shortcomings of compensation philosophies amirsaleh azadinamin

8/2/2019 Shortcomings of Compensation Philosophies Amirsaleh Azadinamin

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2/11Electronic copy available at: http://ssrn.com/abstract=2017448

SHORTCOMINGS OF COMPENSATION PHILOSEPHIES

Abstract

This paper looks upon traditional performance measurements and compensation philosophies

and assesses their shortcomings in todays competitive market. Paper suggests that new

methodologies are needed in order to properly align the interest on the employees with that of the

employer. It also recommends new methods of compensations that are more properly aligned

with the employees productivity and effectiveness. In such a system both employees and

employers can benefit from the system. Managing the value and tools to measure the added value

are the main topics of discussion here. The paper first talks about the traditional and dominant

compensation philosophies and then focuses the discussion on the topic of ownership versus pay

and the effectiveness of each. The pros and cons of each method, equity ownership and pay for

performance, are each debated.


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Performance Measurements and Their Effectiveness

New talents enter the fast-changing economy and it is up to the old economy to modify

itself into the new one. Performance measurements and reward schemes have always been the

subject of discussion in finding proper compensation methods. Authors Pettit and Ahmad (2000)

discuss the main methods of compensation and whether they need to be the subject of change or

modifications to achieve a more efficient strategy that is more effectively aligned with

employees productivity and efficiency. One may also state that in a system where the interest of

the employee is aligned with the interest of the organization, the incentive compensation will

benefit both the company and the employee. Managing the value and tools to measure the added

value are the main topics of discussion here. Measures that are obtained from financial

statements lack the sufficiency to indicate the added value. These numbers fail to consider the

weighted cost of capital. The only cost item mentioned in financial statements is the cost of debt;

however, the cost of equity capital is overlooked. Thus, the income statement profit does not

properly illuminate the added value. This has been discussed as of the main deficiencies of

accounting standards. Furthermore, the cost of equity is not the sole factor distorting the financial

statements. Saeedi and Akbari (2010) state yet another factor distorting the balance sheet:

Considering the issue that the economic value added is calculated using information

produced from conventional historical cost accounts, inflation can distort information

content and applications of the performance measurement criteria. Inflation can distort

economic value added through three factors, i.e., the operating profit, the cost of capital,

and capital base and these distortions potentially result in inefficient investment and

compensation outcomes.


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Accordingly, many managers take on projects that make the balance sheet seem more

attractive, but may ultimately fail to generate added value. Judging from the previously failed

compensation philosophies, one may believe that a new compensation philosophy is called for.

The Dominant Compensation Philosophy

Competitive levels of compensation, pay-for-performance, and significant levels of pay at

risk are currently the dominant compensation philosophies. The primary focus of compensation

committees seems to be determining an optimal level of competitive pay reflecting widespread

belief that their most difficult challenge is to find an optimal balance between competitive pay

and total cost (Pettit & Ahmad, 2000, p. 2). Management is often the sole decision making

authority in determining the target capital structure and policies regarding pay distribution. This

will ultimately lead to agency issues, which stems from the managerial team having the decision

making authority affecting two parties with conflicting interest, the interest of managers with

those of the shareholders. Pettit and Ahmad (2000) emphasize that pay-for-performance or

incentive pay must avoid violating the existing balance among three competitive objectives, and

furthermore, in compensation design for executives, one must take extra care to govern the

balance between these factors: align employee interest with value creation, limit retention risk

risk of losing good people during inevitable periods of poor or volatile performance, and to

achieve this all at a reasonable total economic cost (p. 2). However, the question remains and

one may ask whether the existence of balance among all three elements is effective in the

compensation design. In a statistical regression analysis of thousands of executives, we found

very little correlation between pay and performance (Pettit & Ahmad, 2000, p. 2). Pettit and

Ahmad (2000) go on to explain that the total shareholder return, TSR, explains only 1% of the


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variation in the CEO pay. This is yet further evidence that dominant compensation philosophies

have not been very effective, if not futile.

Despite the discouraging results of our regression analysis we did find that most CEO pay

seems to be pay at risk even more so for the New Economy CEOs. Base salary

constitutes only about 30% of the Old Economy CEO pay at the 25th

percentile, and less

than 20% of pay for 75th

percentile. Overall, more than 70-80% of total pay is typically

pay at risk. For New Economy companies the proportion is even higher

overwhelmingly in equity. Yet, its not working (Pettit & Ahmad, 2000, p. 3).

In practice, variable pay is based on the ex post or the actual return, as opposed to the

fixed pay salary which disregards the actual returns. With a robust compensation system in place

that can truly align the interest of the owners with the interest of employees, both employees and

managers can benefit from the system, as owners can enjoy the value added and managers can

enjoy their share of the resulting pie. With proper compensation design in place, both parties will

enjoy the fruition of the company.

Ownership versus Pay

Failure in effectiveness in other forms of compensation has driven organizations to use

equity stocks or the ownership method. Equity based compensation plans have been widely

embraced, specifically in the last decade due to the bull market. Bronstein (1980) believes that

[a]n ownership positionwhich established an economic basis for equating executive interests

with corporate goals is fundamental to compensating the executive, whose responsibilities exert

a basic economic effect on business outcomes (p. 64). However, criticism about the efficiency

of the ownership design still remains.


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Compensation consultants and governance critics alike have effectively given up on

compensation as a tool to achieve any alignment in interests whatsoever, resigned to the

status quo where entrenched thinking and over-riding concerns with competitiveness

have subordinated the alignment and motivational aspects of compensation (Pettit &

Ahmad, 2000, p. 4)

However, the equity schemes are not free of flaws, and there must be a strong owner-

employee compensation contract. Based on the current literature, the wide use of stocks and

stock options has also failed to cover the shortcomings in aligning the interests of owners with

employees. There are some limitations to equity based compensation packages. Volatility and the

price fluctuations is the first of the limitations. Many may not be able to psychologically handle

the volatility, and to many others bearing the downside risk may be frustrating. Also, since the

shares are always granted from the same company, the employee cannot enjoy diversification.

The second factor imposing limitations on the scheme is the vague understanding that the

majority of employees have on valuation, and in general from the global equity market. Besides,

many employees may care about capital growth and the increase in stock prices, while the

company may forgo the growth in stock prices for a market expansion. The third factor

imposing limitation is the lack of direct link between the actions and the incentives. In case of

cash incentives, the employee would receive the incentive for her decisions in a shorter period in

comparison to equity based packages where the change in share prices has no correlation with

the actions of the employee.

There is yet another open question regarding the design which could ultimately be

recognized as a flaw in the incentive design. The following question can best illuminate the

issue. Should the managers pay be a function of performance and managerial ability as it is


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intended to be, or is it a function of the size of the company? A study has been done, as

mentioned by Wyld (2008) which contributes to the understanding of managerial pay, and

whether the pay will change if the manager is replaced by a manager with less or more

managerial capability. [P]erhaps the money invested by top firms to attract and retain

superstar management talent doesnt improve market returns relative to less talented (and

cheaper) executives (p. 83). This study is yet another proof of ineffectiveness in aligning the

pay with performance.

The Case for Change

A comprehensive design with the capability to eradicate the dysfunctional impact of

compensation designs has yet to emerge. There have always been elements of the design that are

impractical but recurring, that do not perfectly align the interests of the company with that of the

employees. These elements may cause the employees to act and follow lower work ethics than

those expected of them. The insufficiency in the design may be due to various factors. Pettit and

Ahmad (2000) explain these factors as the following:

Too many measures. The performance metrics that have been traditionally used have

not been able to completely convey the values that have been initially intended for the incentive

packages to imply. Besides from the fact that they are numerous, many of them appear vague to

the employees as how they can maximize their pay based on compensation designs intended for

them.

Performance legacy issues. Value is created when performance is increased. Reaching a

high, but previously obtained performance target, does not add value to the organization. This is

yet another factor overlooked in design packages. Tying incentives to absolute levels


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performance, rather than performance improvements, effectively pays for history (Pettit &

Ahmad, 2000, p. 6)

Budget arbitration. The concept of fixed annual budget that comes out of the

negotiation table will undermine the efforts of those who over perform and rewards those who

are not performing up to the expectations of the organization.

Performance floor and ceiling. Very similar to the previous point, if the performance

index is below the floor or over the ceiling, it will cause the employee to slack off in bad or good

years respectively. If the performance target of the employee falls outside the range of given

range, outside the floor or the ceiling, then the employee has no motivation to act.

Short time horizon. Compensation pay practices are mostly done annually, and this

comes in conflict to long-term goals of organizations. The short-time horizon of the employee

may come in conflict with the interest of organizations that are mostly based on a long-term

horizon.

Sharing Value Creation

As it was mentioned above by Pettit and Ahmad (2000) there are clearly shortcomings to

the design compensation processes. These are the limitations that would lead to ineffectiveness

of the incentive packages and their failure to align the interest of the company with the

employees. A new approach is needed, and it must encompass new measures to effectively align

the interests of both parties. This approach can only be reached through a comprehensive

combination of tools and features that would effectively create an owner-employee contract to

share value creation. The following are suggested features offered by Pettit and Ahmad (2000):


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A proper single measure. Economic value added could be named as a single and most

credible measure that captures true profit. It bears into self the capital and cost of it, and thus, it

is a clear indication of improvements and growth.

Value-based goal-setting. Goals that are based on value will appear essential in

establishing the correct performance standards in which the values are shared by both the

company and its employees. These sets of goals create a common ground for both parties, and it

avoids the issue regarding conflict of interest.

Multi-year accountability. This element will eradicate the discrepancy in the time

horizon for the employee and that of the company. This will create an annual payment as a

function of annual performance, but holding a draw against cumulative, multi-year

performance (Pettit & Ahmad, 2000, p. 7).

Equity-like payoff. In order to eliminate the mentioned factor of performance floor and

ceiling, a straight line incentive, where there is no limitation to upward /downward incentives

and employees are paid in proportion to their performance, is called for. Following this design

feature, employees would be aware of short-term misbehavior as it will affect their performance

even in the short run. This measure would not only guard against short term damages in case of a

random misbehavior, but it would also ensure the continuous flow of payments.

Concluding Remarks

Equity shares are granted to managers as part of the reward schemes intended for pay-for-

performance compensation packages. Through these programs stocks are granted to those whose

performances meet a certain predefined criteria. The performance matrices are not free of flaws,

and they have been rather insufficient in aligning the pay with performance, which ultimately

leads to conflicts of interest of the company and that of the executive. Performance measures


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commonly used are mostly based on business growth indicators such as earning-per-share, which

fail to consider the cost of equity. These measures fail to consider the true cost of doing business,

and hence, they fail to illuminate the true profits or the economic value added. And again, this

poses as an obstacle in aligning the pay to the performance. In addition, the time horizon of an

organization may differ with that of executives, which may lead to managers with priorities that

are not in the best interest of the organization. Goals that are value based and multi-year are

better performance measures and are ultimately better replacements for a new compensation

philosophy.


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References

Bronstein, R. J. (1980). The equity component of the executive compensation package.

California Management Review, 23(1), 64-70.

Pettit, J., & Ahmad, A. (2000). Compensation strategy for the new economy age.EVAluation, 2,

1-9.

Saeedi, A., & Akbari, N. (2010). Impacts of inflation on the effectiveness of EVA: Evidence

from Iranian companies.International Research Journal Of Finance & Economics, (37),

66-78

Wyld, D. C. (2008). Bigger CEO pay packages: Does market value matter more than ability?.

Academy Of Management Perspectives, 22(4), 82-83. doi:10.5465/AMP.2008.35590357

shortcomings of compensation philosophies amirsaleh azadinamin

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