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The role of the Board's Compensation Committee is to approve the design of the pay programs for the top executive officers and to approve specific payments based on the plans and the company's performance. Typically, the specific responsibilities of the compensation committee is specified within the company bylaws. This includes composition of the committee, statement of pay philosophy, implementation of plans approved by the board, identification of specific performance objectives, assessment of competitive pay practices, approval of employment contracts, role of external consultants, preparation of a Compensation Discussion and Analysis Report consistent with Securities and Exchange Commission requirements and filing a copy of the committee minutes to the board of directors and responding to their questions. Committee members have responsibility to put shareholder's interest above their own (duty of loyalty), understanding the issues and alternatives (duty of care) and exercising prudent judgment (avoiding conflict of interest) and acting in good faith. These actions are required to meet the business judgment rule and avoid being held liable to their actions.

Those who own shares of stock in a company are called shareholders. As such they are in part owners of the company. Typically, stock of large companies is in the hands of institutional investors: mutual funds, private money managers, and public sector pension funds. It is the latter who are long-term investors. Stock is typically sold on a stock exchange (such as the New York Stock Exchange). Shareholders elect members of the company's board of directors and vote on other matters needing their vote. The 2010 Dodd Frank Act requires that companies submit to shareholders a non-binding vote on executive pay. Since shareholders seek an appreciable return on their investment, they are interested in tying executive pay to shareholder value (stock price and dividends). Shareholder watchdogs review and comment on proposed company actions including executive compensation and anti-takeover devices. Shareholders have a high interest in executive benefits and short as well as long-term incentives. More specifically, they do not like: payouts based on internal goals (ignoring shareholder value); restricted stock awards not tied to performance; stock option reloads; omnibus plans; stock options without performance factors; and evergreen plans.

Unlike the popular market-value stock options, stock awards and stock appreciation plans, phantom stock plans do not involve ownership of publicly-traded stock, although market-based stock may be used as a measurement of the phantom stock plan. Another popular method for valuing phantom stock plans is book value (i.e. assets minus liabilities). It is important to note that phantom stock plans can incorporate any design features of a market-based plan. However, under FAS 123R, phantom plans will be treated as a liability award and subject to a variable accrual, unlike market based plans which are considered equity awards and fixed accounting using a pricing model. The company has a tax deduction at time of the recipient having taxable income in the same amount of such income.

When using one long-term incentive plan (e.g., stock options), one is able to neutralize the disadvantages of that plan by combining it with another long-term plan (e.g., stock awards). They are either independent of each other (aka stand-alone plans) or dependent on each other (aka tandem plans). The difference is that with the latter, the action taken under one plan reduces the benefits of the other plan. Plans are market value (company stock), nonmarket value (cash) or a combination of the two. The most common market value plans are stock awards and stock options; the most common nonmarket value plans are phantom stock plans.

Unlike stock options, stock awards require no cash outlay for the stock. However, like stock options they are taxable as personal income. They are taxable at the point in time when a recipient has access to its value. Some stock awards have no restrictions and are taxable when granted but it is more common to have a restriction of time and/or performance before having access to the income. There are four possible combinations of number of shares and when the shares are received: (a) fixed number at a fixed date, (b) fixed number at a variable date, (c) variable number at a fixed date and (d) variable number at a variable date.

Company stakeholders have varying degrees of interest and influence on executive pay actions. These are analyzed in terms of their relative importance on the pay elements and time periods beginning with 1900. The ratio of CEO pay to other workers is reviewed. The stakeholders include executives themselves, other employees, shareholders (and their representatives on the board of directors and compensation committee), company customers and suppliers, as well as the community (business press, governmental regulators and rule makers and shareholder watchdogs).

The impact of the five pay elements (salary, employee benefits, perquisites, short-term incentives and long-term incentives) on attracting, motivating and retaining executives is described along with the interest in stakeholders (especially shareholders) in each of the pay elements by time period (beginning with 1900). The level of pay is also analyzed in relation to level of effort and achievement, along with the personal qualities that define effective executives.

This article positions the short-term incentive plan in relation to the other four pay elements: salary, employee benefits, perquisites (executive benefits) and long-term incentives. Short-term incentives typically have a measurement period of 1 year or less; long-term incentives measurement periods are multiyear in nature. Top down plans begin with a determination of how much to pay in aggregate and then proceed to determine individual awards. These plans begin with a fund determined by a formula, judgment (discretion), or a combination of the two. Bottom-up plans typically begin with how much to pay for individual performance and then aggregate those awards to determine total payment.

This article describes both deductible and nondeductible bonus formulas, including a review of the economic profit type deductible plans. This is followed with a review of shareholder protection formulas. Following these formulas, desired objectives are set, the number of participants is identified and desired payouts drive creation of a fund formula which will either be a target or no-target plan. The plan is tested based on assumptions about performance factors. Finally, a decision is made as to whether or not there will be divisional funds in addition to a corporate formula and whether carryovers will be allowed.

Charges of excessive executive pay combined with financial malfeasance in some situations have been featured in the business press the past several years. But how did this happen? As one might suspect, it did not occur in a vacuum. Dating back to when President George Washington was paid about 1,000 times that of the average worker, there have been examples throughout U.S. history where top executives were paid handsomely. This can be examined in the following four time frames: (a) up to 1913 with the appearance of stock plans and no taxes or pay regulations; (b) 1913 to 1933 with the introduction of personal income tax and a booming stock market up to the 1929 crash; (c) 1933 to 1972 with insider trading rules coupled with fluctuating tax rates, three periods of pay controls, a relatively flat stock market, and significant creativity in executive pay plan design; and (d) 1972 to present, which added the importance of stock plan accounting to the mix. Tax law, SEC-required disclosure, and APB/FASB accounting rules have provided headaches for many companies but also opportunities for the few creative executive pay planners.

The chief personnel officer of a major multinational firm tells compensation professionals how to become effective members of their employers' management team.