Evaluating executive compensation packages

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Authors: Arantxa Jarque and John Muth
Date: Fall 2013
From: Economic Quarterly(Vol. 99, Issue 4)
Publisher: Federal Reserve Bank of Richmond
Document Type: Article
Length: 10,783 words
Lexile Measure: 1530L

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Executive compensation is a topic that has received attention both in the media and the academic literature. This article discusses issues relevant to the construction and interpretation of compensation figures typically reported in both sources. First, it is not clear what precisely should be included within a measure of the chief executive officer's (CEO's) income tied to his firm. Second, the study of executive compensation remains constrained by the availability of data. We discuss the main source of data used in most studies on the topic: Execucomp. We highlight where the lack of data requires a deviation between a theoretical "ideal" measure of compensation and that which the researcher must use as an approximation. In this way, we hope our article will be a useful first introduction for those looking to do further research on the topic.

We propose a measure of realized annual pay, compare it to other measures used in the literature, and illustrate the difficulties in calculating it. Using data in Execucomp, we provide our pay measure for CEOs of large U.S. firms in the period 1993-2012 and use it to estimate sensitivity of pay to firm performance. The main diff culties in this exercise lie in the fact that compensation packages of most executives include stock and option grants on their own firm's shares, which typically come with requirements that they be held by the executive for at least three or four years. (1) This implies two important things. First, the compensation figures that are reported by firms (and are readily available to the press and researchers) are a combination of both expected value of compensation (for deferred compensation in the form of restricted stock and option grants that are not convertible into cash right away) and realized value (salaries, bonus payments, and perks). Second, a given year's compensation package provides income for several years to follow, since the CEO will be able to realize gains from selling and exercising stock and option grants once their vesting restrictions expire. That is, an important part of the annual realized pay of a CEO in any given year comes from his net gains from trading stock that he received in a past grant. Due to the fact that stock price realizations may differ from ex-ante expectations of those prices, the ex-post realized gains from those trades will typically differ from the valuation made at the time of the grant.

A measure of what is sometimes called direct compensation (the sum of salary, bonus, other compensation such as pension plans or perks, and the value of new stock and option grants during the year) is readily available in Execucomp (variable TDC1). (2) As we just discussed, grants included in this measure are valued in expectation. Our objective in this article is to provide a measure of realized pay instead. We define realized pay as the sum of salaries, bonuses, and other compensation, plus the gains from trades that the CEO realizes in a given year. We will argue that...

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Gale Document Number: GALE|A413337389