Aggarwal (2008) measure executive
compensation for incentive purposes as the total annual compensation, including
“the annual change in wealth for the executive based on changes in firm value” (Aggarwal 2008: 504). The total
annual compensation is measured in terms of “salary, bonus, new grants of
restricted stock, new grants of stock options, long-term incentive plan payouts,
gross-ups for tax liabilities, perquisites, preferential discounts on stock
purchases, contributions to benefit plans, and severance payments” (Aggarwal 2008).
The latter focuses on the size of the position held by the executive in the
firm. Therefore, it is able to document how well the executive’s interests
align with those of shareholders.
So, how do you translate executive
compensation packages into incentives and how are these desired incentives
determined? Historically, pay-performance sensitivity (PPS) has been used to
capture the relationship between executive pay and firm performance (Jensen and Murphy 1990). Firm
performance is typically calculated in terms of stock- or accounting returns.
PPSs can be calculated using the implicit method where “total annual
compensation (or its logarithm) is regressed on firm performance (measured
either as the dollar change in firm market value or the percentage change in
firm market value)” (Aggarwal 2008: 508). The PPS is the coefficient on firm
performance. However, because the risk of having executive compensation linked
to firm performance is not accounted for, Aggarwal and Samwick (1999) suggest that the previous estimate of
PPS is biased downward (too low?). This is why
an alternative method exists to calculate PPS. Under the explicit method, the
pay-performance sensitivity from stockholdings is denoted by the executive’s
holdings of stock as a fraction of total equity. The pay-performance
sensitivity from options is denoted by the number of shares on which options
are written, divided by the total amount of shares outstanding, multiplied by
the deltas of the options (Aggarwal and Samwick 2003).
The PPS is the sum of the explicit pay-performance sensitivity from stockholdings
and the explicit pay-performance sensitivity from options. (Aggarwal 2008) Next,
how do you determine the incentives? Incentives are generally used with the
goal to maximize shareholder wealth. However, due to the separation of
ownership and control within corporations, managers are less inclined to take
actions that are in the interests of shareholders. This is caused by the fact
that the manager does not own a significant fraction of the firm’s equity. Why
is this the case? “As a measure of firm performance, equity returns are subject
to random fluctuations that are outside of the manager’s control” (Aggarwal 2008:
512). If management were to have full ownership of the equity, the exposure to
risk would be too large. This is why incentives are used to motivate managers
to take the right actions.