A study on Executive Compensation Plans

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Many businesses and leading corporations around the globe have followed creative guidelines in establishing plans for executive compensation for their CEOs, executives and top management team. Efforts to provide realistic means of achieving corporate objectives and rewarding the executives who provided leadership with comparable compensation package have become difficult dilemma for many companies under the backdrop of providing good and reasonable returns to shareholders. Many businesses scramble to attract, retain and motivate top notch human resources have ended up with plans considered overly generous, poorly linked to performance, and poorly controlled.

Events at Enron, WorldCom and the recent financial meltdown and upheaval in corporate America have brought into political and economic discourses about the adverse effect of executive compensation on the financial and capital markets. Under such cloud that in 2005, GE find itself in re-evaluating its executive compensation plan four years after the turmoil following the departure of former CEO and Chairman of the Board Jack Welch.

In spite of showing strong characteristic for sustainable growth, top notch global governance practices, and implementing several important changes to its executive compensation since the arrival of the new CEO and Chairman Jeff Immelt, GE continued to fine-tune its compensation policies amidst criticisms over the objectives and measurement of the scheme. It is seen as too generous and over compensated top executive and management at the expense of shareholder value. To curb criticisms the package was set for a new transformation with company executives rewarded based on new criteria of customer satisfaction, sales, and new ideas - Imaginative Breakthrough proposals - that would enhance customer profitability growth with less emphasis on financial results. These hence became the new GE philosophy behind its development policies for executive compensation plan. The question then becomes whether such plan can or will work to motivate and satisfy the corporate objectives of measurability, fairness, and making all parties aware in advance which are considered as the hall-marks of a good compensation plan for businesses.

Compensation is a significant factor in determining employee job satisfaction. Because pay directly impacts the income of employees. Employees desire compensation plans that are fair and reasonable, which are representative of their skills and knowledge that further their motivation and performance. However, to the company compensation is a significant portion of a company's operating cost. For example, generally compensation contributes a large percent of total expenditures in manufacturing firms and often exceeds the total expenditures in the service industry. Therefore, strategic planning is needed in managing a firm's compensation program in order to simultaneously motivate employee productivity and control labor costs. Firms can manage compensation through both direct and indirect methods, direct compensation includes employee wages, salaries and bonuses. Whereas, indirect compensation includes benefits, and other non-financial forms of compensation, such as recognition programs, work environment.

The right combination of a compensation plan affects the success of a company massively as the executives produce the results of the company and they implement the strategies necessary to achieve the goals and objectives of the company. It is important for the company to make sure that executives are motivated enough to be productive so that the company can attain its desired goals. Companies establish precise goals to merge their company motives with their compensation plans. Frequent goals of strategic compensation planning comprise of rewarding employees past performance, remaining competitive in the labour market, interconnecting employees' future performance with organizational goals, attracting new employees and at the same time reducing turnover. The plan should be designed so that it pays for performance, the focus of the plan should always be on rewarding and paying for performance, results and productivity. There should also be a concern to base some of the plan on what is used throughout the industry but it should always be above average because of executive attraction and retention.

For any compensation plan to succeed over time, it must meet the needs of three critical stakeholders: the employees, the executives and shareholders of the company. A plan should involve all of the three stakeholder's to design the plan. Moreover, a compensation plan should balance rewards for results and effort. Executives who worked hard for results but failed to achieve them based on circumstances outside their control should receive recognition, even if it is not monetary. Also, a compensation plan should identify measures, define targets and track the performance of the executives. Executives should be given a target first and then measure their performance and evaluate whether they achieved it or not. Implementing a new or revised compensation plan requires constant and detailed communication so there is a need to ensure sufficient time is allocated to involve everyone in the design of the program. Also, many organizations also use balanced scorecards as a mean for a compensation plan. This instrument measures customer satisfaction, the ability to innovate and produce quality service leadership.

It may also be appropriate to require the return of compensation in the event of a material earnings restatement or other company specific shock that can significantly reduce shareholder value where the executive had an active involvement in the issue that caused it.

Furthermore, the package should put management stock ownership guideline in place. In order for management to be in the same boat as the shareholders, management should have a downside financial risk as well as an upside opportunity. In order to align the interests of shareholders and senior executives, executives should be required to hold a significant portion of their net worth in shares of the company while employed and for a period of time after leaving. Consideration should also be given to requiring an executive to hold shares issued on the exercise of stock options and to prohibit or limit hedging or pledging of equity positions.

Investors make decisions and judge a company's performance, using the financial statements that is why financial targets should be greatly emphasised. The major source of information to the investors is the financial reporting in the financial statements, that being the should be on the financial targets as that is how investors and stakeholder's measure the performance of the company. Investors have come to realize companies who have growth without profitability or who have profitability without growth are usually less desirable investments. They actually desire both profitability and growth of the company. The main method of long term incentive plans for executives is stock options. Executive stock ownership supports the desire of both the company and outside investors for senior management to have a significant stake in the success of the organization. There are three stock option categories including, stock price appreciation plans, restricted stock and restricted cash plans, and performance-based plans. Companies usually give out options to compete with increasingly tight markets for top labour talent. The stakeholder's should be confident that the executives main aim is to working towards improving the financial results of the company which is why the compensation needs to make sure that the plan incorporates compensation based on financial results.

Executive pay is a major part of an organization's overall compensation initiatives, as it serves to pay the senior leaders responsible for establishing the company's strategic goals and mission. However, compensation plans for executives are different when compared to those of other employees. The general rule is that greater percentage of their compensation should be tied to performance results. Various companies have adopted compensation strategies that tie executive pay to long-term performance measures. Companies realize that while incentive pay for executives may be based on a specific goal, the package must also take into account the performance of the organization as a whole. Performance results that are tied to incentive plans include growth in earnings per share, return on stockholders' equity, and stock price appreciation. Further than financial goals, customer satisfaction and various quality measures can also be used as metrics for executive compensation. Commonly organizations have numerous compensation strategies for executives, allowing the organization to meet various corporate goals, while at the same time addressing executive needs.

GE totally transformed its executive compensation beginning in 2005 and turned towards rewarding executives based on customer satisfaction, sales, and new ideas. Less emphasis would be placed on financial results and more on meeting pre-established measures of how well a business was improving its ability to meet customer needs. GE's new plan was in line to match its growth aspirations which focus externally on creating success in market terms.

Furthermore, the plan desired them to be clear thinkers who can simplify strategy into specific actions, make decisions and communicate priorities. The executives are expected to have a strong team that have sagaciousness and courage to take risks on people and ideas. They should energize teams through inclusiveness and connection with people, building both loyalty and

commitment and develop expertise in a function or domain, using depth as a source of confidence to drive change.

General Electric's new strategy to compensate the managers based on the metric of customer satisfaction may prove difficult to measure as it will require customers to provide feedback on the items purchased. This type of compensation method may turn out to be rather subjective as most customers typically only provide feedback when they are displeased with a product. There may be different criterion set to determine the customer satisfaction, product returns and warranty claims for instance.  A fairer method to base executive compensation on will be the one that indirectly relates to customers' feedback. Warranty claims and product returns are appropriate criteria that recorded in a company's financial accounting system and give a fair assessment of customer satisfaction and product quality.  The warranty claims and product returns are incorporated into financial statements; they are related to direct performance of the managers, which justify as a criterion of compensation plan. However, the cost of measuring the performance and determination of customer satisfaction should not exceed the benefits yield.

GE's new initiative is devoid of qualitative financial target which would offer some level of measurability of executive performance. It should put effort into development or obtaining a database to measure financial performance against industry standard and other benchmarks to see its success.

The corporate goal of GE's executives is to flourish and stem in different geographical areas while maintaining organic growth of 8%. Managers and employees are compensated for proposing various feasible ideas, which help to achieve the goals. The executives are compensated based on implementation of new feasible ideas, which assist in the proliferation of the business, which is directly complicit with the corporate goals and objectives. By the virtue of this type of compensation plan, it is a type of deferred compensation plan much like Mr. Immelt's PSU (Performance Share Unit) compensation.  The compensation is deferred until the results of the implemented ideas are revealed, enticing the executives to stay with GE.  In addition, it encourages strong leadership and stewardship and fiduciary responsibility, because of deferred compensation effectively requires executives to stay with GE until the results.  This is the case because this type of compensation is also tied to the fact that each idea must result in incremental growth for GE of $100 million.  As growth of $100 million dollars may take a few fiscal years, GE is assured that its top executives will remain with the company. Moreover, the executives will tend not to implement those ideas that are not feasible, because the deferred compensation plan prompt them to be associated with GE.

GE's PSU (Performance Share Units) serve as an attractive method of motivating top executives as they are only exercisable if specific financial performance metrics are achieved over five consecutive years.  The use of a PSU does have the benefit that it requires that annual cash flows to increase by 10% over a five year period and that total shareholder return be greater than that of the S&P 500 over the same five year period. Conversely, PSU's have a major flaw as there are systematic risks associated with it; it can galvanize intentional manipulation of cash flows. These are risks which can be averted by enforcement of stringent effective internal control, which requires significant contribution of resources. The use of a PSU may not be the appropriate compensation for GE's executives due to existence of systematic risk, which will attenuate management's efforts to maintain an annual cash flow growth of 10%.  Therefore, PSU compensation will not help to motivate the management and thus not maximize shareholder's return.   

In spite of the GE's assiduous growth over the last few years, they have been castigated on their executive compensation plan. The general insinuation is that the executives were excessively paid relative to their performance. One of the major reasons was to retain the CEO of the company as they were incumbent while the company started to progress, subsequent to a great turmoil. The modification came about after CEO Jeff Immelt took charge; he surrogated restrictive stock units (RSU) with performance stock units (PSU), they were bequeathed upon fulfillment of the performance criteria. Often the executives were awarded despite poor performance of the company. The new compensation plan are long term in nature and are based on achievement of certain earning per share growth and increase in working capital.

These modifications incepted on the basis, contrary to the previous basis, as the main objective was to retain the CEOs in the retrospect, Immelt changed it to the direct performance of the CEO. In the retrospect, the executives exploit the rights and authorities- compensating themselves more despite the poor performance. The modified compensation plan, provide opportunities to the executives to not only to retain in the company but also to perform at par and yield their performance benefits over longer period of time. The stocks are not awarded until certain performance criteria are met- linking the compensation directly to the share price.

Another consolidation modification was conversion of PSU to GE shares, which are only allowed if the operation cash flow is increased by 10 percent for five years. This conjunction encourage the management to perform consistently over longer span of time and to stay with the company to reap the benefits.

The awareness of these compensation plan modification will help to acknowledge the existence of fiduciary responsibility, among the investors. Many organizations are concerned with the growing gap of pay between top-level executives and employees. This growing gap threatens the credibility of leadership within an organization.

The compensations are recorded in the financial statements that are easily traceable for the investors; compensation plan can become very controversial if inappropriate. Investors are very concern of executive compensations especially when the company's performance is not commendable. Compensation is an imperative tool to motivate employees to perform, and to drive them in accordance with the strategic corporate goals. The modification by Immelt eradicated short term benefits for employees and injected long term benefits to those who perform consistently over a considerable time. It will help to retain employees for longer period of time and prevent reap of benefits on short term basis. The employees are required to show assiduous effort to yield excessive compensation.

Conversely, the introduction of PSUs in compensation plan stipulates the increase of operating cash flow at the rate of 10 percent for five years to reap the benefits. This intervention will assist in retaining human capital; however such stringent policies may hinder the effort, thus the performance- due to its implausibility. The increased emphasis on the non-financial criteria such as customer satisfaction and creation of new business ideas, for compensation, can adversely affect the future financial results. As the energy and efforts are deviated to customer satisfaction and creation of business ideas, the performance related to financial outcomes will be significantly affected. The creation and implementation of new business lines will affect the original business operation due to dichotomy of effects and focus. The expectation of the executives to implement new business lines and take risks can also be counterproductive due their prudency. The proposition of new ideas and its feasibility can be easily sighted, however the operation and implementation may result as counterproductive. Therefore, we believe that the new compensation plan proposed by Immelt is quite efficient to solve problems countered by GE in the retrospect; it will however propel loopholes that executives can take advantage of. It is incomprehensive as all the aspects are not covered to motivate the executives and to accomplish strategic corporate goals.