Executive Compensation Programs: Structure and Components

Introduction: The Rise of Executive Pay

In 1996, the average salary plus bonus for CEOs was $2.3 million. After other benefits were added, this sum rose to $5,781,300. Beginning with Revlon executive Michael Bergerac, who broke the $1 million mark in 1974, executive pay and bonus plans have soared to staggering proportions. Although various governmental agencies have set limits on tax-deductible executive compensation, these efforts not only failed but served to raise the bar on executive compensation even higher (Milkovich and Newman 455). In general, the CEO of a corporation makes at least twice as much as the next highest-paid executive and 35 times the salary of the average worker (Bogie 118). This pay disparity becomes even more alarming when poor leadership causes mass layoffs and shareholder losses even as top executives continue to receive their oversized compensation.

Executive compensation consists of five basic components: (1) base salary, (2) annual incentives and bonuses, (3) long-term incentives and capital appreciation plans, (4) employee benefits, and (5) perquisites (Milkovich and Newman 458). The exact proportion of this mix depends on the executive's position within the organization. For example, CEOs will often have their benefit packages weighted toward long-term incentives, given that their decisions affect the long-term positioning of the organization, while vice presidents' compensation packages will often lean toward short-term incentives (Bohlander, Snell, and Sherman 414).

Components of Executive Compensation

Executive base salaries are usually benchmarked against other executive salaries in the same field. They are typically determined in part by a survey of salaries at comparable companies, commissioned by the board of directors or a compensation committee. In the automotive industry, CEO salaries average approximately $814,000 (Bohlander, Snell, and Sherman 414). Executive base pay also depends on the type and size of the organization and its geographic location. In general, an executive's base pay constitutes approximately 40 to 60 percent of total annual compensation (Mathis and Jackson 479).

When compensation committees are composed of board members, problems can arise because many of these individuals lack expertise in compensation matters. In such cases, the committee often defers to the plan proposed by the CEO, who has typically hired an outside consultant to advise on compensation. According to Graef Crystal, a former compensation consultant, it is considered politically incorrect to ignore the CEO's recommendations: "If things get bad enough, you can fire the CEO. But until you do, you'd better support him. Indeed, about the only time I have seen a board attack a CEO on his pay has been when it has already decided to get rid of him" (Bogie 113).

Short-Term Incentives and Bonus Plans

Short-term performance incentives are based on the executive's individual contribution to the company. These bonuses may be calculated as a percentage of the organization's total profits or as a percentage of profits in excess of a specific return on stockholders' investments. Other plans base the executive's bonus on specific objectives set forth by the board of directors and agreed to by the executive. Like other employees within the organization, executive bonuses may be tied to performance ratings for achievement (Bohlander, Snell, and Sherman 414).

Short-term bonus plans are designed to motivate better performance. Two decades ago, annual bonuses for executives were offered by approximately 38 percent of U.S. organizations; today, that figure is closer to 90 percent. For many industries, these bonuses make up a significant portion of the executive's total compensation — in some cases, as much as 72 percent. For example, in the financial industry, annual bonuses are 2.5 times higher than base pay, yet represent only 38 percent of base pay in the utility industry (Milkovich and Newman 460).