DEEP Insight

Compensation: Solving the Pay Puzzle Premium

Money may make the world go round, but does it guarantee good results?

This executive dossier includes the following articles:

How Our Conception of Pay Has Changed Premium

Scaling Back Compensation

Gómez, Sandalio; Contreras, Ignacio

The enormity of the recent economic crisis has forced many companies to reassess their objectives and business strategies, including their employee and executive pay systems. Salary levels, as a whole, have remained flat, so as to help reduce costs. The most significant changes have been to variable pay models. New approaches, such as pay deferral, clawback or vesting, are increasingly common, often as a result of new regulations and better governance codes. The authors take a comprehensive look at current trends in fixed and variable pay. Based on their study of the financial and insurance sectors in Spain, they recommend several ways in which companies can improve employee and executive compensation policies.

Don’t Be Seduced by Charisma Premium

Is Your CEO Worth It?

Tosi, Henry L.; van Scotter, James

When a firm is not doing so well, and the board thinks about replacing the CEO, the first question is, “What kind of CEO do we need?” The answer is often the same: someone with lots of experience and a proven track record, but also, a highly charismatic figure. But how essential is it for the CEO to be charismatic? Do charismatic CEOs achieve better financial performance, which might justify the higher personal compensation they command? Be careful what you wish for, say the authors, because you might get more than you bargained for: A CEO who exudes charm, but turns out to be a dud. The corporate world is full of overpaid, underperforming executives, like Ken Lay, one of the CEOs included in a study by Henry L. Tosi, which examined the relationships among charisma, compensation and firm performance in a sample of Fortune 500 companies in 26 industries over a 10-year period. While revealing that there may sometimes be a place for a charismatic CEO when the firm is operating in a more turbulent environment, in general, boards and compensation committees would be well advised to see through the charm offensive and stick with measuring business performance.

Debt-Based Pay May Give Much-Needed Balance Premium

Aligning Shareholders & Bondholders

Edmans, Alex

When business takes a bad turn, managers whose compensation only ever contains equity-like instruments, such as stock and options, are often tempted to take bigger risks in a last-ditch attempt to salvage their firms. But even if their firms go down in flames, these managers usually emerge with fewer scars than those unfortunate bondholders saddled with the resulting debt. The litany of corporate failures in the United States and elsewhere remains fresh in everyone’s memory. This article is based on a paper originally written with Qi Liu of Wharton, forthcoming in the Review of Finance, which has attracted considerable attention for being the first to show that debt compensation can be an optimal element in executive compensation, particularly when a company faces financial difficulties. Instead of the typical practice of paying top managers heavily with stock, the author suggests giving them debt-like securities, such as bonds, pensions or deferred compensation, or linking their bonuses to the price of debt or to a firm’s credit rating or credit default spread. He suggests what proportion of a manager’s compensation should be issued in debt: equal proportions of debt/equity if the manager only ever takes project-selection decisions; less so in situations when a CEO has to take decisions in which “effort” is a key variable, depending on whether effort has a greater effect on the firm’s solvency value or liquidation value. With new evidence emerging that an estimated 13 percent of CEOs hold a greater percentage of debt than equity in their firms, along with recent moves by A.I.G. and others in a similar direction, the author feels that this compensation model is an idea whose time has come.

The Art and Science of Target Setting Premium

Hitting the Mark

Franco-Santos, Mónica; Marcos, Javier; Bourne, Mike

The recent economic crisis and the collapse of many financial institutions stand as living proof of the dangers of overly ambitious targets coupled with fat bonuses. Targets, at their best, can motivate people to succeed; at their worst, they induce employees to engage in dysfunctional behavior, leading to detrimental outcomes like those recently witnessed. How can companies get it right? The authors studied target-setting practices involving sales managers, account managers and business development professionals in the U.K. over a two-year period. Their research turned up a litany of failures: unrealistic goals, overemphasis on financials, lack of coordination, bad communication, all adding up to dissatisfaction and poor performance. Based on these findings, the authors identify the key moderators that influence people’s behavior and condition favorable outcomes when it comes to formulating targets, incentive schemes and performance measures. They then suggest a 10-step process to improve the whole way in which performance targets are set. It takes some work, they say, but if well designed, targets can resume their original purpose: to drive superior performance.

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