formerly ACA Journal

Volume 11 Number 1 First Quarter 2002

Executive Compensation 101
Considering the Many Elements

Bruce R. Ellig, SPHR
Pfizer Inc. (retired)

Editor’s Note: This article uses excerpts from Mr. Ellig’s book, "The Complete Guide to Executive Compensation," published by McGraw-Hill in 2001. Mr. Ellig is an instructor of WorldatWork’s Certification Course, C6, Elements of Executive Compensation.

The 20th century saw the introduction and evolution of compensation plans for the non-owner executives of companies. It also saw the introduction and expansion of accounting, disclosure and tax requirements; consequently, these factors have complicated the design and administration of executive compensation.

Executive compensation plans are effective only when reviewed and positioned in terms of market lifecycle, stakeholder impact, strategic thinking and rule makers. While the amount of pay is a critical consideration, how pay will be determined is equally, if not more, important.

Market Lifecycle
There are five elements of compensation: Salary, employee benefits, short-term incentives, long-term incentives and perquisites. Each of these elements can be viewed in degree of importance versus the market lifecycle for a particular organization. When describing an industry, company or product, there are four stages in the market lifecycle: Threshold, growth, maturity and decline. The latter stage ends either in a turnaround, a buyout or going out of business.

During the threshold or developmental phase, the importance of salary is “low” because of the need to preserve capital or reinvestment in the firm for growth and hopefully an IPO. Salary is of “moderate” importance during growth and maturity, but of “high” importance in the decline phase, primarily because incentive plans are more difficult to structure.

The importance of employee benefits in the various stages of the market cycle is believed to be essentially the same as “salary,” except that benefits are probably of “low” importance in the growth phase as compensation dollars are directed to more result-oriented performance measurements.

Perquisites typically are similar to employee benefits, namely “low” in importance during the development and growth phase, rising to “moderate” during maturity and “high” during decline. The correlation between degree of formality and perquisites is rather high. Perquisites are more prevalent in stratified hierarchical (“we-they”) organizations; they are virtually non-existent in egalitarian companies. The importance of perquisites may lag benefits only because improve-ments in benefits also are benefiting the executive. Only after the benefits program has reached significant cost levels is it decided that improvement appropriate for executives may be too costly to build into the benefits program. This results in added perquisite programs.

Short-term incentives are of “moderate” impor-tance in the development phase, primarily because of the need to preserve capital; however, programs with deferral features might be elevated to a “high” rating because cash needs are not negatively impacted.

The “high” rating during the growth phase is tied to the success in new venture lines and becoming a national influence by challenging the established leaders in market share. The “high” rating in the maturity phase is directed to maintaining current market penetration. Plans must be responsive to lowered prices to maintain sales position. The “moderate” rating in the decline phase is only because of the difficulties in structuring incentive plans that target lower market penetration.

Long-term incentives are of “high” importance during the developmental and growth phases, the former because of cash scarcity and the latter because of the need to establish strong, long-term market positions. Market value plans are more prevalent during this stage than nonmarket value plans due to anticipated rapid growth; in earnings.

The “moderate” importance in maturity is because of little real growth; nonmarket value plans are probably replacing market value plans installed during the developmental phase. By definition, long-term plans have a “low” value in the decline phase because long-term success is anathema to market position. During this phase, market value plans have virtually disappeared unless an aggressive turnaround is planned.

Stakeholder Impact
Who are stakeholders and what impact do they have in executive compensation? Stakeholders are the individual executive (or recipient of the plans), other employees of the company, shareholders who own the company, customers, suppliers and the community.

Executives
Each of the five compensation elements is important in attracting, retaining and motivating executives.

Salary is probably very “high” in importance in attracting and retaining executives, but of “moderate” value in motivating them because salary adjustments for outstanding performers are tempered by the lack of downside risk in level of pay. Clearly the opportunity for a promotional pay increase is more motivational than the basic merit pay policy.

The employee benefits program will have “low” ability to attract and motivate the executive but some “moderate” impact on retaining the individual, primarily to the extent the individual is not vested in retirement programs.

Perquisites are believed to be of the same value as employee benefits: “Low” in ability to attract and motivate and “moderate” in retention value.

Short-term incentives, conversely, should have a “high” influence on being able to attract and motivate top-quality executives, if based primarily on individual performance. Heavy influence on group attainment (e.g., divisional and corporate) may lower this to “moderate” importance. The level of payment also must be perceived by the executive as worth the level of effort. Typically, short-term incentives have only “moderate” retaining ability. This can be increased or decreased in relation to the extent payments are forfeitable deferrals. High payment plans have “high” retention, while low payment or a no-payment year has virtually no retention ability. Incentive plans with low risk of paying out are essentially deferred salary plans.

Long-term incentives probably have “moderate” impact on attracting and motivating executives due to their longer-term measuring period. This “moderate” importance also is because long-term incentives are more group than individually oriented, as compared with short-term incentive programs. They usually are “high” in retention because a period of measurement is always outstanding due to their multi-year design. This “high” value is reinforced to the extent payments are also deferred on a forfeitable basis.

Overall, it may be difficult to structure a program that will in total attract, retain and motivate top-quality executives; however, at a minimum it should not repel, encourage turnover or demotivate. Clearly, it is more difficult to structure meaningful programs for professional managers than for entrepreneurs. Their risks, like their rewards, are different.

Other Employees
Typically, the interest of other employees in the organization is one of equity. Is the pay relationship consistent with work responsibilities and performance? This relationship is under very close scrutiny when CEOs are receiving large pay increases while others are receiving termination notices. Employees’ interest is not only on relative pay levels, but also program differ-entiation. For example, do only executives receive stock options?

Pay programs can be described in terms of type of culture: Separate or distinctive versus egalitarian. Benefits are of high importance in a culture where co-workers are perceived as equals, while incentives and perquisites receive high interest in a culture with distinct employee classes.

Customers
These stakeholders are becoming more of a factor in executive pay programs. Some plans include customer satisfaction in determining annual incentives, although not much has been done to include their views in other pay programs.

Suppliers
These stakeholders have not been a factor in executive pay programs to date, but they have a very definite interest in the company’s success because it means more business for them.

Community
This stakeholder looks for business to do well. Namely, to provide a number of good-paying jobs and a good tax basis, and to keep the environment safe and clean. The community does not want the business to cut back on employment, reduce its tax base and contaminate the environment.

Shareholders
Although executives and other employees are stockholders, a very large percentage of the stock is in the hands of other shareholders. Until recently, they were very vocal as pay levels approximated telephone numbers in length with area codes, but that has largely abated because their interest is not in the amount that executives are paid, but how they are paid.

For years, many believed shareholders should be No. 1, but that is not very helpful in determining vision and mission (other than to maximize return on shareholder investment). More executives and boards are realizing that if they know who their customers are and what they want, they are on the way to becoming a successful company. Because research shows that employees are very important in customer satisfaction, the rank order might best be: Employees, customers, community, suppliers, shareholders and executives. It is not a matter of putting shareholders and executives last, it simply means that if one appropriately satisfies the other stakeholders, the shareholders will receive an appropriate return on their investment and executives truly will be rewarded for performance.

Given an understanding of the market lifecycle and importance of the stakeholders, these considerations are factored into the strategic thinking of the organization.

Strategic Thinking
Each strategic business unit (SBU) within a company can be examined not only in terms of its position in the market cycle, but also in terms of its degree of profitability. A review of the market stage of each of the SBUs and their composite makeup in the company is a starting point for a review of the company’s:

• Vision -- What does it want to be? What is the destination?
• Mission -- What is the road to get there? What is the business we are in?
• Objectives -- What are the qualitative reference points on the path?
• Goals -- What are the quantitative targets that will measure success of the objectives?
• Threats and opportunities -- What are the internal and external business situations, economic factors, legal requirements and cultural considerations?
• Issues -- What can be identified from the threats and opportunities?
• Strategies -- What actions must be taken to capitalize on the opportunities and threats? The major strategies and the attendant goals and objectives must be in accord with the desired expectations of the various stakeholders. A representative list of company objectives for each of these stakeholders is shown below.

Employees

• Employer of choice – Create a work environment where individuals want to come to work and give their best efforts.

Customers

• Product/service innovation -- Create new markets for new or existing products/services.
• Productivity -- Reduce costs while increasing quality and quantity.
• Satisfaction -- Provide reliable products/services at prices the customer considers excellent value. Emphasis is on getting new customers while retaining current ones.

Community

• Good citizen – Provide plenty of good paying jobs and comply with all laws and regulations.

Supplier

• Partnership – Provide opportunity to make a reasonable profit over a sustained period of working together.

Shareholders

• Investor identification – Provide a reasonable return on investment in company stock through dividends and increased stock price.

Executive

• Pay for performance – Pay in relation to the extent the stakeholder expectations have been met in a cost-effective manner.

The Rule Makers
Within the community, there are executive compensation rule makers. These are organizations with statutory authority to define disclosure requirements to shareholders, mandate accounting or financial treatment, define tax treatment and determine other requirements affecting executive compensation design.

Disclosure
Disclosure to the shareholders in the United States is defined by the Federal Securities Exchange Commission (SEC). The philosophy is that shareholders or perspective shareholders should have access to information before making a decision to buy or sell their stock or vote on matters brought before them – typically, at the annual meeting. They have set forth detailed requirements of what must be described on executive pay and in which format. These requirements are so extensive that, for some companies, 75 percent or more of the shareholder proxy statement consists only of executive pay material. Pay for the five most highly paid in the company is definitive.

Accounting
Accounting treatment in the United States is prescribed by the Financial Accounting Standards Board (FASB). It is an independent agency and its decisions are subject to the SEC. The issues are whether a pay program is going to require a charge to earnings, a dilution of equity, a reserve account and/or a financial footnote in the annual report. Basic rule: Compensation is an expense charged to earnings and all stock issued is a dilution.

Taxation
Tax rules are the outcome of law (the Internal Revenue Code) as interpreted by regulation (the Internal Revenue Service). Laws and regulations strongly influence executive pay plan design as planners move away from income taxed at high rates to more favorably taxed income. Basic rule: The individual’s compensation is taxed as ordinary income and the company has a tax deduction in the same year that this occurs. The exceptions to this basic rule are: Qualified pension plans, accruals paid within 75 days of the end of year, capital gains and tax preference income.

There are three types of income: Ordinary, capital gains and tax preference.

• Ordinary income is the most common. It covers salary and bonuses (both cash and stock). Tax rates accelerate as income rises, moving from a low of 15 percent to a high of 38.6 percent. The tax paid on the last dollar of ordinary income is called the marginal tax rate. The effective tax rate is determined by dividing total taxes paid by adjusted gross income.
  Section 162 (m) of the Internal Revenue Code states that a maximum of $1 million of pay per person is tax deductible to the company for each of the named executives in the proxy unless the company gets shareholder approval for stock options and other performance-based compensation permitting the deductibility of amounts in excess of $1 million.
• Capital gains is the tax paid on the appreciation in value of property owned. This would include house, land and stock. Property held for more than 12 months is considered long-term capital gains and subject to a 20 percent tax; property held for 12 months or less is considered short-term capital gains and subject to ordinary income tax treatment. Whereas the company gets a tax deduction for ordinary income, it does not get a tax deduction for capital gains because it does not own the property.
• Tax preference income is defined as adjusted gross income plus the tax shelters (which have been deducted from ordinary income) and the gain at time of exercise of an incentive stock option. Adjusting income for these two items may result in an alternative minimum tax of 28 percent that is greater than the ordinary income because the tax preference income is far greater than the adjusted gross income.

Tax effectiveness can be expressed by dividing the company’s after-tax cost into the executive’s after-tax value. The higher the value and the lower the cost, the more tax effective the payment. The company’s after-tax cost is obviously greater if the form of pay is non-deductible (e.g., dividends) than deductible (e.g., salary). The ideal is when it incurs no expense (e.g., title) or the cost is offset by a tax credit. The executive’s after-tax income depends on whether it is completely non-taxable or, if taxable, fully deductible or a long-term capital gain, assuming a favorable tax rate.

In viewing the tax consequences, it also is appropriate to examine several taxable situations, namely constructive receipt, economic benefit and imputed income.

• Constructive receipt occurs when the executive had the right to take the pay, but did not. A taxpayer may not deliberately turn back income and thereby select the year for which it will be reported. The possibility of being in constructive receipt is minimized if the executive makes a determination before the amount is known.
• Section 83(b) is when the executive elects to be taxed on deferred compensation at time of award rather than at time of receipt. The election must be made within 30 days of award. This allows the executive to be taxed on the appreciation in stock value as long-term capital gains. Lacking a Section 83(b) election, the full value of the award when received will be taxed as ordinary income.
• Economic benefit is closely allied with the doctrine of constructive receipt. A company action that results in something of value for the executive will trigger an economic benefit. An example is the funding (rather than simple promise to pay) of a deferred payment. A rabbi trust is an irrevocable company promise to pay a stated amount of deferred compensation. Because it is an unsecured promise, there is no economic benefit. A secured promise to pay, placing the recipient ahead of general creditors, is a secular trust. It would trigger an economic benefit.
• Imputed income is when a service or benefit is provided to the executive at a cost less than what the IRS believes is appropriate. One example is term insurance protection in excess of the tax-free $50,000 allowed by Section 79 of the Code.

Tax effectiveness attempts to maximize the dollar expenditure through the legal use of tax avoidance, not the illegal activity of tax evasion.

Accounting and Tax Treatment of Stock Options
Let’s put this together and look at how the statutory and nonstatutory options differ in accounting and tax treatment using the example of an option granted at $20, purchased when fair market value was $60 and sold for $80 a share. This is illustrated in Figure 1.

Figure 1: Stock Options-Statutory versus Nonstatutory (Using APB 25)
	Grant	Vest	Exercise	Sale
When:	Today	2 years	4 years	6 years
Stock Price
Fair Market Value	$20	$40	$60	$80
Option Price	$20	$20	$20	$20
Statutory Option
Individual Income	-	-	-	$60
Company Tax Deduction	-	-	-	-
Company Expense	-	-	-	-
Nonstatutory Option
Individual Income	-	-	$40	$20
Company Deduction	-	-	$40	-
Company Expense	-	-	-	-

With a statutory option there is no income liability to the individual until the stock is sold (except for the previously described alternative minimum tax). Because it was held (i.e., owned for more than 12 months), it is taxed at the long-term capital gains rate of 20 percent, leaving a net profit of $48 (80 percent of $60). However, a nonstatutory option is taxed as ordinary income when exercised (i.e., purchased). Assuming a top tax rate of close to 40 percent, the optionee not only has to come up with $20 to buy the stock, but almost another $16 to pay the taxes on the $40 gain (i.e., $60-$20). When it is sold two years later, the long-term capital gains tax applies, but only on the $20 difference between selling and purchase prices (i.e., $80-$60). With a statutory option the company has no tax deduction on the $60 because it is long-term capital gains, not income. However, with the nonstatutory option, the company has a $40 tax deduction (matching the individual’s ordinary income) but no tax deduction on the $20 long-term capital gains.

As for accounting treatment, using Accounting Principles Board 25, there is no charge to the earnings with either option because using the Measurement Date Principle, the number of shares and the price per share are both known at time of grant and the price is equal to fair market value.

This is the same type of analysis one needs to make under each type of stock plan.

Executive pay should be based on performance, namely to the extent the stated goals and objectives have been met (within the context of market lifecycle, stakeholder interests and rule maker requirements). This leads to the identification of play plan objectives.

Pay Plan Objectives
Because salary, employee benefits and perquisites are not effective pay-for-performance vehicles, the focus is on short- and long-term incentives; however, before designing the incentive plan, one must identify the plan objectives. A list of possibilities include:

1. Identifies with the shareholder

2. Correlates with individual and unit performance

3. Is easily understood by all

4. Requires no special target setting

5. Ties the high performer to the company

6. Has no earnings charge

7. Has no dilution to shareholder equity

8. Is tax deductible to the company

9. Is not taxable to the individual

10. Requires no investment by the individual.

Unfortunately, it is impossible to design a plan that meets all of these objectives. Therefore, it is important to select the two or three that are most important. Then each of the various type plans has to be profiled against the desired objectives to determine the extent they do or do not meet the objectives.

Having identified the executives, ascertained the respective stages of the organization in the market lifecycle and ranked the relative importance of the stakeholders, a plan is designed within the requirements of accounting, disclosure and tax restraints. Most importantly, it must be consistent with the organization’s vision and mission and stakeholders’ expectations. Both the short- and long-term plans will specify the portion in cash and stock (if stock is available and appropriate performance measured).

Many current executive pay trends are likely to continue long term. They include:

• Less emphasis on salary, more on variable pay
• More emphasis on long- rather than short-term pay
• Equity more dominant than cash
• Line-of-sight objectives emphasized
• A greater use of nonfinancial measurements
• Clear communication of the pay-performance link
• Peer comparison, not simply individual performance
• Qualitative goals
• Plans pushed deeper into organization
• Stock option grant size varied
• Stock ownership guidelines increased
• Director’s pay tied to shareholders.

The above may be viewed as longer-term trends, but with so much emphasis on market value plans, one should consider whether to temper the importance of such plans through design variations. These could include:

• Guaranteeing the option value. Perhaps the Black-Scholes valuation would be the basis for guaranteeing a minimum future value. For example, an option for 1 million shares with a current stock price of $10 a share and present value of $3.5 million might result in the executive being guaranteed a straight line value of $350,000 a year as the total grant. Partial exercise would proportionately reduce the total. Unfortunately, this action will require a charge to earnings for the guaranteed portion.
• More in cash and less in options. This is moving away from market-priced option plans into various type cash plans, such as the cash and pay percentage plans described earlier.
• Greater use of internal measurements. This adjustment shifts the emphasis from market valuation to internal financial measurements; however, the payment might still be in the form of stock.
• Extending performance period, if necessary. If the stock price is languishing, an additional number of years might be added to the stock option; however, this will result in an earnings charge, and it is probably simpler to give a new grant, although this will result in more option shares outstanding.
• Greater use of letter/tracking stock. This internal form of stock pricing might be most appropriate for an SBU with the business.
• More frequent, smaller stock option grants. Instead of 10-year grants, proportionately larger grants for five years might be considered. This is especially helpful if the stock prices slide further downward because the shares are outstanding for five years before a new grant could be made.
• Voluntary cancellation of options to receive restricted shares. If options are significantly under water, the company may decide to give shares of stock for cancelled options. The ratio would need to be determined but could be as high as one-for-one. The company would likely restrict sale for a stated period (e.g., three years) to address retention issues. Restricted shares would incur an earnings charge, but not under variable accounting.
• Pay dividends on outstanding options. If the company’s dividend is a reasonably attractive percentage of the stock price, this can be a more favorable alternative to a cancellation and reissue of options. Unlike normal dividends, it will be tax-deductible to the company.
• Stock purchases with favorable terms. Permitting the executive to purchase stock at a significant discount from current value (e.g., 25 percent) or with a partial company match (e.g., one share for every three bought by executive) can be attractive. Separate or added to these discount/match plans would be a favorable loan with forgiveness either tied to future tenure and/or company performance.
• More use of stock awards. For long-term plans, this would be restricted stock with or without a performance component. For short-term plans, this either would be a mandatory portion of the award paid in current, deferred stock or a voluntary selection with a premium (e.g., 125 percent of bonus if paid in stock).

Change is Inevitable
How can one assume pay plans can remain static while other matters are changing? It is indeed critical that executive pay designers are continually aware of pending changes, but to predict what executive compensation will be at the end of the 21st century would be folly.

The Author

Bruce R. Ellig, SPHR, is the retired corporate vice president of human resources at Pfizer Inc. with worldwide responsibility for human resources operations. He has more than 35 years of HR experience with Pfizer. He is a member of numerous HR associations and has served in leadership positions for many of them, including serving as the charter president for the eastern region of WorldatWork and the 1996 chairman of the board of directors for the Society of Human Resource Management. He currently sits on the board of directors of several companies. He is a frequent speaker and has been widely quoted on human resources matters in such publications as Forbes, Investor’s Business Daily, The New York Times, London Financial Times, Time magazine and The Wall Street Journal. He also is a noted author of more than 70 articles and five books. He has received many awards and honors and is a fellow in the National Academy of Human Resources. He also is an honorary life member of WorldatWork and recipient of the Keystone Award. He received a bachelor’s and a master’s in business administration from the University of Wisconsin, Madison, where he was elected Beta Gamma Sigma and Phi Beta Kappa.

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Author’s Note

Accounting, tax, SEC and other professional service statements in this article, while believed to be accurate, should not be relied upon. They should be reviewed with appropriate professional counsel.

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