Analysis of Executive Compensation: A Finance Report

This report provides a comprehensive analysis of executive compensation, a trending topic in finance. It examines the evolution of CEO pay since the 1990s, exploring the role of incentives, shareholder value, and market competition. The report delves into the determinants of executive compensation, considering managerial power and market forces. It discusses the elements of CEO pay, including salaries, bonuses, stock options, and severance packages, and their changing significance over time. The study also investigates the relationship between wealth and performance, the influence of managerial power, and the ongoing debate surrounding optimal incentive structures. The report highlights the complexities of determining fair executive compensation and its impact on firm performance, providing valuable insights into this critical area of finance.

Introduction
The compensation at the executive level has become trending over the time and has presently
become one of the most creative sections of the research study in the field of the finance. Since
the 1990s, as and when the world economy started to prosper, there was a need felt by the
shareholders to create the contract for the executives as well as provide them with the incentives
to boost up the stock market value of the firm with every passing year. Research makers, as well
as the academic scholars, initiated the exploration of the optimum method of incentives as well
as compensation that can inspire the executives to work harder as much possible. The importance
was not only given to the principles but also the mode of payment to the executives. These
methods of payment can be either in the form of short duration payments such as wages, or
bonus payments or relatively longer duration payments in the form of long-term plans for
incentives or stocks in restricted form or there can be another form of payments like hikes or
increments. The large level of payments to CEO in the United States has resulted in the serious
discussion about the kind of procedure of pay setup and the resulting consequences. Some
researchers have argued that a grand amount of executive packages in the form of pay have been
the outcome of the influential managers negotiating for their own compensation and moreover
extracting rent from the firms. Another side of the story says that such large compensation has
been the outcome of contract agreement in the market of competition filled with the talents and
skills at managerial level. The research study here focusses on the compensation levels of
executives and evaluate the argument in favor and against such descriptions. It has been
suggested that the power at the managerial level and the forces of competition in the market are
the major determiners of the compensation at CEO levels. The origination of the CEO payments
since the Second World War can be segmented into two phases- phase of pre-1970s and post-

1
1970s till now. Before the period of the 1970s, the levels of payment have been quite small, there
have been a lesser amount of variation across the superior level managers as well as the
sensitivity level in terms of performance on the payment basis have been neutral. However in the
period after the 1970s till mid of 2016, the payment levels of the managers grew at a
dramatically faster rate. Moreover, the inequality levels in the payment levels to the managers as
well as the firms have broadened up, and the benefits that arise out of a better performance at
equity accumulation have tied together the interests of managers to the propelling or declining
performance of the firm. However, till now there have been no theory to clearly convince upon
the regimental diversion that has happened during the period of the 1970s and there have been
complications in all the theories either in terms of tendencies observed in time-series data or the
cross-sectional study. The significant contribution in the recent times has evaluated the impact of
changes at the exogenous level in the form of the compensation levels of CEO, behavior patterns
of the firms and their performances. For example, the deregulating process of the industry has
been interconnected with higher compensation levels to CEO.
Decision Maker for Executive Compensation
The relevant thing is to determine the procedure by which payment setting is done and also to
decide who eventually determine the pay for executive level. The principal-agent model has been
considered as the standard theory on economic grounds for the compensation to the executive.
According to this theory, the aim of the firm is to create the most effective package that is
feasible in terms of compensation so as to invite the CEOs and increase their stability power and
the motivation levels as well. Under the principle-agent model, it is the shareholder who is
responsible for the determination of the compensation levels. In the real world, although, the

2
committee is created by the board of directors to set the compensation levels on account of the
shareholders. Here, the shareholder who is considered as a principal is the creator of the
agreement and he is the one who make a proposal offer to the agent i.e. CEO or manager in this
research study. The aim of the shareholders here is to create for a best possible package of
compensation so as to incentivize the CEOs and thereby to interconnect their interest with the
shareholders. Such approach is used to determine the pay at the executive level.
Elements of CEO pay levels
Even though there exist lots of diversities in the practices regarding the payment structure but on
the whole, there are some fundamental elements of bonus on an annual level, salary packages,
payment in the form of high duration incentives, option grants in restricted form, and grants of
stocks in restricted form. Along with these elements, CEOs are also subjected to fixed beneficial
plans of pension, as well as, payment of severance at the time of their completion of work
duration. However, the relevance of these components of compensation has changed over time at
a comparative level.

3
Figure 1 structure of CEO compensation from 1940 to 2016
The above graph illustrates the significance of the major elements of the CEO pay levels of
large scale companies from the year 1940 to 2016. From the period of the 1940s to 1950s CEO
pay levels included only the bonus at the annual level and salaries (The Massachusetts Institute
of Technology (MIT), 2017). Even today when we talk about the bonus, it is non-negotiable in
nature which is interconnected to one or more than one components to identify the accounting
performance on an annual basis. These bonus on an annual level are either paid in the form of
cash on in the form of the kind for example gifts, equity holdings, etc.
However, giving explanations regarding the significant changes in the original composition of
CEO compensation since the 1980s have remained a challenging task. It was speculated that the
sudden increase in the use of stock option has been encouraged due to policies relating to the tax
that resulted in beneficial payments on the basis of performances as well as by keeping an

4
account of the rules that have reduced the cost incurred in the form of compensation of stock
options to the firm itself (Murphy 2002, Hall & Murphy 2003). Additionally, there are chances
that the earlier downfall in the stock market, as well as discovery of the expenditure on the stock
options since 2004, have served to the falling fame of stock in the form of options in the recent
years. This paradigm change from the stock options, however, has not led to capturing much of
the concern in the literature of scholars and extensive research study is required for
determination of the reasons possible and the following outcomes.
Remaining elements of CEO compensation
Certain elements come under CEO compensation levels that have captured little concern in the
academics of literature which includes compensation of prerequisites, pension payments as well
as the payments in terms of severance. Maintaining the record of the organized information of
these elements have been a tough task in the past recent years.
Such kind of payments may even be witnessed in the situation of contracting at the optimal level.
The perks and increments may be rationally good for the manager in the case where the cost
associated with acquirement of goods and services is established at a lower level (Fama 1980), or
in the case where they support the productivity aims at the managerial levels and thus raising up
the value of shareholder (Rajan & Wulf 2006). Fixed amount of benefits arising out of pensions
can be explanatory as a kind of debt on insider level that divides and thereby reduces the
problems of shifting the risk by combining the benefits and perks with the creditors (Sundaram
& Yermack 2007, Edmans & Liu 2010). When the perks are being referred it consist of a
broadened variation in the goods and services that are being facilitated to the CEO. These perks

5
include even the use of aircraft of the company for non-commercial use, memberships for the
clubs as well as provisions of loans at the interest rate levels relatively lower than the market
interest rates. Although there might arise a possibility that the vested stakeholder i.e.
shareholders may retaliate at first at the firm disclosure say for the use of commercial aircraft for
that of a personal reason by the executives (Yermack 2006a). Perks generally were portrayed as
the common indicator of loose regulations at the corporate level because when the perks are
declared, then the resulting decrease in the value of the company is significantly more than
accounting cost incurred. (Yermack 2006a, Grinstein et al. 2009). Hence as per the available
research studies, some levels of consumption of perks are the indicator of the excess managerial
incentives which are over and above the reduced shareholder value. Rajan & Wulf (2006) have
given the examples relating to the hypothesis that the perks are generally provided as an
explanation for enhancing the productivity of the managers. These perks help to save the time of
the employees by raising their productivity levels. However, it remained a big question that by
which mechanism perks were being considered to be as per Fama (1980) or Rajan & Wulf
(2006). There has not been readily available information on the accounting of the pay at the
severance level. However, for a very small number of companies scholars have accumulated data
using the contracts of the workers, agreements relating to separation as well as other
documentations at the corporate level. Yermack (2006b) estimated the payment relating to
separation, which is given to the terminated CEOs or those CEOs whose employment duration
has got over, to be neutral in value. Rusticus (2006) has proved that the agreements relating to a
separation that is being signed by the employees at the time of their recruitment are common in
nature and in most of the cases it is generally equal to two years compensation in the form of
cash for any typical CEO. Along with the pension payments and the perks, research studies have

6
not been able to make a determination of pay of severance as a kind of contract at an optimal
level or as a kind of extraction of rent.
Determinant of relationship between wealth and performance
It has been a persistent debate and discussion as to what are the appropriate measures of the
incentives to the executives. In the very recent framework of theoretical facts, it was shown that
the best method to measure the level of incentives is determined by the pattern how the actions
of CEO affects the value and prestige of the company. The statistical method that has been given
by Jensen- Murphy is the appropriate way of calculating the incentives for those operations
whose currency impact is indifferent irrespective of the magnitude of the operations of the
company. In converse to it, the equity value which is at stake is the appropriate measure of
incentives for the operations whose impact enlarges as with the size of the company. Since the
participation of the executives is in both the type of operations so both the modes of incentive
operations holds same relevance and should be viewed as with mutual exclusiveness
(Repositório Aberto da Universidade do Porto: Home, 2017).
Conclusion
In this research study, there have been rational as well as convincing reasons on the empirical
grounds to believe that power on the managerial levels has a significant effect on the built up of
executive compensation of the companies with a different segmentation of ownership power as
well as authority. Therefore it can be said that compensation at the executive levels acts both as
the medium for dealing with issues of agencies that originations as a result of the separation of
ownership from the influential control power and also as a portion of problems of agency

7
themselves. Thus the outcome that the power at the managerial levels has a significant role to
play in the determination of compensations of the executive has some important, crucial effects
on the governance at the corporate levels. The degree by which the influence at the managerial
level can make the arrangements of compensation move away from the results of contracting in
optimal level is determined by the gravity with which participants in the market say investors
identify the above-discussed issues. The economists in the finance field, therefore, can serve as
the significant contributors to improvise the facilitations of compensations by evaluating the
effect of diversion from the current practices from the practices that are being recommended
under the optimal contracting (School, H., 2017).
The recommendations from this study can be that more emphasize must be given to explaining
the role of power of the managerial position in the future, at least equivalent to emphasize that
have been given to the optimal contracting. The solutions must be provided in regards to what
were the main causes of the regimental change in the compensation level of CEOs that have
happened in the 1970s. The relative significance of the rent extraction, as well as optimal
contracting in the determination of payments to the typical CEOs, are yet not unambiguously
known. The developments that have been shown by the latest research studies on all the pillars
are the main reasons for the emergence of the positivism and recommends that the answers may
be nearer to be accomplished.