Senior Executive Compensation

INTRODUCTION

Executive compensation is an imperative consideration when planning the management structure of a company. A good compensation plan can provide incentives for executives to work harder in order to achieve growth for a company. A poorly planned structure may entice corruption and flaws such as the agency theory, in which management seeks to act only in their own best interest. The Board of Directors needs to govern executive pay to ensure performance and compensation are fairly matched and that market trends are not the basis for decisions.

METHODS

The compensation of many executives encompasses a combination of a base salary, bonuses, long-term incentives, benefits, and perquisites, all of which the Board of Directors determines. The size of the company (measured by revenue) is also another factor in the formation of an executive pay structure.

According to Forbes Magazine, the highest paid CEO in North America is currently Mark Reuben, the CEO of Colgate-Palmolive, taking in approximately $148 million last year. The secret to the company's success has been that only 4% of his compensation has come from salary and bonuses, while stock gains account for the rest. His case demonstrates why it is critical for companies to have high-level executives maintain a personal stake within the corporation. Because of his stock options, Mark Reuben not only maximizes his annual compensation but also that of other shareholders.

In cases such as Enron, shareholders are demanding more ethical and transparent decisions in regards to company spending. They will no longer stand for being left in the dark or having over-inflated base salaries for executives. In order to guarantee the longevity of a company, the Board of Directors must ensure that the goals of the CEO align with the company when deciding on a compensation plan. The best method to accomplish this is by focusing heavily on long term incentives, which directly relate to stockholder value. Although there is still the risk of unethical accounting practices such as artificial stock inflation, accountability is greater and it has become more common to see executives held personally liable for their actions.

Many believe that CEO's in North America are generally over paid; however, CEO's still hold one of the most influential positions in a company and their performance directly relates to the company's success. In order to attract the best talent, many corporations feel that compensating the CEO luxuriously is worth it. However, a conflict of interest may arise as the Board of Directors (comprised of executives from other companies or friends of the CEO) has influence over the CEO's pay structure. In order to remain objective and bias-free, corporations must begin to hire third party agencies to help determine reasonable executive salaries.

MAJOR TRENDS

Over the last several years, the business community experienced two major trends in executive compensation; the rise and fall in popularity of stock options linked with corporate scandals and the unprecedented growth in total direct compensation.

The usual rationale given for stock option grants to employees is to align employees' interests with the interests of shareholders. However, as many widely publicized corporate scandals have proven, this is not always the case. Because of the "bad apples" in corporate leadership, there has been a shift in trends; companies are moving away from an emphasis on stock options to compensation that connects with the long-term growth of the company. The Business Roundtable's fourth annual survey of corporate governance practices, a survey of the association's 160 members (all chief executives of U.S. companies), shows that nearly 57 percent reported an increase in the pay-for-performance element of senior executive compensation in the past year, compared to 49 percent in 2005 and 40 percent in 2004. The trend is now growing in attention, which board compensation committees are receiving from shareholders and news media, as shareholders demand greater disclosure.

To paint a clearer picture of the composition of executive remuneration packages, the findings from a Mercer HR Consulting survey published in The Wall Street Journal, states the following:

* Salary varies from 15% to 18% of total direct compensation

* Bonuses generally range from 13% to 23%

* Long-term incentives range from 62% to 71%

* In 2004 (the most recently completed year), the mix was 15% in salary, 23% in bonuses, and 62% in long-term incentives.

Long-term incentives make up the major part of executive compensation, concluding that the stated executive salary on financial statements may not represent what the executive is actually receiving.

It is evident that a reasonable and fair compensation system for executives and employees is fundamental to the creation of long-term corporate value. Yet, in the past two decades, the world has seen top executive compensation grow exponentially. In 2005, the average CEO received $11.75 million in total compensation; this represents only a 3.66 percent increase in CEO pay over 2004, although a sharp increase from 10 years ago. In the peak of the tech-boom, compensation rose dramatically but we are now seeing it level off to a "new normal". Adapting to this trend may be what corporations need to do to remain competitive, however, methods of governance need to be in place to ensure performance and compensation coincide.

GOVERNANCE

In the past, stakeholders have merely shaken their heads at the realization of the overpaid CEO. Little did they know, until now, that their voice is a powerful mechanism. In an interview published in Chief Executive, Nell Minow, Editor and Chairperson of The Corporate Library stated, "The only people outside a company that can really control CEO compensation are the shareholders." The Board of Directors answers to the shareholders and the Board governs CEO compensation. This process, however, is not the answer. The problem lies in a conflict of interests. As stated earlier, people who associate with the CEO in an alternate capacity often construct the Board of Directors. In fact, in the past, CEO's have had the ability to choose their Board. Minow confirms, "It's still a close loop of friends of friends"