Fair or Excessive? A Reliable Model for Determining the Appropriateness of Executive Compensation

By Anson, Mark; White, R. Theodore et al. | Ivey Business Journal Online, May/June 2004 | Go to article overview

Fair or Excessive? A Reliable Model for Determining the Appropriateness of Executive Compensation


Anson, Mark, White, R. Theodore, McGrew, William, Butler, Bridgette, Ivey Business Journal Online


A divergence of interests between a company's shareholders and executives is at the root of the "agency problem." No issue illuminates just how acute the problem is than executive compensation. Who's right and what's fair compensation. Managers with CalPERS, one of the vocal and visible institutional shareholders, have developed a model that will reveal if a certain executive compensation is warranted or not.

One of the key issues associated with corporate governance is the alignment of shareholders' interests with those of the executive management of a public corporation. Normally, this is achieved with a compensation plan that rewards executive management for good financial performance. In this article, we present an empirical analysis that provides a basis to determine whether the interests of the owners and agents of a corporation are aligned.

The agency problem

In a public corporation, shareholders, or shareowners, are the ultimate decision makers. (CalPERS refers to itself as a shareowner, not a shareholder. For a fuller discussion on this topic see Robert Carlson, Charles Valdes, and Mark Anson, "Share Ownership: the Foundation of Corporate Governance," The Journal of Investment Compliance, 2004.) After all, shareholders own the company and can do with it as they please. However, it is not practical for equity holders to make every day-to-day decision.

Therefore, shareowners delegate the day-to-day decision making authority to the directors and executives. The executive management of the corporation acts as the agent for the equity owners (the principals) of the company. However, directors and executives may not always act in the shareowners' best interests. This leads to what is known as "agency problems."

Agency problems arise when the management of a public company pursues its own economic self-interest ahead of shareowners' interests. This behavior may manifest itself in the form of golden parachutes, long-term employment contracts, corporate jets, and other perquisites. Managers are susceptible to human nature and may pursue their own economic agendas without any concern for maximizing the wealth of the shareowners.

Nowhere is this agency problem more acute than in the determination of executive compensation. Even though the independent directors on the board of directors of a public company are elected to protect the interest of the shareowners, the agency problem between the owners of the corporation and the executive management can manifest itself in a number of ways:

1 Frequently, the role of chairman of the board and chief executive officer are combined. In this dual role, the chairman of the board controls the board of directors, whose job it is to set the pay for executive management. This same chairman is also the president, and part of the executive management team that receives the compensation package. It is in the chairman's economic interest to press the other directors to adopt a generous pay package for executive management.

2 Even when the roles of chairman and CEO are split, the chairman will often defer to the CEO's recommendation when setting the compensation for the executive management team.

3 The chairman and the other directors typically receive information only from the executive management team with respect to their performance and recommended level of compensation.

4 Even when compensation consultants are hired, they are often hired by the executive management team and so receive their information and other input from the executive management team.

In sum, there are many ways that the agents of the corporation (executive management) can enrich themselves at the shareowners' expense. We portray the disconnect between executive and shareholder wealth in Exhibit 1.

Exhibit 1 examines the change in executive compensation for the five most senior executives of corporations in the S&P 500. The information for this table came from the corporations' own annual proxy statements. …

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