The principles of performance evaluation described in the previous sections also apply to executive compensation plans. These plans are based on both financial and nonfinancial performance measures and consist of a mix of (1) base salary; (2) annual incentives, such as a cash bonus based on achieving a target annual RI; (3) long-run incentives, such as stock options (described later in this section) based on a stock’s performance over, say, a 4-year period; and (4) other benefits, such as medical benefits, pension plans, and life insurance.
Well-designed plans use a compensation mix that balances risk (the effect of uncontrollable factors on the performance measures and hence compensation) with short-run and long-run incentives. For example, an evaluation based on a firm’s annual EVA sharpens an executive’s short-run focus. Using EVA and stock option plans over, say, 4 years motivates the executive to take a long-run view as well.
Stock options give executives the right to buy company stock at a specified price (called the exercise price) within a specified period. Suppose that on July 1, 2019, Hospitality Inns gave its CEO the option to buy 200,000 shares of the company’s stock at any time between June 30, 2023 and June 30, 2026, at the July 1, 2019, market price of $49 per share. Let’s say Hospitality Inns’ stock price rises to $69 per share on March 24, 2024, and the CEO exercises options on all 200,000 shares. The CEO would earn $20 per share on 200,000 shares, or $4 million. Alternatively, if Hospitality Inns’ stock price stays below $49 during the entire 7-year period, the CEO will simply forgo the right to buy the shares. By linking CEO compensation to increases in the company’s stock price, the stock option plan motivates the CEO to improve the company’s long-run performance and stock price.
The Securities and Exchange Commission (SEC) requires detailed disclosures of the compensation arrangements of top-level executives. For example, in 2019, Hyatt Hotels Corporation, one of the world’s leading hospitality companies, disclosed a compensation table showing the salaries, bonuses, stock options, stock awards, and other compensation earned by its top five executives during the 2016, 2017, and 2018 fiscal years. Hyatt also disclosed the peer companies it uses to set the pay for its executives and conduct performance comparisons. These companies include competitors in the hospitality industry such as Hilton, Marriott, and Wyndham. The list also includes companies with similar revenues, brand strength, global presence, or business models, as well as firms with which Hyatt competes for executive talent. Examples are Carnival, Starbucks, and Wendy’s. Investors use this information to evaluate the relationship between compensation and performance across companies generally and across companies operating in similar industries.
SEC rules require companies to disclose the principles underlying their executive compensation plans. In its financial statements, Hyatt describes some of its compensation principles. They include motivating through the alignment of total rewards with performance goals; offering compelling opportunities in order to attract, retain and develop talent globally; and staying cost effective and financially sustainable over time. The SEC also compels companies to disclose the performance criteria—such as a firm’s profitability, revenue growth, and market share—used to reward executives. Hyatt uses adjusted earnings before interest, tax, depreciation, and amortization (EBITDA), relative to goal, as the primary basis for annual incentive pay, and performance on metrics tied to four strategic priorities as the secondary basis. The Compensation Committee of the board of directors then reviews each executive’s contributions on individual metrics related to areas of responsibility in setting the final pay award. Hyatt also provides long-term equity-based incentives tied directly to both the company’s stock price performance (e.g., grants of restricted stock) and multiyear adjusted EBITDA goals. For fiscal years starting in 2017, the SEC has mandated an additional disclosure for public companies—the ratio of the CEO’s annual total compensation to that of the median employee. For 2018, Hyatt reported a ratio of 356 (the average ratio across the S&P 500 was 287 to 1).
The Dodd-Frank law was passed in 2010 in response to the financial crisis of 2007–2009 and requires companies to provide shareholders with an advisory (nonbinding) vote on executive compensation. These “say-on-pay” votes must be held at least once every 3 years. This law has reshaped the way companies create, disclose, and communicate their executive compensation policies. To date, however, they have not slowed down growth in executive pay or indicated much shareholder dissatisfaction with compensation plans. In 2018, a record 2.5% of the Russell 3000 companies failed their say-on-pay votes. However, this number is still relatively small, and over 76% of companies received greater than 90% support.