Aggarwal (2008) measure executivecompensation 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 totalannual compensation is measured in terms of “salary, bonus, new grants ofrestricted stock, new grants of stock options, long-term incentive plan payouts,gross-ups for tax liabilities, perquisites, preferential discounts on stockpurchases, contributions to benefit plans, and severance payments” (Aggarwal 2008).The latter focuses on the size of the position held by the executive in thefirm. Therefore, it is able to document how well the executive’s interestsalign with those of shareholders.So, how do you translate executivecompensation packages into incentives and how are these desired incentivesdetermined? Historically, pay-performance sensitivity (PPS) has been used tocapture the relationship between executive pay and firm performance (Jensen and Murphy 1990). Firmperformance is typically calculated in terms of stock- or accounting returns.PPSs can be calculated using the implicit method where “total annualcompensation (or its logarithm) is regressed on firm performance (measuredeither as the dollar change in firm market value or the percentage change infirm market value)” (Aggarwal 2008: 508). The PPS is the coefficient on firmperformance. However, because the risk of having executive compensation linkedto firm performance is not accounted for, Aggarwal and Samwick (1999) suggest that the previous estimate ofPPS is biased downward (too low?).
This is whyan alternative method exists to calculate PPS. Under the explicit method, thepay-performance sensitivity from stockholdings is denoted by the executive’sholdings of stock as a fraction of total equity. The pay-performancesensitivity from options is denoted by the number of shares on which optionsare written, divided by the total amount of shares outstanding, multiplied bythe deltas of the options (Aggarwal and Samwick 2003).
The PPS is the sum of the explicit pay-performance sensitivity from stockholdingsand the explicit pay-performance sensitivity from options. (Aggarwal 2008) Next,how do you determine the incentives? Incentives are generally used with thegoal to maximize shareholder wealth. However, due to the separation ofownership and control within corporations, managers are less inclined to takeactions that are in the interests of shareholders. This is caused by the factthat the manager does not own a significant fraction of the firm’s equity. Whyis this the case? “As a measure of firm performance, equity returns are subjectto 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 torisk would be too large. This is why incentives are used to motivate managersto take the right actions.