EXECUTIVE COMPENSATION

James WellsCatherine Koene

Pamela FeldkampJosh ProkschLorcan Duffy

Francis Moniz

What is Executive Compensation

• Agency contract between firm and manager• Align interests of owners and managers by

basing managers compensation on one or more components of managers performance

Incentive Contracts Necessary?

• Fama argues that managerial labour market controls the moral hazard

• Manager has a reputation for creating higher payoffs for owners, manager market value increases

• Manager with a poor reputation, will suffer a decline in market value

Arguments For and Against

• Manager can in short time hide effects of shirking in the short run

• Opportunistically manipulate earnings however GAAP does prevent certain transcretions from occurring

• Agent/Executives past payoffs does not perfectly predict whether or not individuals “work hard”

Bushmen, Engel and Smith

• Analyzed firms from 1970-2000• Net income is partially informative about

manager performance• Higher cash awarded by compensation

committees accompanied by increased investor probability of higher returns

RBC Executive Compensation Plan

4 Components:1. Salary, paid in cash2. Short term incentive plan bonus awards paid in

cash or if the executive elects, in deferred share units, where deferred share units are converted into RBC common shares after 3 years.

3. Mid-term incentive plan awards paid in deferred share units

4. Long-term incentive plan awards paid in stock options (ESOs)

Total Compensation

• Total compensation is usually positioned relative to the median of a peer group of similar large companies– Total compensation can vary substantially above or

below the median for individual executives as well as in general depending on• Bank• Segment• Individual Performance

• Ex. If ROE is in top 3rd of peer group, total compensation is adjusted upwards by 15% and vice versa

The Plan:Short-term Incentives

• For each business segment RBC sets annual target levels of Net Income growth and ROE– For individual executives, bonus depends on both

overall bank performance and segment performance relative to targets

– Payments are further adjusted for individual non-financial performance measures• such as, goals with respect to risk and cost management,

new revenue incentives etc.

– Bonus also may be adjusted up or down depending on ROE performance of the peer group

The Plan:Mid-term Incentives

• Number of deferred share units awarded depends on the share price performance over the previous 3 years

• Further adjusted depending on share price performance relative to the peer group

• If ROE target is not achieved, no deferred share unit awards are made

The Plan:Long-term Incentives

• ESO exercise price is based on RBC share price around the award date. i.e. intrinsic value=0

• ESOs have 10 year term with vesting rate of 25% per year for the first 4 years

• Executives are required to hold minimum amounts of RBC common shares– E.x. president and CEO must hold 8 times their salary– Requirement extends for 2yrs following retirement

Note: bonus deferrals, vesting periods for deferred share units and ESOs, and required share holdings, decrease the ability of executives to diversify their investment portfolios which causes them to bear firm-specific risk

Changes to the Plan

• Amounts of salary and incentive awards are set by the RBC board which is advised by its Compensation Committee

• Need Compensation Committee since like all real compensation contracts, RBC’s plan in incomplete

• Board has discretion to deal with the effects on compensation of an unanticipated outcome– E.x. awards were still given out in 2008 even though

ROE target was not met

Incentive Effects

• Annual bonus awards are mainly based on reaching financial targets

• Short and Mid-term incentive awards depend largely on current year’s performance, creating incentive to maximize current year’s levels of earnings and ROE– This can be at the expense of the firm’s long run

interests and opportunistic earnings management

Incentive Effects Continued…

• However, ESOs issued through the long-term incentive plan and the requirement of large share of ownership is in place to make executives more interested in the long-term success of the firm– This will hopefully reduce executives from being

tempted to engage in opportunistic practices to increase short-term earnings

Proposed Changes to RBC’s Compensation Plan

• Greater weight on individual non-financial performance measures relative to financial performance measures

• Increases in required executive stock holdings• Provisions to claw back bonuses in cases of

fraud or misconduct• These changes are intended to help to

lengthen decision horizons

Compensation Risk

• RBC’s plan imposes compensation risk on managers

• What is Compensation Risk?– It is when Economy- and Industry-wide events,

which may not be informative about the manager’s effort, will affect both earnings and share prices, hence the amounts of current and future incentive awards

Net Income and Share Price

• Banker & Datar showed that lower “noise” I net income and greater sensitivity to manager effort then

• Greater portion of net income to share price in determining managers overall performance

Sensitivity of Net Income

• Increased by moving towards current value accounting which highlights changes faster

• Reduces accuracy and precision which therefore reduces net incomes usefulness

• Full disclosure of low persistence items, compensation committee able to take into account and better measure manager performance

Share Price

• Heavily influenced by effects of economy wide factors

• Market wide factors add volatility to share price

• Does however reveal additional payoff information and should be used

Short and Long Run Payoffs

• Net Income tends to be more heavily influenced by short term goals and horizons

• Share based compensation tends to reflect more long term goals and horizons

• Mixing the two allows for adjustments to be made in the even of market wide factors, positive net income, yet share price not at exact levels can still result in compensation

Short and Long Run Effort

• This confuses me can you do this part Josh?

Risk

• More risk managers bear, the higher their expected compensation

• Not enough risk, the firm suffers from low manager effort, too much manager may under invest in risky projects

• Relative Performance Evaluation• Measuring difference between net

income/share price compared to that of a peer group of similar firms

Conservative Accounting

• Delays recognition of unrealized gains and discourages premature revenue recognition

• Constrains manager’s ability to inflate current earnings

• Conservative Earnings however give manager little incentive to invest in risky projects

• Employee Stock Options encourage managers to invest in long term profits

Employee Stock Options

• Encourage upside risk and impose little downside risk and promote excessive risk taking

• ESO were the driving force behind WorldCom and Enron

• CEO’s who had significant share holdings were frequently responsible for restating financial positions compared to CEO’s with small share holdings

The Politics of Executive Compensation

• Many have argued that top managers are overpaid• In 1990 an article was published arguing that

managers were not overpaid, but that their compensation was not related enough to performance

• They found CEO’s salary increase by only $2.59 per $1000 increase in shareholder wealth

• They also found that the standard deviation between CEO wages and regular employees were nearly identical

The Power Theory of Executive Compensation

• Suggests that executive compensation in practice is driven by manager opportunism, not efficient contracting

The Power Theory of Executive Compensation (Cont’d)

• Set forth by Bebchuck, Fried, and Walker– Agree that managers have sufficient power to

influence their own compensation– That they use this power to generate excessive

pay• At the expense of shareholder value

• If this happens, managers receive more than their reservation utility

The Power Theory of Executive Compensation

• What it actually means:– It questions the efficiency operation of the managerial

labour market • Like behavioural finance questions efficient securities market

theory

• The source of the power is from the ability of the CEO to influence the board of directors– By influencing their appointment– By managers fear of anti-management reputation

• Will effect interaction with other directors • Reduce likelihood of appointment to other boards

Outrage

• The limits to managements power – If compensation awards become too high• Negative publicity• To limit this: camouflage

– Hire a compensation consultant– Tie total compensation to a peer group

Questions Raised by the Power Theory

• Why are ESO awards not adjusted downwards for gains that are not under manager control?

• Why do managers have so much freedom to control the exercise of ESOs?

Additional Support

• Provided by Core, Holthausen and Larcker• Study showed that a significant portion of CEO

compensation is explained by corporate governance variables– Poorer governance is associated with greater excess

compensation• Ways to guard against this:– Sarbanes-Oxley Act and other governance– Full disclosure provided by accountants– Regulations by the SEC

Regulations About Executive Compensation

• SEC Required firms to give more disclosure of their executive compensation in 1992

• Similar requirements adopted in Canada in 1993– A detailed explanation of the compensation of the five

highest-paid executives – A report from the compensation committee justifying these

pay levels– A Compensation Discussion and Analysis– Extensive disclosure of share-based compensation– Information on late timing ESO awards– Information of any golden parachutes

Conclusions

• Labour markets reduce severity of moral hazard• Important to have a delicate balance of

incentives, risk and decision horizon• Political Controversy is a result of CEO’s

exploiting their power to increase compensation

• Accounting must provide full disclosure, and ensuring stock options are expensed