The amount of executives’ base pay increases as firms get larger89—practically all CEOs of Fortune 500 firms earn a base of at least half a million dollars a year, with an average of $3.1 million in cash compensation annually based on 2011 estimates.90 Executives’ bonuses are usually short-term incentives linked to the firm’s specific annual goals; in 2014 the average annual executive bonus among large firms was about $2 million. More than 90 percent of U.S. firms reward executives with year-end bonuses, but the criteria used to determine these bonuses vary widely.

Two major concerns are often expressed regarding executives’ annual bonuses. First, because executives are likely to maximize whatever criteria are used to determine their bonuses, they may make decisions that have short-term payoffs at the expense of long-term performance. For instance, long-term investments in research and development may be crucial to the firm’s success in introducing new products over time. Yet if bonus calculations treat such investments as costs that reduce net income, executives may be tempted to scale back R&D. Second, many bonus programs represent salary supplements that the CEO can expect to receive regardless of the firm’s performance. For instance, an examination of the Wall Street Journal’s executive pay survey in published every year shows that approximately three-fourths of the CEOs in the survey receive a substantial bonus. An earlier study found that if we focus on companies with a drop in total shareholder return of 40 percent or more, we find that a surprising number of those CEOs received a bonus in excess of half a million dollars during the same period (including, for instance, Aplera, Crown Cork & Seal, Continental Airlines, and Boeing).91

The almost automatic payment of lavish bonuses to top executives has led to much resentment among middle managers. One vice president at a major bank expressed a common middle-management frustration: “It disturbs me when someone on high dictates that no matter how hard you work or what you do, you’re only going to get a 6 percent increase, and if you don’t like it, you can take a hike. Yet whatever they’ve negotiated for themselves—10 percent, 20 percent, or 30 percent—is a different issue from the rest of the staff.” Although this is pure speculation at the moment, it is conceivable that political pressures in response to the economic meltdown at the end of the 2000s, the negative public image of many CEOs, and the necessity for vast federal “bailouts” may force boards of directors to place greater limits on CEO pay in the foreseeable future.

Most executives also receive long-term incentives, either in the form of equity in the firm (stock-based programs) or a combination of cash awards and stock. In 2014, these incentives amounted to approximately $6 million on average per executive of the largest U.S. firms. A brief description of the most commonly used executive long-term incentive plans appears in Figure 11.5.

The primary criticism of long-term incentive plans is that they are not very closely linked with executive performance. There are three reasons for this: First, even executives themselves rarely know how much their equity in the firm is worth because its value depends on stock prices at redemption. Second, the executive is likely to have very little control over the value of a company’s stock (and thus the worth of his or her own long-term income) because stock prices tend to be highly volatile. (As noted earlier, depending on the time period, this can benefit the executive, as during 1995–2007; hurt the executive, as during 2008–2012; or make the executive wealthy again, as in the bull market that started in 2013). This is one reason that many critics see this as unfair given that the market has a logic of its own, and they claim that CEOs have very little influence over share prices, not even for their own firm.92 Third, designing long-term incentive plans involves many judgment calls, and these are not always addressed in a manner consistent with achieving the firm’s long-term strategic objectives. The major questions that firms should address in designing executive long-term incentive programs are listed in Figure 11.6.

Following the demise of major financial investment and mortgage companies in recent years, one aspect of CEO pay that has received much negative publicity is the so called “golden parachute,” which provides a CEO with a large lump-sum payment if he or she is terminated by the firm. These “parachutes” represent a contractual obligation on the part of the company to the CEO, even if the CEO is fired for poor performance. A 2013 study of large U.S. firms found that 92 percent of CEOs have golden parachutes and 87 percent have an additional severance payment agreement if they lose their jobs.93 In 2014, the average payment that would be owed to the CEOs at 200 large companies if those CEOs were terminated would be close to $45 million.

Recently, some firms began to reward and penalize executives depending on the firm’s record of social responsibility. For instance, apart from profitability, executive bonuses and long-term income in polluting industries may be pegged to reducing the level of dangerous emissions. For example, in 2013, Chevron Corporation reduced the bonus of its CEO John S. Watson by 13 percent, or $520,000, due to accidents the preceding year. These included underwater oil leaks in Brazil, a deadly rig fire in Nigeria, and a blaze at a refinery in Richmond, California.94

In addition to cash incentives, many executives receive a large number of perquisites, or “perks.” A 2013 report shows a wide array of “special deals” for most top executives, including physical exams, financial counseling, club memberships, company plane, airline VIP clubs, chauffer service, and concierge service, among other similar perquisites.95 These may keep the executive happy, but they are seldom linked to business objectives.96 They are also an easy target of criticism for those who feel that executive compensation is already excessive and who believe that perks are a form of “stealth wealth,” representing “a hidden way [for executives] to increase their compensation.”97 To make CEO pay more transparent, the Internal Revenue Service and the SEC passed new rulings to provide for better disclosure of CEO pay, including perks, starting in 2007. It is very difficult to understand what the whole compensation package consists of.98

There are no easy answers to these criticisms. Executive compensation will probably always be more an art than a science because of all the factors that must be considered and each firm’s unique conditions. Nonetheless, it is safe to say that an executive compensation plan is more likely to be effective if (1) it adequately balances rewarding short-term accomplishments with motivating the executive to consider the firm’s long-term performance, (2) the incentives provided are linked to the firm’s overall strategy (for example, fast growth and risky investments versus moderate growth and low business risks), (3) the board of directors can make informed judgments about how well the executive is fulfilling his or her role, and (4) the executive has some control over the factors used to calculate the incentive amount.99

The board of directors is responsible for setting executive pay. Traditionally, the board members have been paid in cash. In recent years, however, the relative elements of director compensation have changed fundamentally, as we see a shift toward payment in stock and stock options to tie the financial interests of directors to those of the firm and thus increase their incentive to monitor the executives more closely. Currently, the vast majority of firms include at least some stock as part of the annual compensation of directors, with an estimated $60,000 in stock on average per director.100

Although in theory this change in director compensation is a good idea, two well-known researchers warn us that it could be tantamount to the fox watching the chickens. In other words, boards may be tempted to act in a self-serving manner because in most cases the board sets its own compensation.101 For instance, directors may set lower performance targets for the granting of stock options. And even if the board acts in good faith with the best interest of shareholders in mind, the appearance of a conflict of interest would always loom in the background.102

Historically, boards of directors have played mostly a ceremonial role, meeting a few hours a year and seldom challenging the CEO. However, the large number of corporate scandals in recent years as well as the financial troubles of Wall Street giants in 2008–2009; the appearance of unjustifiably high CEO compensation; and passage of the Sarbanes-Oxley Act (which outlines a set of accountability standards for public companies in the areas of financial reporting, disclosure, audits, conflicts of interest, and governance) are forcing boards of directors to become active watchdogs.103 In a cover story, BusinessWeek summarized this dramatic change: “Boards used to be hired as much for their golf handicaps as for any other expertise. They read reports from management, offered occasional bits of advice, and generally greenlit decisions the CEO had already made. These days, they are apt to become involved in key corporate functions, from strategies to succession to auditing. And if there is a difference with the CEO, they will lawyer up in a heartbeat.”104 In a recent report on executive compensation, the Wall Street Journal notes, “Boards flex their pay muscles: directors, facing unprecedented pressure from investors, lawmakers and regulators . . . are retaining their own lawyers, holding frequent executive sessions, and evaluating management rigorously.”105 Following the “Great Recession” of 2008–2012, boards are creating specialized risk-management committees to “anticipate corporate crises, intensify efforts to review risks and dodge disasters.”106 Apparently, the United States is not alone in this respect. In Japan, for instance, after a decade of disappointing corporate results, “oversight of top decisions, from staffing to compensation is now handled by committees governed by a majority of outside directors.”107 One danger with board overzealousness is that executives may try to please boards composed of people with diverse backgrounds, perspectives, and interests rather than use their own best judgment. Boards are probably better at advising than decision making, which is the primary role of the CEO.108

Sales professionals, working with the marketing staff, are responsible for bringing revenues into the company. There are several reasons why setting up a compensation program for salespeople is so much different from setting up compensation programs for other types of employees.109

• ▪ The spread in earnings between the lowest-paid and highest-paid salespeople is usually several times greater than the earnings spread within any other employee group in the company.

• ▪ The reward system for salespeople plays a supervisory role because these employees generally operate away from the office and may not report to the boss for weeks at a time.

• ▪ Perceptions of pay inequity are a lesser concern with this group than with others because few employees outside the company’s marketing organization have knowledge of either sales achievement or rewards.

• ▪ Sales compensation is intimately tied to business objectives and strategies.

• ▪ The performance variation among salespeople tends to be quite large. Most organizations rely on relatively few stars to generate most of the sales.

• ▪ The salesperson generally works alone and is personally accountable for results.

• ▪ Accurate market data on pay practices and levels are extremely difficult to find for salespeople, and commercial salary surveys are usually unreliable.

• ▪ The positive motivational impact of compensation plan designs is based largely on the accuracy of sales goals and forecasts.110

Sales professionals may be paid in the form of straight salary (with no incentives), straight commission (in which all earnings are in the form of incentives), or a combination plan that mixes the two. Straight salary is most appropriate when maintaining good customer relations and servicing existing accounts are the key objectives, with increased sales a secondary goal. Straight commission is most appropriate when the key objective is to generate greater sales volume through new accounts. Only one-fourth of all firms use either a straight-salary or straight-commission method. Three-quarters use a combination of the two, though the relative proportion of salary versus incentives varies widely across firms. The trend has been to put more emphasis on commissions in a mixed plan.111

As Figure 11.7 shows, all three sales compensation methods have their pros and cons. The main criterion that should determine the type of plan chosen is overall marketing philosophy, which is derived from the firm’s business strategies.112 If increased sales is the major goal and these sales involve a one-time transaction with the customer and little expectation of a continuing relationship, then a greater proportion of incentives in the pay mix is appropriate. If customer service is crucial and the sales representative is expected to respond to clients’ needs on a long-term basis, then greater reliance on straight salary is appropriate. For example, used car salespeople are often paid in the form of straight commission, whereas sales representatives for highly technical product lines (which often require extensive customer service) tend to be paid on straight salary.