280 likes | 286 Views
Managing Employee Performance and Reward Concepts, Practices, Strategies 2nd edition. CEO performance and reward. Corporate governance basics Executive pay – theory and evidence Reward components Trends Short-term incentives (STIs) Long-term incentives (LTIs) Reward disclosure
E N D
Managing Employee Performance and Reward Concepts, Practices, Strategies 2nd edition
CEO performance and reward • Corporate governance basics • Executive pay – theory and evidence • Reward components • Trends • Short-term incentives (STIs) • Long-term incentives (LTIs) • Reward disclosure • A multi-stakeholder perspective
The impact of the global financialcrisis (GFC) • Scrutiny from the public, media, policy makers and academics increased following the GFC of 2007–08, particularly the role of consultants, boards of directors and shareholders in setting rewards. • Some argue the GFC was caused in part by the way executive incentives were organised. • Since the GFC there have been greater requirements in many developed countries for public companies to be more transparent and open about remuneration.
The board–CEO power relationship – theoretical perspectives and prescriptions • Tournament theory • Agency theory (‘adverse selection’ and ‘moral hazard’; ‘optimal contracting’; PRP) • Managerial power theory (‘rent extraction’)
Executive ‘total reward’ components Fixed/guaranteed: • Annual base salary • Fringe benefits • Non-contributory superannuation/pension • Entry, exit and long-service payments (‘golden hellos’, ‘goodbyes’, ‘handshakes’, ‘parachutes’) • Post-employment payments and benefits (consultancy fees, travel, etc.) Contingent/variable/‘at risk’: • Short-term incentives (STIs) – annual, cash • Long-term incentives (LTIs) – multi-year, equity (share grantsor options)
Average remuneration of United States CEOS in Standard and Poors 500 Firms, 1992–2011 Source: Adapted with permission from Murphy, 2013: 16
Average percentage composition of remuneration of Australian CEOs and senior executives, 1990–2014 Note: STI = short-term incentive; LTI = long-term incentive. Source: Neuhold & Hay Group, 2014; O’Neill & Berry, 2002.
Average percentage composition of remuneration of Australian CEOs and senior executives, 1990–2014 Source: Neuhold & Hay Group, 2014; O’Neill & Berry, 2002. Note: STI = short-term incentive; LTI = long-term incentive.
Short-term cash incentive plans Discretionary bonuses Results-based bonuses: • Annual financial goals/‘hurdles’: • Operating expenses compared to budget • Revenue growth • Net earnings, or net income • Net operating profit after taxes (NOPAT) • Earnings before interest and taxes (EBIT), or operating income • Earnings before interest, taxes, depreciation and amortisation (EBITDA) • Earnings per share (EPS), or net income divided by the average number of shares outstanding • Return on assets (ROA), or net income divided by total assets • Return on equity (ROE), or net income divided by total shareholders equity • Economic value added (EVA), or economic profit
Long-term (equity-based) incentive plans Restricted share plans • Conditional free grants • Non-disposal period • May be subject to forfeiture for early departure • Performance hurdles for vesting: • Total shareholder returns (TSR) • Absolute/relative Share purchase plans • Discounted price • Interest-free loans with repayment from dividend earnings • Progressive vesting • Tax deferred • Compulsory acquisition • Not expensed against profit and loss • ‘Skin in the game’ • Favoured in private firms
Fixed-price option plans • Executive receives right to buy a specified number of company shares at a predetermined price at some point in the future • Options typically vest three, four or five years from grant date, but may also vest progressively • Price payable to convert the option to a share – the ‘strike price’ – is usually set at the market value of the shares at the time the option is granted • Nil apparent cost to firm at grant • Low or no interest loans to fund acquisition of vested options • No downside risk for executive • Performance hurdles now applied as a vesting condition • Premium pricing (‘out of the money’ at grant)
Fixed-price option plans Problems: • No real risk • Encourage speculative behaviour • Market manipulation/‘insider trading’ • Dilution • Are a cost to the company • Are remuneration, thus value should be included in reported annual remuneration • Repricing • Reloading • Relative hurdles may be too soft (50th percentile= ‘Joe average’!) • Hurdles encourage volume increase • Risk hedging – ‘cap and collar’ products
Performance shares/ZEPOs • Zero exercise price options (or ZEPOs) plans allow the executive to take up shares at no cost but only on condition of a performance hurdle being satisfied over a designated performance period • Since fewer ZEPOs will be needed to deliver a level of reward comparable to that of a fixed price option plan, there is less potential for dilution, especially when the shares are market purchased rather than new issue • Do not encourage speculative behaviour
Share rights plans • Non-compulsory share purchase plans, with option-like characteristics • Gives the holder the right, but not the obligation, to buy shares in the company • The purchase price is typically the market price at the date of grant • Some emulate direct grant and ZEPO plans by allowing shares to be acquired without payment, but such plans generally involve performance hurdles
Share appreciation rights • Take account of dividend earnings as well as share price appreciation • No requirement to acquire shares of the shares • Often granted as a companion to share options in order to cover the holder for capital gains tax (CGT) liability arising from gain on exercise of an option
Long-term incentive plan types and hurdles, Australia • Dual hurdles may be ‘either/or’ or 50/50. Source: Neuhold & Hay Group, 2005.
Option valuation • Current option holdings do constitute potential future income and should therefore be factored into any estimate of annual total remuneration • Options granted generally have an expected cost to the firm of 30–40% of the fair market value • ‘Present value’/grant date approach takes the projected future value of new option grants, and discounts it to a present value in order to estimate the level of annual total remuneration • Most widely used approach to estimating present value is Black-Scholes, which takes account of: • Strike price • Projected price of an underlying security • Share price volatility • Risk-free rate of return • Expected dividend yield • Term of grant • Where a performance hurdle applies, the probability that this will be met
Explaining executive pay – the theory wars Tournament theory • Lazear and Rosen, 1981 • Many contestants, one prize • Internal pay hierarchy is necessary and desirable Agency theory • Berle and Means, 1933; Jensen and Meckling, 1976 • Separation of ownership and control; ‘principals’ and ‘agents’ • ‘Information asymmetry’ and ‘moral hazard’ principal-agent problem and agency costs • Solution: ‘optimal contracting’ via performance-related rewards Managerial power theory • Finkelstein, 1992; Bebchuk and Fried, 2004 • Intimate nature of executive power • Director ‘independence’ problematic • Absence of ‘arms-length bargaining’ • ‘Rent extraction’ = sub-optimal contracting
Executive reward level and firm performance – research evidence Size matters • A 10% increase in firm size leads to a 3–4% increase in CEO pay • Has merger and acquisition (M&A) implications • The high correlation between size and reward level certainly suggests that CEOs have a strong vested interest in rapid firm growth
Executive reward level and firm performance – research evidence Pay for performance: weak on the downside and in high risk • Some evidence that executive incentive rewards are sensitive to prior increases in firm performance • But relationship only weakly positive on the upside and negligible on the downside • In 1969–83 US CEO wealth increased US$3.25 for every US$1,000 increase in shareholder wealth, while CEOs lost 24.4 cents for every $1,000 lost by shareholders (Jensen & Murphy, 1990) • Sensitivity in the US almost doubled between 1988 and 1996, driven chiefly by share options and direct equity ownership (Murphy, 1999) • Australian CEO wealth (excluding option grants) increased AU$1.82 for two consecutive AU$1,000 increases in shareholder wealth during the 1990s (Merhebi, Swan & Zhou, 2006) • Pay-performance sensitivity (PPS) is related inversely to the degree of business uncertainty and risk (Aggrawal & Samwick, 1999), which supports agency theory predictions regarding agent risk-aversion • Implication: riskier firms that have lower PPS will out-perform high-risk firms that have high pay performance sensitivity (Bloom & Milkovich, 1998)
Executive reward level and firm performance – research evidence Performance for pay: strongest for share ownership • Strongest evidence relates to level of executive share ownership (Jenson, Murphy & Wruck, 2004; Kay, 1999, 2005) • Option holdings have little performance effect
Board composition and CEO reward – mixed US/UK research evidence • Balance of power between CEO and board influences reward level, adjustment and pay-performance sensitivity (PPS) • Board composition, particularly the degree of director independence, influences both reward levels and PPS • CEO ‘entrenchment’ on board reduces PPS: • Combining CEO and chair positions reduces PPS • Fewer independent directors reduces PPS • Internal CEO appointees reduces PPS • More internal directors increases PPS; more external directors increases total reward level • Greater ownership by external directors reduces total reward level • Ownership concentration (‘block-holding’) increases PPS (= owner-controlled firms), while ownership diffusion reduces PPS (= manager controlled firms) • External CEO hires receive higher reward than internal hires
‘Rent extraction’ –fact or fiction? Symptoms of rent extraction/sub-optimal contracting in the US (Bebchuk & Fried): • Un-hurdled options plans • Options that vest at grant • Repricing ‘out-of-the-money’ options • Automatic ‘reloading’ of options following exercise of an existing option holding • ‘Stealth compensation’: • Golden hellos/goodbyes • Retention and long-service bonuses • No-interest company loans • Post-termination consulting fees • Special payments for termination following takeover or merger (or ‘golden parachutes’) • Retirement benefits are not performance-linked and amount to one-third of total accumulated earnings
‘Rent extraction’ – fact or fiction? Solutions (Bebchuk & Fried): • Increase in shareholder power over directors • Exclusion of all but independent directors from board compensation committees • Mandatory shareholder ratification of all components of top executive remuneration • Use of indexed options • Compulsory share ownership • Full disclosure of all post-employment benefits
‘Rent extraction’ – fact or fiction? Counter-arguments (Murphy, Conyon): • Average length of CEO tenure is declining not rising • Growth in CEO pay has coincided with increased presence of independent directors • Pay growth is due to global market pressures • Boards not manipulable, just ignorant of LTI cost complexities Which returns us to the issue of the relationship betweenthe board and the CEO.
Executive reward disclosure – for and against For: • Accountability • Controlling excess • Transparency Against: • Executive privacy • Ratcheting (and role of surveys and consultants) • Perverse outcomes – e.g. 1992 $1 million cash cap on tax deductibility in USA
Beyond ‘shareholder value’– a multi-stakeholder perspective Effective management of senior executive performance and reward, and CEO reward in particular, involves striking a positive balance between the potentially competing expectations of five key stakeholder groupings: • Shareholders • The board • Executives • The firm’s employees • External stakeholders, including corporate regulators, the media, customers, suppliers and the general community