Course Preview : Executive Compensation: Strategies and Frameworks at Wharton

2 December 2022

[Video Transcript] Executive Compensation: Strategies and Frameworks at Wharton

Welcome to the Executive Compensation Program. This program focuses on senior executives' incentive compensation packages, contracts, and corporate policies. My name is Chris Armstrong and I'm the EY Professor of Accounting at the Wharton School of the University of Pennsylvania.

I've taught here for 15 years, and throughout that time and my prior PhD studies, I've published a lot of specific studies about corporate executives' incentive compensation contracts, compensation plans, and plans of other key individuals and classes of employees. And more generally, many articles in the broader governance space. Some of which we'll touch on throughout the course of this program.

These experiences have helped me develop a deep understanding of the complexity and the nuances involved in setting compensation contracts, in providing incentives. Not only across companies, but also within a company over time, and within a company at the same point in time across executives.

I'm looking forward to sharing with you what I've learned throughout my academic research and practice during the course of this program. And I think that'll help you understand things such as why incentive compensation contracts sometimes look so complicated while others are seemingly simple and have very little explicitly spelled out, why some companies approach compensation differently from those of their seeming competitors, what are some of the more important regulations that influence, shape, or constrain how these compensation contracts are structured in practice, how are these compensation contracts disclosed and communicated, and how do we communicate with compensation consultants as they work to help us design more efficient and effective compensation contracts. We'll also take a look at some of the more recent changes to the executive compensation contracting landscape, that'll help us understand why we observe what we do.

One important thing that I'd like to emphasize early on is my use of the term incentive compensation, rather than simply compensation. As we'll see, the terms of incentive compensation, go hand in hand. A compensation contract is designed not only to provide compensation or remuneration, a payoff but also the payoff provides incentives. The executive wants to earn the payoff, so they have to take certain actions. You can't have one without the other, and this is going to be a very important theme as we go through the program.

Another important thing to emphasize early on is that there's no one size fits all incentive compensation contract that'll work for all companies. Just because you see one compensation contract that seems to be working well at one company doesn't necessarily mean it'll work well at another company. Each company has its own competitive landscape, faces its own constraint, and has its different objectives. So each company is unique in that way, in the challenges it faces, and the tools that are available for them when crafting these packages.

So my goal is to help you better understand why we observe what we do in practice and where these differences come from. We're also going to talk about incentive compensation contracts, although seemingly complex, which are obviously important. They're simply one of the many tools under the broader governance umbrella. So a specific contract at one company might not be necessary at another company because there are different governance mechanisms in place. For example, a company might have a whistleblower program, and it doesn't require stringent monitoring of the executive. We'll get into this later in more depth in a subsequent module, but I'm also going to introduce the notion of agency theory. This is a powerful framework that helps understand and explain why we observe many features of these senior executive compensation contracts and practice, and more broadly other governance mechanisms.

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Briefly, principal-agent theory, or agency theory for short, refers to any situation in which one party, the principal, delegates a responsibility to take a certain action to another party known as the agent. Well, agency conflict can arise when the objectives of these parties are not necessarily aligned.

So some classic examples and perhaps the most relevant for us are potential agency conflicts between the company's board of directors and the CEO. The CEO has better information than the board of directors because they're the ones that are involved in the day-to-day operations of the company. Well, in order to design an effective and efficient incentive compensation contract for the CEO, the board needs to have access to this information. So how do they encourage the CEO to truthfully reveal this information? How do they elicit this information from the CEO? That's an example of an agency conflict. Another example of an agency conflict is among stakeholders. So the classic one here is between shareholders and creditors. Oftentimes, they differ in their objectives, and this is due to the different nature of their payoffs. Shareholders participate in all of the upsides, whereas creditors are limited. Therefore, they tend to have different risk-taking objectives. Shareholders tend to prefer more risk, creditors, less. How do we balance these conflicts and make sure that these are incorporated in senior executives' incentive compensation contracts?

So it's important to recognize that each company faces its own unique agency problems, its own unique constraints, and also has certain tools available to it. And all these come together to help influence and shape the incentive compensation contracts that we observe in practice. This is one of the many reasons that account for the complexity, but not the only one, as we'll see. Also, keep in mind that the senior executives' incentive compensation contracts are also structured within the broader corporate governance framework. So the bottom line is before we begin, just be aware of the fact that there is no one size fits. And just because something seems to be working at one company, doesn't necessarily mean it'll work well at another company. I appreciate that you joined this program, and I look forward to sharing with you what I've learned throughout the course of my career in the next six modules. Thank you.

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