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This document contains Chapters 11 to 12 CHAPTER 11 Legally Required Benefits Learning Objectives 1. In a historical context, discuss at least two main reasons why the U.S. government required certain employee benefits. 2. Summarize three main components of legally required benefits. 3. Indicate the main benefits and costs of legally required benefits. 4. Summarize the five fundamental objectives of employee benefits program design. Outline I. An Overview of Legally Required Benefits II. Components of Legally Required Benefits A. SSA B. Unemployment Insurance C. OASDI D. Medicare E. State Compulsory Disability Laws (Workers’ Compensation) F. FMLA III. The Benefits and Costs of Legally Required Benefits IV. Designing and Planning the Benefits Program A. Overview B. Determining Who Received Coverage C. Financing D. Employee Choice E. Cost Containment F. Communication V. Discussion Questions and Suggested Answers VI. End of Chapter Case; Instructor Notes, and Questions, and Questions and Suggested Student Responses VII. Additional Cases from the MyManagementLab Website; Instructor Notes, and Questions and Suggested Student Responses Lecture Outline I. An Overview of Legally Required Benefits 1. Established to protect individuals from catastrophic events a. Disability b. Unemployment 2. Protection programs to: a. Promote worker safety and health b. Maintain family income streams c. Assist families in crisis d. Enable retirees to maintain subsistence income levels 3. Provided a form of social insurance 4. Reasons for implementation a. Rapid growth of industrialization in early 1900s b. Hardships caused by the Great Depression in the 1930s 5. Apply to virtually all U.S. companies a. Does not factor directly into a competitive advantage b. Can indirectly promote competitive advantage i. Enables unemployed and disabled individuals and their families to participate in economy as consumers ii. Helps promote a vigorous economy 6. As of September 2012, U.S. companies spent an average of $4,950 annually to provide legally required benefits II. Components of Legally Required Benefits A. SSA 1. Historic background a. Great Depression lead to chronic unemployment b. Chronic unemployment caused further hardships on U.S. economy c. Companies forced to shift focus from just profits to staying solvent d. SSA allowed the unemployed and injured to contribute to the U.S. economy by continuing to purchase goods e. Chronic unemployment also prevented workers from being able to save for retirement and medical insurance, but the SSA provided these workers with subsistence levels of both 2. Programs a. Unemployment Insurance b. OASDI c. Medicare B. Unemployment Insurance 1. For those unemployed through no fault of their own 2. States administer within federal parameters 3. States pay into a (federal) central unemployment fund, federal government invests, then disburse funds back to states 4. Does not cover most agricultural or domestic workers 5. Criteria to qualify for benefits a. Varies from state to state b. In general, workers must have been employed for a minimum period of time before filing a claim (base period) c. Base period tends to be the first four of the last five completed calendar quarters immediately prior to becoming unemployed d. Workers’ have to make a minimal amount of income (around $1,000) during the previous four calendar quarters e. Must not have left job voluntarily f. Must be able and available for work g. Must be actively seeking work h. Must not have refused an offer for work i. Must not be unemployed because of a labor dispute j. Must not be fired because of gross misconduct 6. Benefits a. Based on a weekly schedule b. States vary amounts c. Amounts generally calculated as a fraction of the workers’ weekly earnings during the highest quarter of the worker’s base period d. Unemployed individuals usually collect unemployment insurance benefits for several weeks i. Since 1972, the average duration of benefits has ranged between twelve and eighteen weeks ii. The average duration refers to the mean number of weeks for which unemployment insurance claimants collect benefits under regular state programs e. Legislation after deep economic recession beginning in late 2007 i. The Emergency Unemployment Insurance (EUC) Program of 2008 provided thirteen additional weeks of federally funded unemployment insurance benefits to the unemployed who had exhausted all state unemployment insurance benefits for which they were eligible ii. The Unemployment Compensation Act of 2008 expanded the EUC benefits to twenty weeks nationwide (from thirteen weeks) and it provided for thirteen more weeks of EUC (for a total of thirty-three weeks) to individuals who reside in states (such as Michigan) with high unemployment rates iii. This temporary program was extended three times, most recently in January 2013 under the American Taxpayers Relief Act of 2012 iv. Under the extension, unemployment insurance benefits are available to individuals for weeks of unemployment ending on or before January 3, 2012. The number of weeks for which an individual is eligible to receive unemployment insurance benefits depends upon the unemployment rate of the state in which unemployed individual resides v. Under the extension, unemployment insurance benefits are available to individuals for spells of unemployment ending on or before January 1, 2014 7. Financed by federal and state taxes levied on employers under the Federal Unemployment Tax Act (FUTA) a. Exempt from FUTA i. State and local governments ii. Not-for-profit companies b. Employers contribute 6.2 percent of first $7,000 of each worker’s wages i. 5.4 percent is disbursed to states ii. 0.8 percent covers administrative costs and to maintain a reserve to bail out states with very low balances in their accounts c. States set the taxable wage base according to the average wage level -in 2013, states’ taxable wage base ranged from $7,000 to $39,800 d. The more a company lays-off workers, the more tax the company must pay - experience rating system i. A company that lays-off a large percentage of employees will have a higher tax rate than a company that lays off relatively few or none of its employees C. OASDI 1. Amendments a. Old age (retirement) was in the original bill b. Survivor benefits added in 1939 c. Disability insurance in 1965 2. Three classes of workers exempt from Social Security Administration a. Civilian employees working for federal government, and railroad workers with over ten years of service b. Workers for state or local governments covered by other retirement plans c. Children i. Younger than age 21 who work for a parent ii. Except those 18 years and older who work in parent’s business 3. Old age (retirement) benefits a. Determined by how much credit each worker has earned i. Based on “quarters of coverage” ii. Through eligible payroll deductions b. In 2013, a worker earns credit for one quarter of coverage for each quarter in which she makes $1,160 of Social Security taxable income c. Will be fully insured after earning credit for 40 quarters of coverage, or 10 years of employment d. Once eligible, individuals remain fully insured during their lifetime e. To receive benefits, the retired worker must: i. Be at least 62 years of age to receive reduced benefits ii. Be at least 65 years of age to receive full benefits iii. The U.S. Bureau of Census estimated that individuals age 65 in 1997 would live and additional 17.7 years and in 2007, this estimate increased to 22.5 years iv. Between 2000–2022 age will increase to 67 (to receive full-benefits) v. The average monthly benefit for all retired workers was $1,261 in 2013 vi. The Social Security Administration increases retirement benefits by a designated percent of each month worked beyond full retirement until age of 70 (subject to maximum percentage increase)
• Example: Let’s assume that an individual’s full retirement age is 66 years and his benefit at that age is $1,000. His monthly benefit would be $750 if he were to take retirement at 62. His monthly benefit would be $1,320 if he were to delay his retirement until age 70.
4. Survivor benefits a. Based on insured’s employment status and survivor’s relationship to deceased i. Spouse (at least age 60) ii. Dependent, unmarried children iii. Parent (at least age 62) b. Deceased must be fully insured for dependents to receive full benefits c. In 2013, the average monthly benefit was $1,214 5. Disability benefits a. Worker must be fully insured when disabled b. Two criteria for seriously disabled workers: i. Worker must have accumulated at least 40 credits ii. Worker must have earned at least 20 credits of the last 40 calendar quarters in the last 10 years ending with the year of disablement c. Worker must be disabled for at least a year, or the injury diagnosed as terminal d. In 2013, $1,132 average monthly disability D. Medicare 1. For citizens at least 65 years of age 2. To provide them with insurance coverage for: a. Hospitalization b. Convalescent care c. Major doctor bills d. Prescription drug costs 3. Five Separate Plans a. Medicare Part A—hospital insurance b. Medicare Part B—medical insurance c. Medigap—voluntary supplemental insurance to pay for services not covered in Parts A and B d. Medicare Part C: Medicare Advantage—choices in health care providers, such as through HMOs and PPOs e. Medicare Part D: Medicare Prescription Drug Benefit—prescription drug coverage 4. Part A a. Compulsory hospitalization insurance b. Covers: i. In/out patient hospital care and services ii. Skilled nursing facility iii. Some home health care c. Those eligible include: i. Social Security beneficiaries ii. Retirees iii. Voluntary enrollees iv. Disabled individuals d. Financed by both employer and employee contributions of 1.45 percent of all earnings e. In 2013, the monthly Part A premium was $441
• Example: Medicare Part A Coverage Inpatient hospital care in a semiprivate room, meals, general nursing, and other hospital supplies and services. Home health services limited to reasonable and essential part-time or intermittent skilled nursing care and home health aide services, and physical therapy, occupational therapy, and speech-language pathology ordered by a doctor. Skilled nursing facility care, including semiprivate room, meals, skilled nursing and rehabilitative services, and supplies for up to 100 days per year. Examples of skilled nursing care include physical therapy after a stroke or serious accident.
5. Part B a. A voluntary supplementary medical insurance i. An annual deductible ii. Covers 80 percent of physicians’ services and medical supplies b. Pays for medical care such as doctors’ services, outpatient care, clinical laboratory services (e.g., blood tests, urinalysis) and some preventive health services (e.g., cardiovascular screenings, bone mass measurement), and ambulatory services when alternate transportation would endanger one’s health c. Part A coverage automatically qualifies an individual to enroll in Part B coverage for a monthly premium d. Enrollees’ monthly premiums (in 2013, ranged from $104.90 to $335.70) 6. Medigap insurance a. Supplements Parts A and B b. Available through private insurance companies c. Federal and state laws limit plans to ten standardized choices d. Medicare Select offers lower premiums in exchange for limiting the choice of providers e. Three states do not subscribe to this system for offering Medigap insurance i. Massachusetts ii. Minnesota iii. Wisconsin 7. Part C or Medicare + Choice a. Established as part of the Balanced Budget Act of 1997 b. Also known as Medicare Advantage c. An alternative to Parts A and B d. Allows beneficiaries the opportunity to receive health care from a variety of options i. Private fee-for-service plans ii. Managed care plans iii. Medical savings accounts e. Fee-for-service plans provide protection against health care expenses in the form of cash benefits paid to: i. The insured ii. The health care provider f. Managed care plans often pay a higher level of benefits if approved providers are used 8. Part D or Medicare Prescription Drug Program a. Instituted in 2003, with passage of the Medicare Prescription Drug, Improvement and Modernization Act b. Effective in 2006 c. Covers 75% of prescription drug costs after the enrollee pays the $295 deductible, up to $2,930 in 2013 d. After that, expenditures up to $4,750 are not covered and all costs are “out of pocket” e. This gap is known as the “donut hole” f. Pays 95 percent after enrollees total $4,750 of out-of-pocket expenditures g. The Patient Protection and Affordable Care Act of 2010: i. many provisions to make health care more affordable ii. this law will slowly eliminate the “donut hole” coverage gap over several years iii. In 2011, Medicare participants who reached the coverage gap received a 50 percent discount on brand-name prescription drugs iv. Additional savings will be provided each year to eliminate “donut hole” coverage gap 9. Financing OASDI and Medicare programs a. Requires equal employer and employee contributions under the Federal Insurance Contributions Act (FICA) b. FICA requires that employers pay a tax based on their payroll c. Employees contribute a tax based on earnings, which is withheld from each pay check d. Self-Employment Contributions Act (SECA) requires that self-employed individuals contribute to the OASDI and Medicare programs, but at a different tax rate e. The tax rate is subject to an increase each year in order to fund OASDI programs sufficiently f. FICA requires employers and employees to contribute 7.65 percent each; self-employed individuals generally pay twice that amount, or 15.3 percent in 2013 g. The largest share of the FICA tax funds OASDI programs h. In 2013, 6.20 percent of the contributions of employers and employees were set aside; self-employed individuals contributed 12.40 percent i. OASDI taxes are subject to a taxable wage base j. Taxable wage bases limit the amount of annual wages or payroll cost per employee subject to taxation and may increase over time to account for increases in the cost of living k. In 2013, the taxable wage base was $113,700 for everyone l. Annual wages, payroll costs per employee, and self-employed earnings above this level were not taxed m. Medicare tax, or hospital insurance tax, supports the Medicare Part A program n. Employers, employees, and self-employed individuals contribute 1.45 percent; self-employed individuals contribute double the amount, or 2.9 percent o. The Medicare tax is not subject to a taxable wage base—all payroll amounts and wages are taxed p. Beginning in 2013, an additional HI tax of 0.9 percent is assessed an earned income i. exceeding $200,000 for individuals ii. $250,000 for married couples filing jointly q. Under the new projections for the OASDI program, there should be sufficient resources to pay full retirement benefits until through 2033 r From 2034 through 2086, the OASDI program will be able to pay only 75 percent of recipients’ annual benefits s. The disability insurance program trust fund is projected to be exhausted in 2016 t. Medicare program’s financial status is stronger than the other programs because the HI tax will increase for high-income individuals beginning in 2013 u. It is expected that there will be sufficient funding to meet benefits obligations through 2024 E. State Compulsory Disability Laws (Workers’ Compensation) 1. First law enacted in 1911 2. By 1920, all but six states had laws 3. Based on the principle of “liability without fault” a. Employer is liable for providing benefits that result from occupational disabilities or injuries regardless of fault b. Employers should assume costs of occupational injuries and accidents as a cost of production 4. Program run by states a. Compulsory in 49 states b. Elective in Texas, where employers’ are not required to provide workers’ compensation insurance 5. Maritime, federal civilian, agricultural, and small businesses (less than twelve employees) are not covered a. Maritime workers are covered by the Longshore and Harborworkers’ Compensation Act b. Federal civilian workers are covered by the Federal Employees’ Compensation Act 6. Workers’ compensation objectives and obligations a. Provide sure, prompt, and reasonable income and medical benefits to work-accident victims, or income benefits to their dependents, regardless of fault b. Provide a single remedy and reduce court delays, costs, and workloads arising out of personal injury litigation c. Relieve public and private charities of financial drains d. Eliminate payment of fees to lawyers and witnesses as well as time-consuming trials and appeals e. Encourage maximum employer interest in safety and rehabilitation through appropriate experience-rating mechanisms f. Promote frank study of causes of accidents (rather than concealment of fault), reducing preventable accidents and human suffering 7. Financing the program a. According to state guidelines b. Options i. Private carriers ii. State funds iii. Self-insurance c. Self-insurance plans i. Requires companies to deposit a surety bond ii. Companies pay their own workers’ claims directly iii. Gives employers greater discretion in administering their own risks iv. Benefits must be similar to other plans 8. National Commission on State Work mens’ Compensation Laws (NCSWCL) specifies six primary obligations of the program a. Take initiative in administering the law b. Continually review performance of the program and be willing to change procedures and to request the state legislature to make needed amendments c. Advise workers of their rights and obligations and assure that they receive the benefits to which they are entitled d. Appraise employers and insurance carriers of their rights and obligations; inform other parties in the delivery system (e.g., health care providers) of their obligations and privileges e. Assist in voluntary and informal resolution of disputes that are consistent with the law f. Adjudicate claims that cannot be resolved voluntarily
Workers’ Compensation versus Social Security Benefits: Workers’ compensation pays for medical care for work-related injuries beginning immediately after the injury occurs, and it pays temporary disability benefits after a waiting period of three to seven days. Social Security, in contrast, pays benefits to workers with long-term disabilities from any cause, but only when the disabilities preclude work. Also, Social Security begins after a five-month waiting period and Medicare begins twenty-nine months after the onset of a medically-verified inability to work.
9. Recent trends in workers’ compensation a. Number and amount have increased dramatically b. The dramatic increase in repetitive strain injuries is a major cause of increases c. In 2012, workers’ compensation cost nearly 19 percent of all legally required benefits for all civilian employees 10. Employers’ rights under workers’ compensation programs a. Participation in workers’ compensation programs and compliance with applicable regulations protects employers from torts initiated by injured workers based on the no-fault principles of these programs b. Four possible exceptions: i. An employer’s intentional acts ii. Lawsuits alleging employer retaliation for filing a workers’ compensation claim iii. Lawsuits against non-complying employers iv. Lawsuits relating to “dual capacity” relationships 11. An employer’s intentional acts a. Most state courts consider intentional actions to harm employees as reasonable cause for holding an employer liable b. Two kinds of lawsuits: i. Deliberate and knowing torts—entail an employer’s deliberate and knowing intent to harm at least one employee ii. Violations of an affirmative duty—take place when an employer fails to reveal the exposure of one or more workers to harmful substances, or the employer does not disclose a medical condition typically caused by exposure; in particular, failure to notify violates an employer’s affirmative duty when the illness is either correctable at the point of discovery or its progress may be stopped by removing employees from further exposure 12. Retaliation against workers who filed claims a. In most states, employees possess the right to sue employers who retaliate against them for either filing a workers’ compensation claim or pursuing their rights established in workers’ compensation programs b. Retaliation usually entails an adverse effect upon a worker’s status (e.g., a demotion or pay cut) or termination of a worker’s employment c. Employees may initiate these lawsuits by claiming retaliatory action d. Employers then possess the burden of proof to establish their actions as a legally sanctioned business necessity 13. Employer noncompliance a. Workers’ compensation laws oblige employers to comply with applicable state laws b. Employers begin to fulfill their obligations by purchasing insurance from state funds, private insurance carriers, or through self-insurance c. Failure to carry workers’ compensation insurance may lead to one or more consequences such as monetary and criminal penalties 14. Dual capacity a. Legal doctrine that applies to the relationship between employers and employees b. A company may specifically fulfill a role for an employee that is completely different from its role as employer c. Even though an employer meets its obligations under workers’ compensation laws, it may be susceptible to common-law actions d. An employer’s immunity does not protect it from common-law actions by employees when the company also serves a dual capacity that confers duties unrelated to and independent of those imposed upon it as an employer 15. Financing workers’ compensation programs a. Employers generally subscribe to workers’ compensation insurance through private carriers, or, in some instances, through state funds b. A third funding option, self-insurance, requires companies to deposit a surety bond, enabling them to pay their own workers’ claims directly c. In most states, the insurance commissioner sets the maximum allowable workers’ compensation insurance premium rates for private insurance carriers; rates are based on each $100 of payroll d. Increasingly, some states permit insurance carriers to set rates on a competitive basis e. Ratemaking service organizations collect data on workplace accidents and put together rating manuals f. Rating manuals specify insurance rates based on classifications of businesses g. A few states possess independent rating organizations; the remainder consults with the National Council on Compensation Insurance, a for-profit company located in Boca Raton, Florida; this organization prepares three separate manuals for state insurance agencies h. Independent rating bureaus used by a few states compile manuals that correspond to the National Council’s manuals i. Second-injury funds represent an important funding element of workers’ compensation programs—these funds cover a portion or all of the costs of a current workers’ compensation claim associated with preexisting conditions from a work-related injury during prior employment elsewhere 16. Employer and employee tax obligations a. Employees do not pay any income taxes on the amount of workers’ compensation benefits b. Survivors of deceased workers do not pay any taxes on death benefits c. Three circumstances may require payment of taxes: i. First, employees pay taxes on their workers’ compensation benefits when they return to work for light duty ii. Second, workers’ compensation benefits are taxable when they offset (reduce) Social Security OASDI benefits iii. Third, employees pay taxes on workers’ compensation benefits when they do not directly result from work-related illness or injury d. Employers typically do not pay taxes on workers’ compensation benefits, with one main exception: workers’ compensation benefits for nonwork-related illnesses or injuries e. For this circumstance, the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA) apply f. FICA requires that an employer pay a tax based on its payroll; employees contribute a tax based on earnings, which is withheld from each paycheck g. FUTA requires that employers contribute 6.2 percent of the taxable wage base, currently $7,000 F. FMLA 1. To guarantee employees the right to return to either their same position or a comparable one, if they are off work because of a family or medical emergency 2. Provide fathers with the same protections mothers were guaranteed in the Pregnancy Discrimination Act of 1978 a. Credit for previous service b. Accrued retirement benefits c. Accumulated seniority 3. Reason needed—more two-income families 4. Elderly living longer and needing care 5. Men taking on more child-rearing responsibilities 6. Title I eligibility rules allowed up to 12 weeks of unpaid leave in a 12 month period if: a. Absence is due to the family size increasing due to a birth or a child placement, and is applied for within 12 months of the addition b. There is a family member suffering from a serious medical condition c. The employee suffers from a serious medical problem 7. Covers both men and women 8. Eligibility rules a. Must be a private employer with fifty or more employees, or b. A civilian unit of the federal government c. Must have put in at least 1,250 hours in a 12 month period prior to application 9. Benefits a. Twelve weeks of unpaid leave, but may be required to first use up all: i. Sick leave ii. Vacation time iii. Personal days b. Retention of all: i. Earned seniority ii. Health insurance coverage iii. Credit for previous service iv. Accrued retirement benefits c. Employees cannot add any benefits while on leave d. Employees may be entitled to receive health benefits if they do not return from leave because of: i. Serious health conditions ii. Factors beyond their control 10. Major Revisions to FMLA instituted in January of 2009 include: a. Relatives of seriously injured members of the military may take up to 26 weeks off to care for their injured military family members b. Relatives of members of the National Guard or reserves who are called to activity duty may receive up to 12 weeks of leave to attend military programs (official send off of the family member’s troop), arrange child care, or make financial arrangements c. Nonmilitary workers who claim to have chronic health conditions (for example, ongoing back pain) must see their doctor at least twice per year for documentation d. President Barack Obama may ask Congress to extend coverage by including companies that employ at least twenty-five workers (as opposed to fifty workers as the law currently stands) III. The Benefits and Costs of Legally Required Benefits 1. Benefits tend to emphasize social adequacy—benefits are designed to provide subsistence income to all beneficiaries regardless of their performance in the workplace 2. Legally required benefits may be a hindrance to companies in the short term because these offerings require substantial employee expenditures (e.g., contributions mandated by the SSA and various state workers’ compensation laws) 3. Companies could choose to invest these funds in direct compensation programs designed to boost productivity and product or service quality 4. HR managers and other business professionals minimize the cost burden associated with legally required benefits: a. Reducing the likelihood of workers’ compensation claims i. Implementation of workplace safety programs is one strategy for reducing workers’ compensation claims ii. Health promotion programs that include inspections of the workplace to identify health risks (e.g., high levels of exposure to toxic substances), and then to eliminate of those risks b. Integrating workers’ compensation benefits into the rest of the benefits program 5. Employers can contain costs for unemployment insurance—systematically monitor the reasons they terminate workers’ employment and avoiding terminations that lead to unemployment insurance claims IV. Designing and Planning the Benefits Program A. Overview 1. Employee input is key to developing a “successful” program 2. Helps companies target the limited resources they have available for employee benefits to those areas that best meet employees’ needs 3. Involving employees in program development will lead them most likely to accept and appreciate the benefits they receive 4. Companies can involve employees in the benefits determination process in such ways as surveys, interviews, and focus groups 5. Fundamental issues to be addressed by HR professionals: a. Who receives coverage b. Whether to include retirees in the plan c. Whether to deny benefits to employees during their probationary period d. Financing benefits e. Degree of employee choice in determining benefits f. Cost containment g. Communication B. Determining who receives coverage 1. Companies decide whether to extend benefits coverage to: a. Full-time and part-time employees b. Only full-time employees 2. Trend is toward not offering benefits to part-time employees 3. Deciding whether to include retirees in the program a. Depends on whether to extend medical insurance coverage to employees beyond the COBRA-mandated coverage period b. Employers usually finance these benefits either wholly or partly, enabling many retirees on limited earnings to receive adequate medical protection c. Starting in 1997, employers’ contributions to extend medical coverage to retirees are no longer tax deductible, which means that such expenses will reduce company earnings in the short-term—as a result, fewer employers are expected to finance medical insurance coverage for retirees in the future d. Rapidly rising cost of retiree health care benefits have created a tremendous financial strain on companies that choose to offer them e. The various sources of economic uncertainty since 2001 have made it more difficult for companies to support full workforces, as evidenced by sluggish pay increases, reductions in benefits offerings, and layoffs 4. Deciding whether to include employees in the probationary period a. Employees’ initial term of employment (usually shorter than six months) is deemed a probationary period, and companies view such periods as an opportunity to ensure that they have made sound hiring decisions b. Many companies choose to withhold discretionary employee benefits for all probationary employees c. Companies benefit directly through lower administration-of-benefits costs for these employees during the probationary period; however, probationary employees may experience financial hardships if they require medical attention C. Financing 1. HR decisions based on: a. Available resources b. Financial goals 2. Types of programs managers can decide on: a. Noncontributory b. Contributory c. Employee-financed d. Some combination 3. Noncontributory financing implies that the company assumes the total cost for each discretionary benefit 4. Contributory financing implies that the company and its employees share the costs 5. Employee-financed benefits implies that employers do not contribute to the financing of discretionary benefits 6. The majority of benefit plans today are contributory, largely because the costs of benefits have risen so dramatically D. Employee Choice 1. Human resource professionals must decide on the degree of choice employees should have in determining the set of benefits they will receive 2. If employees within a company can choose from among a set of benefits, as opposed to all employees receiving the same set of benefits, the company is using a flexible benefits plan or cafeteria plan 3. Companies implement cafeteria plans to meet the challenges of diversity 4. Benefit satisfaction, overall job satisfaction, pay satisfaction, and understanding of benefits increased after the implementation of a flexible benefits plan 5. FSAs permit employees to pay for certain benefits expenses (e.g., child care) with pretax dollars 6. Core plus option plans extend a pre-established set of such benefits as medical insurance as a program core, which is usually mandatory for all employees 7. Beyond the core, employees may choose from an array of benefits options that suit their personal needs E. Cost Containment 1. HR managers today try to contain costs 2. In 2011, employee benefits accounted for nearly 30.4 percent 3. The current amount has risen dramatically over the past few decades 4. This increase would not necessarily raise concerns if total compensation budgets were increasing commensurably 5. Growth in funds available to support all compensation programs has stagnated 6. As a consequence, employers face difficult trade-offs between employee benefits offerings and increases to core compensation F. Communication 1. Eployees often either are not aware of or undervalue the employee benefits they receive 2. Given the significant costs associated with offering employee benefits, companies should try to convey to employees the value they are likely to derive from having such benefits 3. An effective communication program should have three primary objectives: a. Create an awareness of and appreciation for the way current benefits improve the financial security and the physical and mental well-being of employees b. Povide a high level of understanding about available benefits c. Encourage the wise use of benefits 4. Use a variety of media to communication benefits information a. Printed brochures to convey the “big picture” of the key benefits to potential employees b. Small group meetings, using audio-visual presentations, for new employees c. Individual meetings, with benefits administrators (counselors), to select benefits options d. Personal benefits statements that detail the scope of coverage and the value of each component selected e. Written updates of changes to benefits with newsletters 5. Intranet a. Useful in communicating benefits information to employees on an ongoing basis beyond the legally-required written documents b. Each paragraph contains a hyperlink that leads to more detailed information
Final Thoughts: The inevitably of Social Security running out in its current state is of huge concern to those administering it, and will certainly impact the majority of students reading this textbook. In the coming years, employees, employers, unions, and the government will pay greater attention to the adequacy of Social Security benefits for the succeeding generations. How effective the new additions to FMLA are will also be of great concern to a multitude of interests in the years ahead.
CHAPTER 12 Compensating Executives Learning Objectives 1. Explain the difference between executive pay with pay for nonexecutives. 2. List the main components of executive compensation packages. 3. Discuss with examples the principles and processes of setting executive compensation, including the key players and the theoretical explanations for setting executive compensation. 4. Summarize the executive compensation disclosure rules and the reasons why they have been established. 5. Concisely present the “say on pay” practice. 6. Briefly explain the executive compensation controversy as it relates to whether U.S. executives are paid too much. Outline I. Contrasting Executive Pay with Pay for Nonexecutive Employees II. Principles of Executive Compensation: Implications for Competitive Strategy III. Defining Executive Status A. Who Are Executives? B. Key Employees C. Highly Compensated Employees IV. Executive Compensation Packages A. Overview B. Components of Current Core Compensation C. Short-Term Incentives D. Components of Deferred Core Compensation E. Employee Benefits: Enhanced Protection Program Benefits and Perquisites V. Principles and Processes for Setting Executive Compensation A. The Key Players in Setting Executive Compensation B. Theoretical Explanations for Setting Executive Compensation VI. Executive Compensation Disclosure Rules VII. Say on Pay VIII. Executive Compensation: Are U.S. Executives Paid Too Much? A. Comparison between Executive Compensation and Compensation for Other Worker Groups B. Strategic Questions: Is Pay for Performance? C. Ethical Considerations: Is Executive Compensation Fair? D. International Competitiveness IX. Discussion Questions and Suggested Answers X. End of Chapter Case; Instructor Notes, and Questions and Suggested Student Responses XI. Additional Cases from the MyManagementLab Website; Instructor Notes, and Questions and Suggested Student Responses Lecture Outline I. Contrasting Executive Pay with Pay for Nonexecutive Employees 1. CEO is the seller of his/her services 2. Compensation committee is the buyer 3. Classic Economic Theory a. Reasonable price (of goods and services) is obtained through negotiations b. The negotiators (informed buyer and informed seller) should be an “arm’s length apart” 4. CEO hires a professional compensation consultant to determine own compensation a. Consultant performs an objective analysis of the company’s current executive pay package b. Consultant makes appropriate recommendations c. Consultant believed to be representing shareholders’ interests 5. Shareholders and compensation committee are the buyers of the CEO’s services 6. Compensation committees generally accept consultant’s recommendations II. Principles of Executive Compensation: Implications for Competitive Strategy 1. Key role executives play in promoting competitive advantage 2. Public scrutiny of executive compensation packages intensified during the 1990s (carrying into today) because of heightened concerns about global competitiveness, rampant corporate downsizing, and the more recent practice of relocating jobs to countries with lower labor costs (i.e., offshoring) that has left hundreds of thousands of former employees jobless 3. The number of layoff events initiated by companies and the number of employees who have lost their jobs has risen to unprecedented levels most months since September 2008, following the start of perhaps the deepest economic recession in the United States a. An alarming trend is that the period of layoff is lengthening with significantly more spells that exceed 31 days III. Defining Executive Status A. Who are executives? 1. The Internal Revenue Service (IRS) recognizes two groups of employees 2. They play a major role in a company’s policy decisions a. Highly compensated employees b. Key employees 3. The IRS uses “key employees” to determine the necessity of top-heavy provisions in employer-sponsored qualified retirement plans that cover most nonexecutive employees 4. The IRS uses “highly compensated employees” for nondiscrimination rules in employer-sponsored health insurance benefits 5. Titles a. Chief executive officers (CEOs) b. Presidents c. Executive vice presidents d. Vice presidents of functional areas i. Human resources ii. Marketing 6. Key employees a. At any time during the year b. Must be: i. A 5 percent owner of the company ii. A 1 percent owner having an annual compensation of more than $165,000 iii. An officer having an annual compensation greater than $165,000 in 2013
• Example: U.S. Treasury Regulations Definition of an Officer Officer An administrative executive who is in regular and continued service Implies continuity of service and excludes those employed for a special and single transaction An employee who merely has the title of an officer, but not the authority of an officer is not considered an officer for purposes of the key employee test An employee who does not have the title of an officer, but has the authority of an officer is an officer for purposes of the key employee test
7. Highly compensated employees are: a. 5 percent owners at any time during the year, or during the preceding year b. For the preceding year, had compensation from the employer in excess of $115,000 in 2013 c. If the employer elects the applicable of this clause for a plan year, was in the top paid group of employees for the preceding year IV. Executive Compensation Packages A. Overview 1. Current or annual core compensation 2. Deferred core compensation: Stock compensation 3. Deferred core compensation: Golden parachutes and platinum parachutes 4. Employee benefits a. Enhanced protection programs b. Perquisites 5. Claw back provisions B. Components of Current Core Compensation 1. Base pay 2. Bonuses 3. Base Pay a. The fixed element of annual cash compensation b. Companies that use formal salary structures may use pay grades and ranges for all employees, except for the CEO c. There’s a progressively higher pay range spread for pay grades that contain more valuable jobs in terms of a company’s competitive strategies d. Most higher-level jobs i. Afford employees greater promotion opportunities than entry-level jobs ii. Tend to help companies retain employees longer iii. Require skills seen as valuable to employers e. CEOs are not included in the pay structure because i. CEO’s work is highly complex and unpredictable ii. It is not possible to specify discrete responsibilities and duties iii. The choice of competitive strategy and the influence of external and internal market factors make it tough to describe the CEO’s job iv. Setting CEO’s compensation differs dramatically from the rational processes compensation professionals use to build market-competitive pay structures f. Banks with financial assistance from the federal government could deduct only the first $500,000 annually for an executive’s pay as a business expense as a result of the Troubled Assets Relief Program (TARP) 4. Bonuses a. Represent single-pay-for-performance payments used to reward employees for achievement of specific, exceptional goals b. Compensation professionals design bonuses for: i. Merit pay programs ii. Gain sharing plans iii. Referral plans iv. Sales incentive compensation programs c. Represents a key component of executive compensation packages d. Four common bonuses for executives i. Discretionary bonus ii. Performance-contingent bonus iii. Predetermined allocation bonus iv. Target plan bonus e. Discretionary bonuses are awarded on an elective basis with the amount based on four factors: i. Company profits ii. The financial condition of company iii. Business conditions iv. Future prospects f. Performance-contingent bonus i. Based on attainment of specific performance criteria ii. Similar to appraisal system used for determining merit increases or general performance salary reviews g. Predetermined allocation bonus i. Total bonus pool based on a fixed-formula ii. Company profits are a central factor in determining size of total bonus pool and individual bonuses iii. Amounts are fixed regardless of executive’s performance h. Target plan i. Ties bonus amount to executive’s performance ii. Amount increases commensurably with performance iii. No bonus awarded if the minimum level is not met C. Short-Term Incentive Compensation 1. Used to recognize executives’ progress toward fulfilling competitive strategy goals 2. Uses current profit sharing plans and gain sharing plans 3. Designed to reward executives for meeting intermediate performance criteria that are dictated by competitive strategy, like: a. Change in company’s earnings per share over a one-year period b. Growth in profits c. Annual cost savings 4. Generally for a select group of executives 5. Actually applies to more than one executive because: a. Of the synergy that results from the efforts b. The expertise of top executives influences corporate performance 6. Board of directors distribute these based on rank and compensation level of executives
• Example: Short-Term Incentives Chain of General Merchandise Retail Stores has a goal of becoming the lowest-cost chain in the industry The CEO and Executive VP establish a five-year plan Gain sharing program designed to reward top executives for contributing to the cost reduction objective After one year, the corporation saved $10,000,000 CEO received 2 percent of savings ($200,000) VP received percent of savings ($100,000)
D. Components of Deferred Core Compensation 1. An agreement between an employee and a company to render payments to the employee at a future date 2. A hallmark of executive compensation packages designed to create a sense of ownership 3. Aligns the interests of the executive with those of the owners or shareholders over the long term 4. Provides tax advantages to executives a. Defers payment to executives until retirement should lead to lower taxation b. Executives do not pay taxes on deferred compensation until they receive it 5. Stock shares are the main form of deferred compensation 6. Stocks: a. Company stocks represent the total equity of the firm b. Company stock shares represent equity segments of equal value c. Equity interest increases positively with the number of stock shares d. They are bought and sold every business day in a public stock exchange e. The New York Stock Exchange is among the most well-known f. Stock compensation plans are designed to promote an executive’s sense of ownership of the company g. Stock value increases: i. With gains in company performance ii. In response to reports of profit gains h. Values that are outside the executive’s control include: i. Forecasts of economy-wide recession ii. Increases in the national unemployment rate iii. Threats to national security 7. Six forms of stock compensation: a. Incentive stock option plans b. Non-statutory stock option plans c. Restricted stock d. Phantom stock plans e. Discount stock options f. Stock appreciation rights
• Employee Stock Terminology Stock option: A right granted by a company to an employee to purchase a number of stocks at a designated price within a specified period of time Stock grant: A company’s offering of stock to an employee Exercise of Stock grant: An employee’s purchase of stock, using stock options Disposition: Sale of stock by the stockholder Fair market value: The average value between the highest and lowest reported sales price of a stock on the New York Stock Exchange on any given date. The Internal Revenue Service specified whether an option has a readily ascertainable fair market value at grant. An option has a readily ascertainable fair market value if the option is actively traded on an established stock exchange at the time the option is granted.
8. Incentive stock options a. Allow executives to purchase stock in the future at a predetermined price i. The predetermined price equals the price at the time an executive receives the stock option ii. Executives are generally purchasing the stock at a discounted price iii. Executives generally purchase the stock after the price increases dramatically b. Capital gains is the difference between the stock price at the time of purchase and the lower stock price at the time an executive receives the stock option c. Executives receive a tax benefit because the IRS doesn’t recognize capital gains until the disposition of the stock 9. Non statutory stock options a. Are awarded to executives at discounted prices b. Do not qualify for favorable tax treatment i. Executives pay income taxes on the difference between the discounted price and the stock’s fair market value at the time of the stock grant ii. Executives do not pay taxes in the future when they choose to exercise their non-statutory stock options c. Executives do get a tax advantage i. Tax liability is lower over the long term ii. Stock prices generally increase over time iii. Capital gains will likely be much greater in the future 10. Restricted stock a. Give executives no ownership control over the disposition of the stock for a predetermined period (5 –10 years) b. Must be sold back to the company for exactly the same discounted price that it was at the time of purchase c. Is not taxed until after the restriction period ends d. Is a common type of long-term executive compensation e. Is awarded by the board of directors to executives at considerable discounts 11. Phantom stock a. Boards of directors promise to pay a bonus in the form of the equivalent of either the value of company shares or the increase in that value over a period of time
Example: Phantom Stock • A company could promise Mary, its new employee that it would pay her a bonus every five years equal to the increase in the equity value of the firm times some percentage of total payroll at that time • The company could promise to pay her an amount equal to the value of a fixed number of shares set at the time the promise is made
b. Can convert these into real shares, under two conditions: i. Executives must remain employed for anywhere from 5–20 years ii. Executives must retire from the company c. Capital gains are taxed when stocks are converted after retirement when the tax rate will be lower 12. Discount stock option plans a. Are similar to non-statutory stock option plans, except i. Companies grant stock options at rates far below the stock’s fair market value on the date the option is granted ii. The executive immediately receives a benefit equal to the difference between the exercise price and the fair market value of the employer’s stock 13. Stock appreciation rights a. Provide executives income at the end of a designated period, like restricted stock options b. Executives never have to exercise their stock rights to receive income c. Payments i. To executives based on the difference in stock price between the time the company granted the stock rights at fair market value to the end of the designated period ii. Executives get to keep the stock d. Taxation i. Executives pay tax on any income from gains in stock value when they exercise their stock rights after retirement when their tax rates are lower 14. Golden parachutes a. Provide pay and benefits to executives following their termination resulting from a change in ownership or corporate takeover, that is, the merger or combining of two separate companies
Example: Golden Parachutes • Anheuser-Busch: U.S. corporation known for brewing beer • InBev: Beer brewing company for Belgium • InBev purchased or acquired Anheuser-Busch in 2008, creating a merged or combined corporation named Anheuser-Busch InBev
b. Extend pay and benefits anywhere between one and five years c. Boards of directors include these clauses for two reasons: i. They limit executives’ risks in the event of these events ii. They promote recruitment and retention of talented executives d. Companies can treat these as business expenses e. Companies can reduce their tax liability by increasing the parachute amount f. The total value of these far exceed executives’ annual income levels g. Changes i. Public outcry led to government-imposed intervention that limited tax benefits to companies ii. Companies may receive tax deductions that amount to several times an executive’s average annual compensation for the preceding five years 15. Platinum parachutes a. Lucrative awards that compensate departing executives with: i. Severance pay ii. Continuation of company benefits iii. Stock options b. Given in order to avoid legal battles or critical press reports c. Given in the event the CEO is terminated after a period of unsatisfactory performance as determined by the shareholders and other company executives 16. Clawback provisions a. Allow boards of directors to take back performance-based compensation if they were to subsequently learn that performance goals were not actually achieved b. These provisions are becoming more common: i. because of the increasing scrutiny of CEO compensation packages by the public and shareholders ii. particularly since the recent global financial crisis in the late 2000s 17. Tighter regulations on deferred compensation plans a. Corporate accounting scandals led to tighter restrictions i. Executives were withdrawing deferred compensation money before their companies filed for bankruptcy, like: ii. Enron b. Led to passage of the Sarbanes-Oxley Act of 2002 i. Administered by the SEC ii. Imposes rigorous requirements for companies’ financial disclosure to limit the chance that covert misuses of corporate funds will occur E. Employee Benefits: Enhanced Protection 1. Executives receive discretionary benefits like other employees a. Protection program benefits b. Pay for time not worked c. Employee services 2. Executive discretionary benefits differ in two ways: a. Protection programs include supplemental coverage that provide enhanced benefit levels b. The services component contains benefits exclusively for executives called perquisites or perks 3 Legally-required benefits apply to executives with the exception of one provision of the Family and Medical Leave Act of 1993 4. Enhanced protection program benefits a. Supplemental life insurance b. Supplemental retirement 5. Supplemental life insurance a. Pays additional monetary benefits b. Provides executives favorable tax treatment 6. Supplemental retirement plans a. Are designed to restore benefits restricted under qualified plans b. Make up the monetary difference between IRS limits and desired compensation amounts
• Qualified Plans Limits Entitles employers to take current tax deductions for contributions to fund retirement income Entitles employees to favorable tax treatment of the benefits they receive upon their retirement The IRS limits annual earnings amount for determining qualified plans benefits to $250,000 (in 2013) All earnings above this amount cannot be included in defined benefit plan formulas All earnings above this amount cannot be calculated into the annual additions to defined contribution plans The IRS limits annual benefit amounts for defined benefit plans to the lesser of $205,000 (in 2013) or 100 percent of the highest average compensation for three consecutive years Limits on annual additions to defined contribution plans were the lesser of $51,000 (in 2013), or 100 percent of the participant’s compensation Examples: Supplemental Retirement An executive’s three highest annual salaries were: $690,000 • $775,000 • $1,100,000 The average was $855,000 The difference $855,000 - $195,000 = $660,000 If the annual benefit under the executive’s qualified pension plan will be 60 percent of the final average salary of the last 15 years of service which was $400,000 Annual retirement benefit should be $240,000 The IRS only allows $205,000 Supplemental retirement would be $35,000 ($240,000 – $205,000)
7. Perquisites a. Also known as perks b. Integral part of executives’ compensation c. Are used for personal and business use d. Survey of executive compensation practices are offering perks to their CEOs i. 89.8 percent in 2009 ii. 77.6 percent in 2010 e. The common perks offered in 2010 i. supplemental life insurance (31.7 percent) ii. company cars (30.7 percent) iii. country club memberships (26.1 percent) f. Fewer perks offerings may be due to: i. greater economic uncertainties ii. the recent requirement that companies report perks valued at $10,000 or more apiece
• Example: Perquisites Company car Supplemental life insurance Legal services (e.g., income tax preparation) Recreational facilities (e.g., country club and athletic club membership) Travel perks (e.g., use of corporate jets)
V. Principles and Processes for Setting Executive Compensation A. The Key Players in Setting Executive Compensation 1. Executive compensation consultants 2. Board of Directors 3. Compensation committees 4. Executive compensation consultants a. Propose several recommendations for alternative pay packages that are based on strategic analysis b. Permits consultants to see where the company stands in the market c. Consultants can adjust recommendations accordingly
• Strategic Analysis An examination of a company’s external market context including Industry profile • Information about competitors Long-term growth prospects An examination of a company’s internal factors like: Its financial condition Permits consultants to determine how their client company compares to the market
5. Many are employed by large consulting firms like: a. AON Consultants b. Buck Consultants c. The Frederic W. Cook & Company d. Hay Associates e. Pearl Meyer & Partners f. Towers Watson g. William M Mercer 6. Possible conflict of interest a. Consultants are hired by CEOs b. If the CEO does not like the recommendations, the CEO can fire consultant c. Recommending lucrative packages could bring the consultant or consulting company more business 7. Board of Directors a. Supposed to represent shareholders’ interests 8. Most boards contain fifteen members that generally include: a. CEOs and top executives of other companies b. Distinguished community leaders c. Well-regarded professionals like i. Physicians ii. Lawyers d. Top-level executives of the company 9. Give final approval of the compensation committee’s recommendations 10. Possible conflict of interest a. CEOs use compensation to co-opt board independence b. CEOs often nominate candidates for board membership c. There is a statistical relationship between how highly the CEO is paid and how highly the outside members of the board of directors are paid 11. Board members receive compensation for serving such as a. Money i. more than $50,000 yearly ii. $10,000 or more per board meeting attended b. Stock compensation c. Discretionary benefits like: i. Medical insurance ii. Life insurance iii. Retirement benefits 12. SEC rulings and the passage of the Dodd-Franc Act have increased the transparency of how executives are compensated as well as board members’ accountability for approving sound executive compensation packages—supportive of shareholders’ best interests 13. The compensation committee a. Is comprised by Board of Directors members b. Inside company board members c. Outside board members i. Help to minimize conflicts of interest ii. Make up the majority of most committees 14. Perform three duties: a. Review consultants’ alternative recommendations b. Discuss the assets and liabilities of each recommendation c. Recommend the best proposal to the board of directors to consider B. Theoretical Explanations for Setting Executive Compensation 1. Three theories: a. Agency b. Tournament c. Social comparison 2. Agency theory a. Ownership is distributed among thousands of shareholders in large companies like: i. Microsoft ii. General Electric iii. General Motors iv. IBM b. Shareholders delegate control to top executives c. Shareholders negotiate executive employment contracts with executives i. To minimize loss of control ii. To define the terms of employment pertaining to performance standards and compensation iii. To specify current and deferred compensation and benefits d. The main objective is to protect the company’s competitive interests e. Shareholders use compensation to align executives’ interests with shareholders’ interest f. Possible problems i. It could allow executives to pursue activities that benefit themselves ii. Executives may emphasize the attainment of short-term gains iii. The Board of Directors may provide executives with generous annual bonuses for the attainment of short-term gains that do not lead to long-term gains 3. Tournament theory a. Casts lucrative executive compensation as the prize in a series of tournaments among middle- and top-level managers who aspire to become a CEO b. Winners at one level enter into the next level c. Chances of winning decrease dramatically as winners rise through the ranks 4. Social comparison theory a. Individuals compare themselves to individuals of similar or greater stature b. Demographics and occupation are common comparative bases c. CEOs on compensation committees might rely on their own compensation packages and those of other compensation CEOs of equal or greater stature to determine executive compensation VI. Executive Compensation Disclosure Rules 1. The Securities and Exchange Commission (SEC) requires companies that sell and exchange securities (i.e., stocks, bonds) to file a wide variety of information including executive compensation practices 2. The SEC is a nonpartisan, quasi-judicial federal government agency responsible for administering federal securities laws 3. The Securities Exchange Act of 1934 applies to the disclosure of executive compensation a. Modified in 1992 and 1993 b. Two main objectives: i. Clarify the presentation of the compensation paid to the CEO and the four most highly-paid executives ii. Increase the accountability of company boards of directors for executive compensation policies and decisions
• SEC Disclosure Requirements for Executive Compensation Stock option and stock appreciation right tables Long-term incentive plan table Pension plan table Performance graph comparing the company’s stock price performances against a market index and a peer group Report from the compensation committee of the Board of Directors explaining compensation levels and policies Description of the directors’ compensation disclosing all amounts paid or payable Disclosure of certain employment contracts and golden parachutes
4. Board of Directors’ members may be subject to personal liability for paying excessive compensation 5. Under securities law, publicly held corporations are required to disclose detailed information on executive compensation to shareholders and the public 6. Shareholders can bring derivative lawsuits on behalf of a corporation, claiming that executive compensation is excessive 7. The Summary Compensation Table discloses compensation information over a three-year period on: a. CEOs b. Four highest-paid executives 8. Contains main subheadings a. Annual compensation b. Long-term compensation 9. Annual compensation includes: a. Salary b. Bonus 10. Long-term compensation includes: a. Restricted stock awards b. Stock appreciation rights c. Long-term incentive payouts 11. All other compensation a. To record all other forms of compensation b. Must be described in a footnote 12. In 2008, the SEC unveiled additional rules for disclosing executive compensation that require companies to reveal how much executives are paid making previously hard-to-find information as such as pension and estimated severance package totals, transparent 13. In 2009, the SEC Chairperson announced that the Commission would consider further changes in the disclosure of executive compensation in a company’s summary compensation table pertaining to the reported value of stock options and stock rewards 14. SEC disclosure rules will show components of compensation previously hidden as well as provide clarity into elements of compensation already disclosed. The most significant changes follow: a. Total: The Summary Compensation Table of a company’s proxy will now have a column that adds up and displays the total compensation an executive received for the previous year, shown in our pay database as SEC Total b. Change in Pension Value and Nonqualified Deferred Compensation: This column in the Summary Compensation Table shows the increase in actuarial value to the executive officer of all defined-benefit pension plans and earnings on nonqualified deferred compensation plans c. All Other: This column captures compensation that does not fit in any other column of the Summary Compensation Table including perquisites and other personal items (e.g., aircraft usage, car service, club memberships). Each item of compensation included in All Other that exceeds $10,000 will now be separately identified and quantified in a footnote d. Pension Benefits: The new rules require companies to disclose the present value of accumulated pension benefits showing the total lump sum amount of money an executive would receive in retirement e. Severance Benefits: Companies must disclose any termination or change-in-control agreements with executives. They must disclose the specific circumstances that will trigger payment and the estimated total payments and benefits provided for each circumstance VII. Say on Pay President Barack Obama signed the Wall Street Reform and Consumer Protection Act of 2010 to further enhance the transparency of executive compensation practices Commonly referenced to as the Dodd-Frank Act Three provisions for companies that trade stock on public exchanges: a. Requires say on pay i. Gives company shareholders the right to vote yes or no on executive compensation proposals ii. Includes current and deferred components, and golden parachute agreements at least once every three years iii. Guarantees shareholders the right to vote on executive compensation proposals iv. The vote is not binding v. The outcome of shareholders’ voting does not overrule any compensation decision made by the board of directors b. Details independence requirements for compensation committee members and their advisors (e.g., compensation consultants and legal counsel) i. Possible violations of Dodd-Frank independence requirements may arise when at least one committee member also receives compensation as a company employee ii. A compensation committee member who does not receive compensation from the company as an employee or external consultant would not violate the independence requirement iii. The Dodd-Frank Act specifies independence requirements for advisors to the compensation committee. Compensation committee must consider whether the fees charged by advisors exceed unreasonable limits. Another consideration is whether an advisor has a business or personal relationship with committee members c. Requires that companies disclose the circumstances under which an executive would benefit from a golden parachute agreement VIII. Executive Compensation: Are U.S. Executives Paid Too Much? A. Comparison between Executive Compensation and Compensation for Other Worker Groups 1. Median annual earnings for all civilian U.S. workers was $45,790 in 2012 a. Least paid nonexecutive—shampooers at $18,600 b. Highest paid nonexecutive—anesthesiologists at $232,830 2. Typical annual salary and bonus for chief executives earned in 2011 was about $3.5 million B. Strategic Question: Is Pay for Performance? 1. A simple statement cannot be made about the relationship between CEO pay and company performance 2. Shareholder returns most often describe company performance, but there are complex forces beyond the control of CEOs that may influence shareholder returns
Performance Measures Size Sales Assets Profits Market value Number of employees Capital Markets Dividend yield Total return to shareholders Price/earnings ratio Payout Growth Sales Assets Profits Market value Number of employees Liquidity Current ratio Quick ratio Working capital Cash flow Profitability Profit margin Return on assets Return on equity Leverage Debt-to-equity ratio Short- v. long-term debt Cash flow v. interest payments
C. Ethical Considerations: Is Executive Compensation Fair? 1. Three main considerations: a. Company’s ability to attract and retain top executives b. Income disparity between executives and nonexecutive employees c. Layoffs of thousands of nonexecutive employees 2. Company’s ability to attract and retain top executives a. The Board of Directors and compensation professionals believe lucrative compensation for top executives is vital b. Presumably, executives’ decisions promote competitive advantage by positioning companies to achieve lowest-cost and differentiation strategies effectively 3. Income disparity a. Typically, annual earnings for the lowest-paid occupation (shampooers) amounted to a mere 0.53 percent of average CEO salary and bonus, in other words, CEO pay was 178 times greater b. Typically, annual earnings for the highest-paid occupation (anesthesiologists) amounted to a mere 6.7 percent of average CEO salary and bonus, CEO’s pay 21 times greater 4. Layoffs a. Between late 2008 and mid 2009 alone, more than two million employees lost their jobs b. Reasons include: i. Global competition ii. Reduction in demand iii. Technological advances iv. Mergers and acquisitions v. Relocating production plants overseas vi. Steep economic downturn due to the 9/11 terrorist attack D. International Competitiveness 1. Has forced companies to a. Become more productive b. Reduce expenditures on compensation: i. When they outpace the quality and/or quantity of employees’ output ii. When the compensation expenditure amount far outpaces the competition 2. Comparisons based on two dimensions: a. Total compensation amounts b. Components 3. Comparisons difficult because foreign countries do not require same disclosure rules as SEC 4. U.S. CEOs earn the most 5. This undermines U.S. companies’ ability to compete a. No evidence that the high U.S. executive compensation practices have undermined efforts to compete internationally b. However, massive U.S. worker layoffs might i. Heightens workers’ job insecurities ii. Workers may lose faith in pay-for-performance system 6. CEO pay will not undermine U.S. companies’ ability to compete because CEO pay increased as company profits increased Instructor Manual for Strategic Compensation: A Human Resource Management Approach Joseph J. Martocchio 9780133457100, 9780135192146
