Executive compensation

Executive compensation is composed of both the financial compensation and other non-financial benefits received by an executive from their employing firm in return for their service. It is typically a mixture of fixed salary, variable performance-based bonuses and benefits and other perquisites all ideally configured to take into account government regulations, tax law, the desires of the organization and the executive.
The three decades from the 1980s saw a dramatic rise in executive pay relative to that of an average worker's wage in the United States, and to a lesser extent in a number of other countries. Observers differ as to whether this rise is a natural and beneficial result of competition for scarce business talent that can add greatly to stockholder value in large companies, or a socially harmful phenomenon brought about by social and political changes that have given executives greater control over their own pay. Recent studies have indicated that executive compensation should be better aligned with social goals. The rate of executive pay is an important part of corporate governance, and is often determined by a company's board of directors.

Types

In a modern corporation, the CEO and other top executives are often paid a salary, which is predetermined and fixed, plus an array of incentives commonly referred to as the variable component of the remuneration package.
The variable component of compensation or remuneration can be broken down into three time frames:

short-term incentives
medium-term incentives
long-term incentive plans
Short-term incentives (STIs)

As employees rise through the ranks in the business, it is likely that short-term incentives are added to their total remuneration package. The combination of Fixed Pay and Short Term Incentive is referred to as Total Cash Compensation. Short-term incentives usually are formula driven and have some performance criteria attached depending on the role of the executive. For example, the Sales Director's performance related bonus may be based on incremental revenue growth; a CEO's could be based on incremental profit margin and/or revenue growth. Bonuses are after-the-fact and often discretionary. Short-term incentives can also take other forms, namely, fringe benefits, employee benefits and paid expenses. Common fringe benefits can vary from meal plans to health insurance cover, retirement plans, company cars and even interest-free loans for the purchase of housing. Fringe benefits are also often tax deductible for the employee. The level of STI relative to basic salary is typically a function of seniority eg. a junior executive may have an STI that is capped at 10% of basic salary whereas for a senior executive, it may rise to 50% or more.

Medium-term incentives (MTIs)

Medium-term incentives are often associated with the delivery of corporate strategic goals and therefore extend beyond the scope of short-term incentives. The performance of the company in achieving the predetermined targets is the basis for the benefit which is usually cash. There is often no determination of an individual's contribution to achieving the targets - the performance is calculated purely at the corporate level. As with STIs, the weight of the MTIs relative to the basic salary is dependent on seniority. Because deployment of corporate strategies typically covers a 2-5 year period, the MTIs are only paid out when an assessment of the achievement is possible. This feature is therefore seen as supporting employee retention. MTIs are not common, most publicly listed companies disclose only STIs and LTIs, although purists may argue that one or both of these are more aligned to a medium term reward.

Long-term incentives (LTIPs)

The most common form of LTIs in the US are stock options. In Australia Performance Rights are more common - see below. This is where executives are given options to buy shares in their employment company, often at a significant discount, but at some point in the future. To reach that point in the future, the time taken is defined as the vesting period. The number of options granted is subject to the company's performance relative to very high-level metrics such as total shareholder return versus a select number of other listed companies. These can be very valuable incentives - in 2017, S&P 1500 named executives held $31.4 billion of in-the-money stock options.
A Performance Right also known as a Zero Exercise Priced Option is the right to receive a share in the company at some time in the future if a performance metric is achieved. Typical performance metrics are financial ratios growth, Return on Equity and/or use some form of Total Shareholder Return metric
Vesting refers to the period of time before the recipient exercises the right to take ownership of the shares for a predetermined price and realize value. Vesting can occur in two ways: "single point vesting", and "graded vesting" and which may be "uniform" or "non-uniform". If the company has performed well and the actual share price at the time of vesting has grown to be higher than the strike price, the executive can realise a capital gain should he/she sell the stock and pocket the proceeds. If the share price is lower than the strike price at vesting, it is unlikely the executive would exercise his option immediately, if at all. Following the vesting period, the options can be exercised for a predetermined period, typically a 10 year period, before they lapse.
Vesting refers to the number of options or rights that convert to shares in accordance with the performance criteria. Typical practice would be for 50% of the options or rights to vest at some predetermined target, and 100% to vest at some predetermined stretch target. Below target results in zero vesting. "Cliff vesting" refers to the portion below 50%.
Supporters of stock options say they align the interests of the CEOs with those of shareholders, since options are valuable only if the stock price remains above the option's strike price. This form of incentive is also designed to reward long term service of an individual and is an important retention tool. Stock options are now counted as a corporate expense, which impacts a company's income statement and makes the distribution of options more transparent to shareholders. Critics of stock options charge that they are granted without justification as there is little reason to align the interests of CEOs with those of shareholders. Empirical evidence shows since the wide use of stock options, executive pay relative to workers has dramatically risen. Moreover, executive stock options contributed to the accounting manipulation scandals of the late 1990s and abuses such as the options backdating of such grants. Finally, researchers have shown there to be relationships between executive stock options and stock buybacks, implying that executives use corporate resources to inflate the stock prices before they exercise their options. Stock options also may incentivise executives to engage in risk-seeking behaviour. This is because the value of a call options increases with increased volatility. Stock options also present a potential up-side gain for the executive, but no downside risk. Stock options therefore can incentivise excessive risk-seeking behaviour that can lead to catastrophic corporate failures.
Another way executives are incentivised over the long term is with restricted stock, which is stock given to an executive that cannot be sold until certain conditions are met and has the same value as the market price of the stock at the time of the grant. As the relative size of stock option grants has been reduced, the number of companies granting restricted stock has increased. Restricted stock has its detractors, too, as it has value even when the stock price falls.
Restricted stock is an increasingly common element of the Short Term Incentive. The STI is often dependent on performance against Key Performance Indicators, which are reported to the Board by management. There is increasing shareholder lobbying for "clawback" provisions to enable the company to recapture rewards that were improperly received. Deferring realisation of the reward for one or more years gives the Board more ability to re-capture the reward in such circumstances. Technically recapturing deferred STI before it vests is a "malus" rather than a clawback.
As an alternative to simple vested restricted stock, companies have been adding performance type features to their grants. These grants, which could be called performance shares, do not vest or are not granted until these conditions are met. The performance conditions could be based on, for example, earnings per share or return on equity.

Levels

The levels of compensation in all countries has been rising dramatically over the past decades. Not only is it rising in absolute terms, but also in relative terms. In 2022, the world's highest paid chief executive officers and chief financial officers were American. They made 400 times more than average workers—a gap 20 times bigger than it was in 1965. In 2019 the highest paid CEO was Tesla's Elon Musk at $595.3 million The U.S. has the world's highest CEO's compensation relative to manufacturing production workers. According to one 2005 estimate the U.S. ratio of CEO's to production worker pay is 39:1 compared to 31.8:1 in UK; 25.9:1 in Italy; 24.9:1 in New Zealand. This trend continues to rise.

Mathematical Formula

In a globalised world economy, all businesses compete with one another to hire their CEO from the same talent pool. In its most simple form, the talent of any individual CEO is determined by the percentage increase in profit margins the individual is expected to bring to the firm. The desired outcome of this is that, in part due to efficient allocation of resources in the economy, the largest firm will be matched with similarly the best CEO, the second largest firm will be matched with the second best CEO and so forth. While there have been numerous methods for formulating executive compensation, some complex and some very basic, the method proposed by Xavier Gabaix is a good reference point. It is worth noting that results vary significantly after share options, bonuses and benefits are taken into consideration.
The compensation of CEO number equates to:
where:
Consider, for example, a firm that is 27 times bigger than the median firm and suppose that = 2/3. The CEO's remuneration would be 3 times larger than the median CEO's compensation. Should the size of all the firms increase 27 times, however, the compensation of the CEO for the company that is 27 times larger, will increase 27 times over. This formula exhibits a strong correlation between the rise in executive compensation and the rise in value of the S&P 500.