2 Executives

Executives: Incentives and Compensation
Semester A, 2022-2023
FB5690, City University of Hong Kong
© 2021 City U of HK All rights reserved 1

Labor Pool of CEO Talent
CEOs of Public U.S. Corporations (Spencer Stuart, 2007)

Number of CEOs > 6,000 Average tenure, with company 14 years
% with 0-5 years as CEO 57% Average tenure, as CEO 5 years
% with 6-10 years as CEO 25% Undergrad degree: engineering 21%
% with 11-15 years as CEO 10% Undergrad degree: economics 15%
% with 16+ years as CEO 8% Undergrad degree: business 13%
Prior to CEO: finance 22% Undergrad degree: accounting 8%
Prior to CEO: operations 20% Undergrad degree: liberal arts 8%
Prior to CEO: marketing 20% MBA degree 40%
Prior to CEO: engineering 5% Military experience 7%
Prior to CEO: law 5% International work experience 34%
Prior to CEO: consulting 4% Same company entire career 19%

Evidence from the Field
https://www.youtube.com/watch?v=RWBigA8R5oc

Theory
Conflicts in objectives between shareholders and executives

Shareholders’ objective: maximize the value of their investments, and expect
executives to exercise efforts to achieve their objective.
Executives’ objective: maximize their own interest.
The actions executives take to maximize their own interest could destroy shareholder
value.

Theory
Different risk attitudes between shareholders and executives: executives

are more risk-averse than shareholders.
Shareholders invest financial capital, and can easily diversify their
investments.
Executives cannot diversify their human capital investment.
Shareholders may prefer risky projects, while executives like safe projects.
High risk, high return (e.g., interest rate on bank deposit vs. yields on
corporate bonds).

Theory
To align executive and shareholder interests: a mechanism that can

increase executive interests when they exercise efforts to create value
for shareholders.
Incentive contract: reward executives based on firm performance (short-

term & long-term).
Underlying assumption: firm performance is directly affected by the level

of efforts exercised by executives.
Inputs are not observable.

Executive Compensation
The compensation program serves three purposes.

It must attract executives with the skills, experiences, and behavioral profile
necessary to succeed in the position.
It must be sufficient to retain these individuals, so they do not leave for
alternative employment.
It must motivate them to perform in a manner consistent with the strategy
and risk-profile of the organization and discourage self-interested behavior.
Managers with high perceived contributions to shareholder value are

supposed to obtain higher pay (Nguyen and Nielsen, 2014)

Elements of Compensation
Base salary
Determined ex ante
Not vary with ex post performance
Average US $975,000 (tax deductibility below $1 million) for CEOs in largest U.S.
firms in 2004
Cash bonus
Receive at the end of a fiscal year
Awarded for short-term performance, e.g., earnings, earnings growth
Average US $1.5m for CEOs in largest U.S. firms in 2004
Equity-based (long-term) compensation

Stock options: Average option-based compensation realized for CEOs in largest U.S.
firms in 2004 is US $2.7m.
Restricted stock (restricted in transferability): Subject to a vesting schedule. The
average restricted stock (vested) is $1m in 2004.
Performance units (shares): Equity (or cash) awards granted only after specified
targets are met during a three- to five-year period. Similar to a longer-term version of
the annual bonus. Average performance shares is a little less than $1m in 2004.

More Recent Data
For S&P 1500 firms in 2019 (Execucomp database)

Salary: $897,000
Bonus: $154,000, 75% of CEOs have zero bonus
Stock options realized: $2.6 million
Stock award (performance shares): $4 million

International Comparison of CEO Compensation
Cropped from Edmans, Gabaix, and Jenter (2017)

How to Determine Executive Compensation
The compensation committee recommends compensation of the CEO

and other executive officers.
Packages are approved by independent directors of the full board.

Shareholders ratify equity-based compensation.
Details are disclosed in the annual proxy statement.

Proxy statement also specifies the time and location of the annual meeting,
as well as any material matters of the company concerning shareholder
voting and nominated directors.

Most boards benchmark CEO pay against a peer group of companies

comparable in size of the firm, industry, and/or geography.
Common practice targets cash compensation (salary + bonus) at 50th

percentile and long-term pay at the 75th percentile.
What is the impact on the salary next year?
Ratcheting effect
There are potential drawbacks to benchmarking:

Is based on size rather than value creation.
‘Empire building” argument: CEO will want to build empire, since it makes his
payment high.
Is highly dependent on companies included in peer group.
The CEOs can influent the choices of peer group.

Compensation consultants
Most companies use a third-party consultant to advise on compensation
levels and program design.
CEO can recommend compensation consultant to board of directors.

Conflicts of interest?
CEO pay is higher in U.S. and Canadian firms if other services are provided,
and that pay is higher in Canadian firms when the fees paid to consultants
for other services are large relative to those for compensation advice.
However, CEO pay is 13% higher in U.S. firms if the consultant works for
the compensation committee rather than management.
For companies that used multiservice compensation consultants, CEO

pay increases with the level of “influence” that the CEO has over the
board.

Pay Inequity
There is a large pay difference between the pay granted to the CEO and
the pay granted to other senior executives.
On average, the CEO earns 1.8 times the pay of the 2nd highest
officer. The 2nd highest earns 1.2 times the 3rd (2013-2014).
(+) Might reflect relative value creation of these jobs.
(+) Pay inequity provides incentive for promotion.
(–) Might reflect management entrenchment.
(–) Discourages executives who feel they are not paid fairly. They may not
work hard, demotivated

Pay Inequity
The press often cites the ratio of CEO pay to that of the average
employee as a sign of excessive compensation.
If the CEO is going to be paid more than 100 times the average worker, we
want to know why. . . . It’s bad for the long-term performance of a
company because it breaches the trust between top management and
people who work for them.
– Gretchen Morgenson, New York Times, January 25, 2004
Dodd-Frank Act requires companies to disclose the ratio of CEO pay to

average employee pay in proxy statements.
It has been calculated as either 180, 300, 400, or 500 in recent years.
Mean or medium
Work force structure; industry; size; location; and measurement period
It is difficult to interpret. Does it reflect relative value creation, scope of

job, or expendability of the position?

Short-Term Incentives
Short-term incentives offer an annual payment (usually cash) for

achieving predetermined performance objectives.
The size of the bonus is expressed in terms of a target, with a minimum

and maximum level.
The board should consider the following:

Are the performance targets sufficiently difficult? Evidence suggests
otherwise.
Does the plan encourage a short-term focus?
Does management defer investments to achieve targets?
Are earnings deferred after maximum targets are met?
Do managers manipulate earnings up to beat the target?


Accounting income is usually used to measure short-term performance.

Reflect the performance for that year
Advantages: more precise and controllable, relative to stock prices.
Disadvantages: not sensitive to managers’ efforts to improve long-term

performance.
Investment myopia (or short-termism)
Too much weight on short-term performance may induce undesirable

managers’ behavior.
Some expenditures that would increase earnings in the long term might be
cut by managers: e.g., research & development expenditure, advertising
expenditure.
Earnings management: e.g., earnings inflation; take a big bath.

Restricted Stocks
Common stocks given to executives that include a limitation that

requires a certain length of time to pass or a certain goal to be
achieved before the stock can be sold (vesting period).
e.g., executives may receive a grant of shares that requires 10 years to pass
before they can sell those shares.
Restricted stock is increasingly used in the U.S.

Performance Shares
A company’s stocks given to executives only if certain performance

criteria are met, such as earnings-per-share targets.
Similar to annual cash bonus, it rewards past performance.
Similar to other long-term compensation forms, it can motivate managers
to maximize long-term value of stocks because performance shares can
become more valuable.
Performance shares are increasingly used as long-term incentives in the

U.S.

Executive Stock Options
Option (call): giving options to buy shares later on.
Executive stock options (ESOs) are issued by a firm to executives; such

options give executives the right but not the obligation to buy a certain
number of stocks from the firm at a pre-determined price in a certain
time period.
Terminologies
Strike price (exercise price): the price to purchase a share, determined on
the day the options are granted.
In-the-money option: the strike price is below the market price.
Out-of-the-money option: the strike price is above the market price.
ESOs are usually granted at the money.

Executive Stock Options
Payoff to executives at the expiration date of options

Max [(market price of stocks – strike price), 0]
Example: Strike price = $20/share
20
15
10
0
0 5 10 15 20 25 30 35 40
-5
-10
The higher the stock price on the exercising day, the larger the payoff
to executives.
Thus, executives might have strong incentives to work hard to improve

performance, which will lead to higher stock prices.

Advantages to use stock options as incentives
Align managers’ interest with shareholders’.
Reduce managers’ myopic behavior and encourage them to maximize

long-term shareholders’ wealth.
Encourage managers to take risk (e.g., invest in risky projects that

could bring huge profits to shareholders)
Discussion: Reasons?
Firms do not need to pay a large amount of cash to attract excellent

managers.
We more often observe that growing, high-tech firms grant options to their
executives and employees.

Disadvantages to use stock options as incentives
Stock price is affected by many other factors not controllable to

managers (2/3 of stock price movement is explained by the market- and
industry-wide factors).
e.g., bad but lucky managers in bull markets, good but unfortunate
managers in bear markets.
Encourage managers to take excessive risks: theoretically, the higher the

risk (volatility), the larger the options’ value.
Induce short-term behaviors when substantial options are about to vest.

Less investment, more repurchases, more good news disclosure, etc.

Manipulation of Equity Grants
Equity ownership might encourage executives to manipulate equity

grants to extract incremental value.
Manipulate the timing of grants.
Delay grant date to occur after a stock price decline.
Bring grant forward to occur before expected rise.
Manipulate the timing that information is released.
Delay the release of favorable information until after grant date.
Bring forward release of unfavorable information to precede grant date.
In both cases, the executive seeks to maximize value by taking actions

not in the interest of shareholders.

Manipulation of Equity Grants (Evidence)
When equity awards are granted on a random basis, there is no

discernable pattern in the stock price around the grant.
A “V-shaped pattern” around the grant date suggests manipulation

might be taking place.
There is considerable evidence that this occurs.
Reproduced from Heron and Lie (2007), Figure 3

Manipulation of Equity Grants
Stock option backdating is the practice where insiders retroactively

change the grant date to correspond with a relative low in the company
share price.
When practice was discovered in 2006, more than 120 companies were
implicated. Abuses stemmed back to 1981.
Stock option backdating largely stopped following Sarbanes Oxley,

which requires that grants be reported in two days.

An Example
Monsanto Inc. (Definitive Proxy Statement

http://www.sec.gov/Archives/edgar/data/1110783/000120677409002
291/monsanto_def14a.htm)
Core principles
Align management interests with those of shareholders
Encourage employees to behave like owners
Promote creativity, innovation, and reasonable risk-taking
Reward for results rather than on the basis of seniority, tenure, or other
entitlement
Comparable to similar companies
…
Role of management: the Compensation Committee considers inputs

from CEO and other executives

Monsanto Inc.
Role of compensation consultants

Committee consultant: Frederic W. Cook & Co. “The chairperson discusses the
independent consultant’s input with the Committee at its meeting and the Committee
considers the input as part of its decision-making processes.”
Management consultant: Towers Perrin. “To assist the Committee in its decision-
making processes, management may also independently seek Towers Perrin’s input on
various matters to provide information to the Committee.”
List comparable companies (comparator group)
Key components: base salary, cash annual incentive awards, and stock-based
long-term incentive awards
How are different components awarded?

Base salary: comparable to similar companies, adjusted for inflation
Annual incentive plan (AIP): based on short-term performance such as growth in net
sales, EPS, and cash flow
Long-term incentive: stock options
Summary

Do Incentive Contracts Work?
On firm value:
Use large samples, studies fail to find a robust relationship between firm
value and executives’ equity stakes (Edmans et al. 2017).
Does this mean equity compensation fails to work in practice?
On risk-taking:
An increase in new options granted to CEOs leads to increases in equity

volatility. This increase in risk is driven largely by increased leverage
(Shue and Townsend 2017).
In the oil and gas industry, option-based compensation encourages

CEOs to take risks: more exploration activities; less hedging activities
after option grants (Rajgopal and Shevlin 2002).

Executive Compensation in Hong Kong
Discussion:
Why are stock options relatively uncommon among Hong Kong companies?
Example:
Li Ka-shing controls 41.5% of Cheung Kong stocks (0001)
He receives $10,000 from Cheung Kong every year
Link to the 2009 annual report:
http://202.66.146.82/listco/hk/ckh/annual/2009/ar2009.pdf (page 107)
Family firms: executives are often large shareholders
Most firms operate in traditional industries

Grasso Event: Are CEOs Overpaid?
Richard Grasso: Former CEO of New York Stock Exchange (NYSE)
The compensation in 2001:

Salary: $1,400,000
Annual Incentive: $16,100,000
Capital Accumulation Plan: $8,050,000
Special Payment: $5,000,000
Total: $30,550,000
In addition, he received $139.5 million payout on his retirement plan.

Grasso Event
Is he over-paid?
As early as in 1991, the former Chairman of Coca-Cola, Roberto Goizueta
got pay of $86m, including a record of $80m stock grants. He defended his
1991 pay in Annual General Meeting and was interrupted 4 times – by
thunderous applause. Shareholders were happy – under his management,
Coke stock had increased by 1300%.
Almost at the same time, executives of the top 3 auto makers were
together paid $5.3m and they were blamed for taking too much…because
their combined loss totaled $7.5b in a year.
The issue: not how much but how!

Grasso Event
How to assess?
Sensitive to performance?
Comparable to peers?
Determined independently from the CEO?

Grasso Event
NYSE is a non-for-profit institution similar to a regulatory agency.

The chair of compensation committee then argued that Grasso was worth
every dime, in part for getting the markets running after the Sep 11
terrorist attacks.
Grasso was paid more than $76 million from 1999 through 2002 – more
than 1/3 of the exchange’s net income in that period.
The total compensation of the CEO of London Stock Exchange (David
Schwimmer) in 2019 is $3.47m – 0.5% of the exchange’s net income.
The total compensation of the CEO of Hong Kong Stock Exchange
(Charles Li) in 2019 is $6.58m – 0.5% of the exchange’s net income.

Grasso Event
If NYSE is considered as a financial institution …

Grasso Event
If NYSE is considered as a regulatory agency …

Grasso Event
NYSE is a regulatory agency and it urges listed firms to improve

corporate governance but it is revealed that NYSE itself has bad
governance…
The chair of the compensation committee is Mr. Grasso’s long-time

friend.

39
Grasso Event: Takeaways
Can a good performance or a performance improvement justify huge

bonuses to a CEO?
Rising tides lift all boats …

Lucky managers in bull markets all get good pay although they may not all
exercise efforts to improve performance.
CEOs should be compensated for their efforts.
Need a benchmark to calculate relative performance.

The former HP CEO, Carly Fiorina, can collect full amount of cash award
in a three-year period only if HP stock has outperformed at least half of the
companies in the S&P 500 at the end of the third year.
The role of an independent compensation committee.
May set maximum amount for bonus

https://www.youtube.com/watch?v=PnyT3ukfLBQ

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Executives: Incentives and Compensation

© 2021 City U of HK All rights reserved 1

CEOs of Public U.S. Corporations (Spencer Stuart, 2007)

© 2021 City U of HK All rights reserved 2

© 2021 City U of HK All rights reserved 3

Conflicts in objectives between shareholders and executives

© 2021 City U of HK All rights reserved 4

Different risk attitudes between shareholders and executives: executives

© 2021 City U of HK All rights reserved 5

To align executive and shareholder interests: a mechanism that can

Incentive contract: reward executives based on firm performance (short-

Underlying assumption: firm performance is directly affected by the level

© 2021 City U of HK All rights reserved 6

The compensation program serves three purposes.

Managers with high perceived contributions to shareholder value are

© 2021 City U of HK All rights reserved 7

Equity-based (long-term) compensation

© 2021 City U of HK All rights reserved 8

For S&P 1500 firms in 2019 (Execucomp database)

© 2021 City U of HK All rights reserved 9

Cropped from Edmans, Gabaix, and Jenter (2017)

© 2021 City U of HK All rights reserved 10

The compensation committee recommends compensation of the CEO

Packages are approved by independent directors of the full board.

Details are disclosed in the annual proxy statement.

© 2021 City U of HK All rights reserved 11

Most boards benchmark CEO pay against a peer group of companies

Common practice targets cash compensation (salary + bonus) at 50th

There are potential drawbacks to benchmarking:

© 2021 City U of HK All rights reserved 12

CEO can recommend compensation consultant to board of directors.

For companies that used multiservice compensation consultants, CEO

© 2021 City U of HK All rights reserved 13

© 2021 City U of HK All rights reserved 14

Dodd-Frank Act requires companies to disclose the ratio of CEO pay to

It is difficult to interpret. Does it reflect relative value creation, scope of

© 2021 City U of HK All rights reserved 15

Short-term incentives offer an annual payment (usually cash) for

The size of the bonus is expressed in terms of a target, with a minimum

The board should consider the following:

© 2021 City U of HK All rights reserved 16

© 2021 City U of HK All rights reserved 17

Accounting income is usually used to measure short-term performance.

Advantages: more precise and controllable, relative to stock prices.

Disadvantages: not sensitive to managers’ efforts to improve long-term

Too much weight on short-term performance may induce undesirable

© 2021 City U of HK All rights reserved 18

Common stocks given to executives that include a limitation that

Restricted stock is increasingly used in the U.S.

© 2021 City U of HK All rights reserved 19

A company’s stocks given to executives only if certain performance

Performance shares are increasingly used as long-term incentives in the

© 2021 City U of HK All rights reserved 20

Option (call): giving options to buy shares later on.

Executive stock options (ESOs) are issued by a firm to executives; such

ESOs are usually granted at the money.

© 2021 City U of HK All rights reserved 21

Payoff to executives at the expiration date of options

Thus, executives might have strong incentives to work hard to improve

© 2021 City U of HK All rights reserved 22

Align managers’ interest with shareholders’.

Reduce managers’ myopic behavior and encourage them to maximize

Encourage managers to take risk (e.g., invest in risky projects that

Firms do not need to pay a large amount of cash to attract excellent