What is Executive Compensation in Corporate Governance?

Sep 21, 2021

Executive compensation is a unique pay structure designed to motivate top executives based on job performance and their perceived ability to maximize shareholder value.

As this recent Guardian article noted, the wages of the average American CEO are now 351 times higher than the typical worker, a 1322% rise since 1978.

As the report says, "... The average CEO makes nearly nine times what the average person will earn over a lifetime in just one year... It’s worth remembering that the federal minimum wage would be $24 an hour today had it kept pace with worker productivity, rather than $7.25, where it’s been stuck since 2009."

Why do senior executives earn so much more than the average worker? And are these high wages tied to performance?

The answer to these questions is in the set of high-level policies and processes guiding the activities of corporations, termed corporate governance. Typically championed by a Board of Directors, this set of guidelines determines how much executives earn and why.

What is corporate governance?

Corporate governance is to a firm what a system of government is to a country.

A system of government is a unique structure of rules and processes that guides how power is controlled and shared in a state. Corporate governance is a system of rules and procedures that enable large companies to be managed.

Just as a government system (like democracy) binds people with competing interests together for a common cause, corporate governance ensures the interests and behaviors of a firm's various stakeholders (employees, senior management, shareholders, business partners, etc.) align with the goals of the company.

Firms that prioritize long-term success must embrace good corporate governance policies. Some components of good policies and processes include structures for accountability, ethical and morally conscious practices, and transparency.

And since corporate governance is led by the Board of Directors, a firm's highest governing body, its impact affects the entire organization, including how employees are hired, managed, paid, motivated, or fired. In other words, senior managers only get hefty paydays because their firms' corporate governance enables it.

What is executive compensation?

Executive Compensation is a reward-based payment structure that firms use to incentivize executives. It's typically an addition to their base salary, which isn't dependent on performance.

Executive pay packages are influenced by the compensation committee, which typically includes the firm’s Directors. The committee has to review an executive's compensation and ensure that it's reflective of the firm's corporate governance policies and supports the interests of shareholders.

There are two common types of incentives: short-term incentives and long-term. While short-term is based on annual performances, long-term incentives cover several years and require that the executive positively impact shareholders' returns. Long-term incentives are potentially more lucrative and include mouthwatering opportunities to buy the company's stock.

Executive compensation also includes the special privileges of the office, such as special retirement packages, security fees, hotels, and travel expenses.

But why do firms give executives such lucrative compensation packages?

Is executive compensation an effective corporate governance tool?

In theory, executive pay is the perfect tool for corporate governance. The hypothesis goes, firms that want long-term growth use it because executive compensation is another way to align executive interests with the firm's long-term interests. When this happens, the executive is likely to commit to the cause, stay on the job longer, and advance corporate governance.

But reality hasn't matched these expectations. While executive compensation has soared over the years, many executives have also abused these opportunities.

Reports of execs earning massively while their company suffers financially are all too common and have rightly drawn ire in recent decades. Others exploit corporate governance lapses to enrich themselves.

What is a compensation risk analysis?

And on the part of shareholders, how much an executive truly deserves to earn can be complex to find out.

At a roundtable convened by the Harvard Business Review and the University of Delaware’s Center for Corporate Governance, Ed Woolard, a compensation expert, highlights this:

"Jack Welch likes to say he deserves all this money because he created $400 billion worth of value. But if all the people who owned stock in GE had tried to cash in and enjoy that $400 billion, it would have crashed the stock. Now 60% of that paper value has vanished along with the stock market bubble. I’m not saying that Jack didn’t create a lot of value. Heck, he’s the best CEO in the last 50 years—maybe ever. But he should not be saying he created $400 billion of value."

However, even with the downsides, executive compensation can still be an effective corporate governance tool. Firms that are serious about improving corporate governance can keep trying new tactics to find better compensation solutions, which are raised in this report and this study.