An examination of executive compensation practices: managerial power or agency theory?

• Author: Hollowell, Byron J.

Management compensation policies should be aligned with the long-term prudential interests of the institution, be tied to the risks being borne by the organization, provide appropriate incentives for safe and sound behavior, and avoid short-term payments for transactions with long-term horizons.

--Fed Reserve Chairman Ben S. Bernanke, March 20, 2009

1. INTRODUCTION

   From a compensation growth perspective, the nineties were a great time to be a top executive in a large U.S. company (Evans and Hefner, 2008). Figure 1 shows the median total compensation of CEOs nearly tripled from $2.3 million in 1992 to over $6.5 million in 2000 in the S&P 500 Industrials (S&P 500 companies excluding utilities and finance firms). The primary driver of this remuneration spike was the dramatic growth in stock options that grew from 27 percent to 51 percent of total compensation.

   However, some CEOs profited greatly even as their firms and stakeholders suffered financial downturns (Harris, 2008). In some instances, the board of directors adjusted performance targets to make meeting benchmark standards much easier to achieve. There are a number of examples of companies in 2008 that did not tie its CEO pay levels closely to adding to shareholder value. For example, Warner Music Group paid its CEO Edgar Bronfman a $3 million bonus for an operating year in which the company experienced a $56 million loss and its share priced fell by 25%. The rationale for the bonus payout was "management outperformed peers and the firm wanted to reward strong operating performance in a historically challenging industry environment." Similarly, Varian Semiconductor CEO Gary Dickerson received over $1 million in incentive pay despite a 53% stock price decline and a 31% drop in net income. In its proxy filing the firm said its CEO and his management team exceeded market share gain expectations and new business expansion targets. However, Chief Executive Officer (CEO) compensation fell for the first time in two decades in 2008. According to Murphy (2009), median compensation, which includes options, bonus payments and base salary, declined by a net of 1% across the 50 largest non-financial companies (salary increased by 4.5% over 2007 levels, annual incentives increased .3%, annual bonuses increased 2.4%, however options dropped by 3.5% compared to 2007).

   In March 2009, while in a protracted recession and during a severe banking financial industry retraction there was severe populist blowback because of the over $165 million in retention bonuses paid to 73 American International Group (AIG) employees including 11 people who no longer work for the firm following the government bailout of the firm.

   A few prominent members of Congress proposed a 35% tax on employees receiving bonuses and another 35% levied to the firm that paid it. The proposed bill would also apply to bonuses paid after Jan. 1, 2009, and would cover not just AIG but all companies that received funds from the government's financial bailout fund. Similarly, White House officials are investigating the creation of an executive-pay provision to be appended to the recently passed stimulus law could allow the Treasury Secretary to" claw back" bonus payments if they were inconsistent with the purpose of the Troubled Asset Relief Program. In a letter to Congress, Treasury Secretary Timothy Geithner said the Treasury planned to use this law to deduct the cost of the bonuses from the government's pending $30 billion cash infusion, and will also extract additional penalties from AIG operating funds.

   In addition, the Security and Exchange Commission will require approximately 400 companies that participated in the Troubled Asset Relief Program to institute shareholder votes on executive pay this year. Among the most active shareholder activists are union pension funds. For example, the United Brotherhood of Carpenters has submitted proposals to limit bonuses, severance, stock options and retirement benefits for executives of the 23 financial institutions that participated in the $700 TARP program. Similarly, the American Federation of State, County and Municipal Employees has submitted thirty two proposals to put constraints on executive pay by asking firms to hold the majority of their stock for two years after retirement and to consider adopting a "bonus bank" where a portion of executive pay will be held for three years and recalibrated based on multiple years of corporate performance.

   Blending agency theory predications and managerial power theory is the missing link in executive compensation studies to date and will help us to understand many seemingly anomalous compensation practices: why is the executive pay for current year's performance seem low? Why newer, younger executives seem to be underpaid while older, longer tenured executives appeared to be overpaid? Why is the pay of some executives with good recent performance seemed to be too high relative to peer group norms? Why is the pay of some executive with poor current performance seemed to be too high? Why the pay to performance sensitivity is lower for certain types of new hires such as those from a different industries, from smaller company, or measured against the pay to performance sensitivity of internal hires. Why are some executives, at least partly compensated on their performance compare with that of...