sort or another. Individual job-related standards may relate to job outcomes or to the performance of particular activities beyond minimum expectations.

Bonus standards may be either single or multiple. Profit sharing is a single standard. Organizations may choose to focus managers on a number of variables that they feel are important measures of success. These may include combining organizational and job measures. Each variable must be weighted when multiple criteria are used. The problems with multiple plans are that they are more complex and therefore not as understandable. The manager may have a hard time knowing what he or she will receive, since the factors may overlap or cancel each other out. Although profits may be the most popular organizational measure there are a number of other ones.

To learn how to calculate these measures, see DLC Course 29: Quantitative Methods Used in Executive Compensation.

Bonus formula

Most managerial short-term bonuses are established on the basis of a formula that operates at given levels of profit or other measures, such as those described above. It is possible, however, to establish a totally discretionary plan in which the Board of Directors determine each year whether a bonus will be given for the past year's performance, and if so how much. The arbitrary nature of this procedure and the lack of knowledge by the manager of the effect of his or her actions ahead of time decreases the motivational value of a discretionary plan.

Ordinarily, a managerial bonus is based upon the base pay of the manager. When profit sharing is used, a percentage of total profits is placed in a fund and each manager shares in the fund in the proportion of total managerial base pay represented by his or her base pay. When other measures are used, goals are established for each of the appropriate measures. If the organization achieves or exceeds the goal, the managers would receive a percentage of their base pay. For instance, assume that the organization wished to maintain a minimum return on assets of 10 percent. The managers may receive 20 percent of base pay if the organization achieves a 10 percent return on assets and an additional 5 percent of base pay for each 5 percent increase in return on assets over 10 percent. These calculations could be made for one measure or for a number of measures. Further, the measures could be independent, or any bonus at all could depend upon maintaining a minimum level of performance on all measures. Often limits are placed on the percentage above base pay that can be earned, such as 50 percent.

Eligibility

Bonus plans are usually based on a formula designed to reflect the participant's contribution to profits or other organizational measures of success. The motivational value of the plan depends in large part on whether the manager's actions do have an impact on these measures. Members of top management seem to meet these requirements, and thus such incentive plans would seem ideal for this group. For middle management the connection is not as clear, but the possibility of earning a substantial amount over base pay may keep these managers' attention on and increase their interest in the organization's goals. For lower-level management the case for incentives tied to organizational performance is hard to make. The amounts these managers typically receive are small and the connection of their actions to the performance standard nonexistent. Incentive plans for lower-level managers should be based more upon establishing job-related measures of performance that the organization believes will also relate to organizational success.

Long-Term Incentives

In contrast to short-term incentives, which are ordinarily paid in cash, long-term incentives are usually deferred. The purpose of long-term incentives is to tie the executive into the long-term success of the organization. In today's competitive business climate, when American business is being criticized for its focus on short-term profits, these longer-term incentives take on added importance.

Long-term managerial incentives are usually restricted to top management, the 5% percent at the top of the organization. The exception to this are stock option plans, which are now being granted to lower levels of employees. These incentives usually involve the granting of rights to the executive to become a stockholder of the organization at a reasonable cost today so that if the organization does well in the future, the stock will be of significant value.

This form of incentive has become more popular in recent years because of the concern with the performance of American business and because of the tax advantages that can be achieved through this form of incentive.³⁴ One of the problems has been that the tax laws have changed over time, and plans that are attractive and useful today may no longer qualify under tomorrow's tax laws. There are a number of ways in which these programs operate, which are covered in this section, but there is no guarantee that they will stay useful with future changes in the tax laws.

Stock option plans

Basically under a stock-option plan the manager is offered stock at a set price. He or she may purchase that stock at any time within a period specified by the plan. If the value of the stock rises, the manager gains a considerable value amount. Exercising the option does take money, however, and this is often a problem for the manager. Taxation is another problem. Finally, the executive may not always be able to take advantage of increases in the price of the stock, since he or she may not use insider information when selling the stock.

Non Qualified Stock Options (NQSOs) are now the norm (and many large corporations utilize NQSOs throughout their organization). A form of NQOs are Incentive Stock Options (ISOs). The difference between employee, management, and executive treatment with stock options today revolves solely around the number of shares granted. To find out more about how these plans work, see DLC Course 20: The Basics of Employee Stock Option Plans.

Stock Appreciation Rights (SARs). These types of plans work like stock options, but the manager does not have to buy the stock. As with a stock option, the manager is granted an option at a stated price. The manager then may call in that option at any time during an established period. But rather than having to purchase the stock, the manager receives from the organization the difference between the current market value of the stock and the stated option value of the stock. This saves the manager from having to come up with the cash necessary to purchase the stock. However, many plans restrict the amount of possible gain to 50 to 60 percent of growth in the stock's value. The gain is taxed as ordinary income to the manager when received, but there is no tax obligation when the rights are offered. This incentive plan provides a cash incentive over a longer period but no ownership advantages.

Restricted Stock Plans. In this type of plan the manager is granted a certain number of shares of stock as a bonus but may not sell those shares until certain conditions have been met. These conditions usually involve holding the stock for a period of time and remaining employed with the organization during that period. Another condition may be meeting some performance objectives on the job. As far as taxes are concerned, the lifting of the restrictions creates an ordinary income liability for the difference between the current value and employee cost. The manager may choose, at the time of the award, to be taxed on the current value of the stock, but any appreciation would be taxed at time of sale.

Phantom Stock Plans. In some circumstances it is impossible or undesirable to allow managers to have stock. This may be because the organization is closely held and does not want ownership dilution. Phantom stock plans can work well in these circumstances. In these plans the manager is awarded units that represent shares of stock. These units typically mature at some time, ordinarily four to six years. At maturity the manager is paid the then-current value of the stock or the difference between the original value and current value. Obviously, the manager does not have to invest in the stock in this case. Again, the award is treated as ordinary income when received. Determining the current value of the stock can be a problem. Where the stock is not widely traded there is no real market value. Sometimes a number of other financial measures, such as those illustrated, are used as surrogates of the stock value and the rise in them is assumed to create a higher value in the stock. Other times, organizations will use the services of an appraiser to make annual valuations (much like that required by an ESOP).

Performance Share Plans. In this type of plan the manager is granted performance units that represent shares of common stock. He or she earns these shares through the performance of the organization. For instance, a manager might be granted 100 units. If the organization's earnings per share averaged 10 percent growth over 5 years, the manager would receive 25 percent of the shares. If the earnings per share averaged 15 percent growth over five years, the manager would receive up to 100 percent of the shares. Typically the payoff in this type of program is 50 percent stock and 50 percent cash based upon the current value of the stock. The manager is taxed on both the cash and the value of the stock as ordinary income.

In all these plans there are three common themes. One is to reward the manager for organizational success. The second is to establish performance goals for the manager that reflects this success. The third is to try to maximize the value of the reward to the manager by taking advantage of the tax laws. The first two are relatively stable goals, but the third is constantly changing. The value of and interest in different long-term managerial incentives will continue to change with changes in the tax laws.

Taxes

As described, the "non stock" option (which look like stock options but do not include stock) are simply forms of annual or long-term cash incentives. Value is derived from performance in future years and when paid, these sums are taxed exactly like any other form of compensation. This is not the case with stock options (which use stock) in that large compensation amounts can be built up over time, but because the employee decides not to exercise (for example, until the last day of the 10th year), these amounts accrue and are accounted for in a manner that spreads out their compensation affect over the years. This then leads to a second problem, if expenses are to be recognized in present years for this compensation plan, how does one know the appreciation that might exist (when one doesn't know what the price of the stock will be in some distant year)?

Most publicly traded companies today use the Black-Scholes Formula to calculate this amount (although it appears that no two companies use the formula in exactly the same way). This formula was developed by two economists who earned Scholes and Merton a Nobel Prize in 1997.

Factors include: volatility of the stock, a risk free interest rate (annualized), the exercise price of the option and the present price of the stock, along with the time for the maturity. For those interested in working through this formula as it applies to the value of an option, we refer you to the DLC Course 22: Black-Scholes Valuations.

Deferred Compensation

At their simplest, deferred compensation lans are promises to pay future retirement benefits (often with death benefits) and to supplement qualified retirement plan benefits levels. However, technically they are "unfunded" plans and are nothing more than a promise of a company to pay benefits in some future year to managers who will no longer be with the organization. Managers, then, are creditors of the organization and stand in line just like other creditors should financial problems befall a firm.

To partially offset this, Rabbi Trusts were created, where a quasi-trust partially protects managers from creditors (and a hostile succeeding management team). Not well understood by many practitioners, DLC Course 42: Accumulated Earnings and Deferred Compensation takes one through the implementation of an Executive Deferred Compensation Plan.

Golden parachutes

Another form of deferred compensation is a "golden parachute." A golden parachute provides pay and benefits to an executive after being terminated due to a merger or acquisition. Golden parachutes extend pay and benefits for a period of time, usually one to five years. There are two reasons put forth for doing this. The first is that it makes recruitment easier, since it limits the risk for executives for unforeseen future events (such as a hostile takeover). They are also attractive to organizations because these payments can be treated as business expenses.

Time-off

Although their time-off provisions are the same or higher, managers tend not to take advantage of them as readily as other groups. It is sometimes necessary to insist that managers take the time off that is available to them, both because they need that time off and because a large liability can be created for the organization, if a category like vacation time is allowed to accrue.

Perquisites

This is a set of special benefits available to managers, primarily top managers, which are designed to satisfy the special needs of this group. There are a number of perquisites. The first category is internal. These perquisites consist of items that are part of the work setting of the manager, such as special offices and furniture that distinguishes the status of the manager. A second category, external perquisites, has to do with conducting business outside the organization, and may include a car, entertainment expenses, and club memberships. The last category is personal perquisites. This category consists of a wide variety of items, such as free medical examinations, low-cost loans, and financial or legal counseling. The last group is distinguished from the first two in that it is usually taxable to the employee.

ADMINISTRATION OF EXECUTIVE COMPENSATION

The administration of executive compensation differs from other compensation programs in the organization in one major regard: "Who is to set the executives pay?" For all other groups the answer would be the executives, but having the executives establish their own pay is unsatisfactory.

The Role of the Board of Directors

The answer in publicly traded companies, ESOP organizations and many privately held corporations is to utilize a special committee of the Board of Directors known as the "Compensation Committee." This committee typically consists of three to five members who are not managers within the organization. That is, they are "outside" directors, as opposed to "inside directors." This committee assures the stockholders, creditors, and other interested parties that the management group is not unfairly taking advantage of its place of power to strip funds from the organization. Outside board members typically meet independently of the management group, often with consultants, to ascertain the level and effectiveness of the organization's compensation plans.

Executive pay in America has risen dramatically over the past twenty years and the gap between the average employee and top management has drastically widened. Since Compensation Committees are relatively new to the corporate scene (in the 1960s a Board's Audit Committee often oversaw executive compensation matters), there is a very strong correlation between active Compensation Committees and the rise in executive pay. That is, the argument for these committees is not necessarily one of cost control. What appears to be happening is that the need to remain competitive (or above competitive levels) is feeding upon itself because of the information available.

One critic of executive pay illustrates how executive pay rises in all circumstances. When an Executive Compensation Consultant is hired one of the following three things happens:

1. The CEO is truly underpaid. The consultant reports this to the Compensation Committee, and the executive's salary is increased.

2. The CEO is not underpaid and the company is doing well. The consultant is asked to compare the executive's salary to a set of companies who are known to pay highly. The result is a recommendation to raise the executive's pay.

3. The CEO is not underpaid and the company is not doing well. The consultant finds management lamenting that with these low wages, turnover is inevitable. The consultant then suggests a raise to prevent turnover.

Maximum Reasonable Compensation

In the mid 1980s, the IRS approached ERI to develop a method of estimating the maximum amount of direct compensation that might be reasonably paid an owner/manager in a privately-held corporation. After much thought, ERI set that amount at 3.01 standard error above the mean for chief executive officer's pay within any one industry. (Some may argue that this amount should be 2.0x, but because of the nature of skewed distributions for top management pay, we believed a high range was appropriate.) ERI's Executive Compensation survey software provides these estimates for any of 2,000 industry groupings. Raw data can be reviewed from the publicly traded sector by reviewing the proxies for an industry.

Why would the IRS be interested in "unreasonable compensation"? The answer lies in taxes. Assume a $1,000,000,000 revenue corporation with $20,000,000 in earnings were to pay this $20,000,000 as a one-time bonus to the owner/executive. This charge to revenue, as compensation expense, would bring the company's taxable income to zero and the executive would pay individual income tax on $20,000,000 of compensation. However, if this bonus is deemed to be unreasonable by the IRS, then the bonus would become a dividend in the hands of the executive and the company would not be allowed to deduct the bonus as compensation expense. The result is a double taxation windfall for the government...the same $20,000,000 is taxed at the corporate level and the individual level.

Tax policy leads to challenges, the latter of which, if carried to the extreme, end up in Federal Tax Court under the "unreasonable compensation case" heading. Since the U.S. Federal Court is a District Circuit court (where judges travel out from Washington D.C. to preside), each of the judges and each of the various U.S. Districts have created case histories that are diverse and sometimes contradictory. It is not the role of this text to review these differences, but we have provided a course, DLC Course 12: Maximum Reasonable Compensation, which takes one through an example case to illustrate the arguments that are often made (most times unsuccessfully) when a challenge is made.

(*Note: Unreasonable compensation pertains to owner/managers only. Rock stars, athletes, executives who work for a Board of Directors, lawyers working on contingency fees, and many others may appear to be "unreasonably compensated." Under the definition above, this challenge only occurs to the owner/manager of a regular U.S. "C" corporation. ERI knows of no cases in Canada, Mexico, etc.)

ARE EXECUTIVES PAID TOO MUCH?

An issue that periodically catches the attention of the public is whether executives in the United States are overpaid. This question gets raised whenever large pay raises or bonuses are awarded to executives at seemingly inappropriate times.

Critics routinely point out the growing disparity between executive and employee pay.

Source: Business Week

Is this a problem?

We will see how these differentials are explained by the motivation models discussed in this text.

The Equity Model

The public looks at the high salaries of executives as a problem of equity and asks, Is this person worth this much more than other people? If the rewards are this high then the contributions must be equally great.³⁵ It is not easy to prove that the executive is in fact worth that much more than others. Some people would claim that this much difference in contribution and therefore reward is not possible. It is difficult to describe the contribution made by the executive to those outside the organization. The visibility of the executive can be easily exploited by the press, making this figure even more public and pointing out the supposed discrepancy.

The Performance-Motivation Model

Each of the three major facets of the performance-motivation model provide a question regarding the size of executive salaries. As we have seen, the first part of the model is valence, or the attractiveness of the reward. Clearly the reward is attractive, but does it take this much to be attractive? Critics point out that executives in Europe and Japan do not get these large salaries but still perform very well. (In most of the Pacific Rim the unwritten rule is a 20 to 1 ratio.) One response is that there are more alternatives in the United States for these talented people to go out on their own and make high incomes in an entrepreneurial manner.

The performance-reward connection questions whether there is in fact such a connection in executive salaries. As discussed in this chapter, there is evidence that this connection is tenuous at best. So this may be a major area in which pay reform is needed. If American organizations need to improve their performance, assuring this connection would seem to be a high priority.

The performance-effort connection questions whether it is the executive or other environmental factors that lead to the organizational results for which the executive is rewarded. At times it may be true that the executive gains from improvement in the general economy rather than from his or her efforts. Of course, the reverse is also true ... the executive gets blamed for poor performance that may not be his or her fault...so this should even out. Unfortunately, executives often receive raises even when their companies falter. Even executives of failed corporations receive large walking bonuses.

Source: Jennifer Dixon, "Departure of Kmart Chief Raises Questions about Severance Package," Detroit Free Press, March 12, 2002.

Agency Theory

Three further theories add to the description of how and why executive pay has gotten so high. The first of these is agency theory. According to this theory, top executives are the agent for the stockholders. This assumes that the interests of the stockholders and the top executives are the same, which they are not. This creates the agency problem. Shareholders then attempt to align the interests of top management with their own by designing attractive compensation packages.

Tournament Theory

This theory views the promotion ladder in the organization as a series of tournaments. Promotion means one won that tournament and is entitled to the rewards from winning that tournament. Each level has higher rewards for winning, but the number of tournaments (i.e. positions) diminishes as each step up the ladder is attained. The ultimate tournament is that of CEO. The rewards must be high because the probabilities are so low of winning. In this way the situation looks like the lottery.

Social Comparison Theory

In social comparison theory, people need to evaluate themselves in comparison to others. For an executive to be seen as doing well, he/she must be rewarded as well as other executives, especially those who are perceived to be comparable to them. Compensation committees respond to this by keeping the executives compensation comparable to that of executives at competing organizations. In fact, one of the driving forces in forcing executive pay incessantly upward is that these committees decide that their executive is better and therefore increase the compensation even more. If all committees follow the same formula, compensation is driven up rapidly.

SUMMARY

Managers are probably the most important group of employees in the organization. While they represent a small percentage of the workers, they represent a major portion of the cost of compensation. It is important to develop a compensation program for this group that both obtains the most from these employees and keeps the costs within reason. The managerial job is one of high stress and a great deal of variety. Further it requires considerable judgment. Managers are highly committed to the organization, have an action orientation and a need to express their power motive.

Compensation programs for managers are a combination of base pay and incentive pay. Given the importance of this group, its high visibility, and easy movement to other organizations, it is usual to use a high-paying wage level strategy for this group. Individual pay determination is most typically dominated by pay-for-performance, with management by objectives used as a basis for measuring performance. All organizations have a keen interest in the rewards being earned by similar individuals in similar positions.

Managerial incentives are divided into short- and long-term plans. Short-term programs are typically rewards for performance in a particular year based on how well the manager did in achieving his or her goals. Long-term managerial incentives are intended to tie the executive to the organization, both so the executive will stay with the organization and continue to perform highly. Most of these plans are a variation of a stock option plan that grants stock or money, based on overall organizational worth, to the executive over a long time period. These plans are typically deferred income. Managers are also granted a variety of benefits and perquisites that are not available to other employee groups.

Today, top executives receive upwards of 500 times blue-collar workers' pay. This may be necessary due to an undersupply of candidates. But it is also attributed to a lack of board oversight and the desire to pay execs more than the competition.

Internet Based Benefits & Compensation Administration

Thomas J. Atchison
David W. Belcher
David J. Thomsen

ERI Economic Research Institute
Copyright © 2000 - 2009

Library of Congress Cataloging-in-Publication Data

HF5549.5.C67B45 1987 658.3'2 86-25494 ISBN 0-13-154790-9

Previously published under the title of Wage and Salary Administration.

The framework for this text was originally copyrighted in 1987, 1974, 1962, and 1955 by Prentice-Hall, Inc. All rights were acquired by ERI in 2000 via reverted rights from the Belcher Scholarship Foundation and Thomas Atchison.

All rights reserved. No part of this text may be reproduced for sale, in any form or by any means, without permission in writing from ERI Economic Research Institute. Students may download and print chapters, graphs, and case studies from this text via an Internet browser for their personal use.

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