At Work

What you should know about executive pay

President Barack Obama delivering remarks on n...

I'll never be overpaid (unless I can ge that rap thing going).

During the liberal left enlightenment we have become obsessed with executive pay, the wealthy, millionaires and billionaires, all 400 or so of them.  During the health care debate you were told the pay of health insurance executives was a cause of high premiums (utter nonsense by the way). Notably absent from the target wealthy were the  entertainment and sports elite and their multimillion dollars pay days, lavish life styles, private planes along with a few college presidents and football coaches who earn over a million dollars a year. Don’t get me wrong, if you can make millions dunking a ball into a net or singing garbage mouth “music” that demeans women and any other rational person, more power to you.  It’s not them who are dumb.

Before we continue let me say some executives are overpaid, some are greedy and most receive extra compensation in the form of bonuses for work that should be part of their job in the first place. In addition, in many cases the assessment for meeting incentivized goals is questionable at best. But if you think about it, that is true for most of us only on a smaller scale. Building up OT, extra long breaks, calling in sick or just goofing off on the job are all forms of over compensation.

However, whether or not an executive is overpaid is a problem for the organization’s board of directors and its shareholders. They must determine if they are getting value for their money, if performance is reflected in their investments and what it takes to attract and retain the executives they want to run the company. Relatively few executives receive the headline grabbing $100 million payouts and most of the reported compensation packages are misleading because they include far more than what most of us think of as pay, in other words all those big bucks are not in the paycheck. Regardless of an executive’s pay, it has an insignificant effect on the cost of products and services or health insurance premiums.

I know all this because I was a VP of Compensation and Benefits for a Fortune 500 company where I drafted and negotiated employment contracts and designed compensation plans for executives and below.

Where did it come from?

If you are going to be envious of or just disgusted with executive pay you should know what it is. Aside from the few hedge fund managers who make the occasional billion, most corporate compensation packages are made up of several components which may include all or several of the following: base pay, deferred compensation, stock options, restricted shares, supplemental pensions, bonuses, performance shares and the like.

When you look at all this stuff you see that the majority of compensation is not cash in the paycheck and most is deferred to a future payout which may or may not occur. In theory at least and if administered correctly the big payout will come with the growing success of the company which benefits shareholders and ultimately all employees.

Stock options give the executive the ability to convert options into stock in the future at a fixed price and benefit from the gain. Let’s say I give you 1,000 options to buy XYZ stock at $50 a share any time after three years have lapsed, but after ten years they expire and are worthless. How much did I give you? For you to receive any value the price of the stock must be above $50 when you exercise the shares during the period between three years after you receive the options and when they expire. For you to benefit you must help create value for all shareholders. So, what may appear to be $50,000 in compensation will only be that amount if the price of the stock doubles (benefiting all shareholders).

Other forms of stock compensation (restricted shares, performance shares) do provide immediate value, but the number of shares actually given to the executive depend on meeting both short and long-term performance goals typically tied to the company’s results such as earnings per share, return on investment, total shareholder return or something like that; often comparing results with other companies in an industry. In addition, there are vesting periods of several years before the executive has a right to the shares of stock.

Deferred compensation is often reported as part of the compensation package too, generally when an executive leaves a company, but deferred compensation is just what it says, it is money earned, but not taken by the employee. Instead it is deferred to some future date. Let’s say you earn $50,000 a year but tell your employer to defer $5,000 each year. Since the employer is using the money he would otherwise pay you, he is going to pay you interest.  At some point when you leave the employer, you will receive your money plus the interest.  During the period you are still employed, there is no guarantee you will ever be paid as the money now held by the employer is subject to creditor demands and if the employer gets into financial trouble all your deferred compensation is lost.  Sound like a good deal?  Most of the time it is and it defers paying income taxes, but given the likely trend in tax rates, money paid at some point in the future may pay a higher tax.

There is one other major element in executive pay and that is pensions.  Because of federal limits on the amount that can be paid from a qualified pension plan, most large corporations provide a supplemental reinstatement pension plan to allow an executive to receive a pension using the same formula used for other employees, some of which may be above IRS limits because of their pay.  Compensation above $250,000 per year cannot be counted when funding a qualified pension plan and no pension from a qualified plan can be above $200,000 a year.  When you hear about huge payouts upon an executive retiring that amount will include the present value of the pension earned by the executive even though it will most likely be paid over his or her lifetime. For example, let’s say you have a pension of $3,000 a month and you retire at age 62.  The lump sum value of that pension based on current annuity rates is about $546,000.  Of course if you were earning a million dollars a year and your pension was a million dollars a year the lump sum value would be about $15,000,000.  That is the amount you will hear about as part of their total compensation.  Keep in mind that if the retired executive dies within a short time of leaving the employer, he may never receive the total amount promised. Oh, about that fair share thing, in addition to normal income taxes on their pension, the person receiving one of these special pensions must pay Social Security and Medicare taxes in advance on the lump sum value of the pension even if they don’t live to receive the full value. In our example, that amount is $217,500.

That is a simple explanation of executive compensation.  The reality is the subject is immensely complicated and subject to rules and regulations from a variety of federal departments. Legions of consultants, tax advisors, and lawyers make a living from advising corporations about executive compensation matters.

Between base pay, cash bonuses, stock award and retirement benefits some executives receive a great deal of compensation, a great deal. One could argue that they are overpaid and in many cases they are, but does that mean their pay should be the business of the federal government beyond compliance with the scores of applicable laws?  Should executive pay be used by politicians to foster their own agendas and mislead Americans as to the implications of this compensation?

If a person in business earning a total of $10,000,000 a year is a problem, then we should also have a problem with movie stars, sports stars and anyone else who earns an amount that makes them stand out among us mortals.  It’s not easy to accept that any one person can be worth $10 million a year in compensation when the average family income is around $50,000.  These folks are an easy target, they make for good rhetoric and needless to say most of us would like to earn a tenth of what they do.

However, don’t be fooled by the class baiting we are seeing in politics today. It’s not what someone else has earned that matters, it is what opportunities you have to do the same that matters.  Most of the wealthy in this Country earned their wealth whether we agree with their value added or not. And most of the highest net worth Americans got that way through increasing stock value, and they brought along millions of average people with them.

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2 replies »

  1. Well done Dick. The concept of varied and balanced components is a “win-win”. Don’t forget that Total Compensation includes employee benefits too, something often taken for granted.

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    • Right you are. As an aside, most people don’t understand how much of their “pay” is now consumed by what an employer has to pay for health care benefits.

      Like

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