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How can we design incentive systems to align executive behavior with corporate goals and ethical standards? This is what we are talking about in this video. But first of all, let's have a look at our learning objectives.
In this video, we are reflecting upon the relevance of monetary and non-monetary incentives for ethical organizational behavior. Furthermore, we're getting to know the regulatory guidelines and toolboxes for executives and supervisory board remuneration. In the third step, we're identifying key challenges associated with and measures to increase the effectiveness of board remuneration practices.
So there's a long ongoing debate in the public and also in media about executive remuneration, and there are statements that executive payment has become overly complex—too many cash and share-based awards, long- and short-term targets, and the profusion of measures of success ranging from earnings per share to total shareholder return to return on equity. So many chief executives and other top managers struggle to understand what is in their pay package and how to hit their targets.
So what is the statement here? Payment for executives—for the ones who make the decisions in the firm, for the managers—is too complex. There are too many forms, and how these forms relate then to the target is not clear.
The statement here goes on or includes also other groups. Pay consultants agree with this assessment of the statement above, saying that the link between achievement and reward is frequently opaque. So very often, executives don't understand the plan—their payment plan—because it's too remote from them.
And above all, the amount of top managers and what they earn in the US especially is unjustifiably high. So here we see in the statement in the Financial Times that between 1978 and 2020, adjusted for inflation, the payment rose by 1,129%. So that's roughly 28% faster than the stock market has grown in the same period. So the payment really outcompeted, so to say, the stock market growth, and thereby questions are coming up whether this is fair or not, especially compared to worker payment, which rose by only around about 15% in the same period, according to the Economic Policy Institute.
There's also a statement that in 2022, CEOs were paid 344 times as much as a typical worker, compared to 1965 when they were paid 20 times as much as a typical worker. And this really brings incentives and payment schemes for executives center stage as a measure to align behavior with moral and ethical behavior of organizations. And we could ask whether the payment itself is ethical, and the ratio between CEO payment and worker payment is in focus here.
So incentives are now our focus here in that video as the third pillar of corporate governance—how we can align ethics and organizational behavior in a firm. And again, there are different logics behind incentives, right? So there's an agency logic where we want to ensure that incentives make sure or ensure that board members follow what is—or that their behavior is aligned with the interests of shareholders. And there's an entrepreneurial logic where we say, okay, we should have incentives in a way that they ensure that the company or the executives behave in a way that the organizational chance of survival is as high as possible.
So let's take a look at the agency logic first. Here we want to align board members' interests with the interests of the shareholders. And therefore, we want to align what board members do with the preferences of what the shareholders would want, with their risk preferences but also with their general behavioral interests. And therefore, we would reward board members mainly with stock with regards to the stock performance, because the stock performance and the dividend per stock is what shareholders get. And therefore, if payment is aligned with what shareholders get, payment of executives—their behavior—is as best aligned with shareholder interest as possible. So we use as a key incentive mechanism stock-related compensation, and thereby board members are similar to shareholders—they even become shareholders because they receive stocks, stock options, virtual stocks, restricted stocks—what it is you will hear later about that.
In the entrepreneurial logic, the idea is slightly different, right? So we would align the board members' interest with the long-term interest of the firm—the long-term interest of an entrepreneur. So we want to encourage, to some degree, morally and socially appropriate behavior, and reward board members for the overall health of the organization, for the overall survivability of the organization. And the incentives here would be then more health-related. So health-related means the health of the organization. So we could have a cash bonus that is tied to a certain health indicator for the organization. It could also be stocks, but some with a defined long-term holding period where you only can sell the stocks after a longer period of time. And there could be a non-monetary mechanism to guide behavior, namely culture here.
So let's now have a deeper look at how the regulatory guidelines are formed and what regulatory guidelines are present for executive board remuneration.
For executive board remuneration, it's typically the supervisory board that is setting the guidelines or the regulatory frameworks for their remuneration. So they formulate a remuneration proposal by the remuneration committee and approve then by the entire supervisory board.
On the one hand, we can talk about appropriateness of compensation. So what can be the evaluation criteria of the supervisory board here? For example, individual responsibilities and competencies. So whenever we're thinking about the remuneration of a member of the executive board, it's about to question their responsibilities and competencies. Then, of course, the individual performance and the firm's economic situation and outlook—so what is the current situation of an organization and what might the future look like of the organization? And this is also something the supervisory board could have or could take into consideration when thinking about evaluation criteria. Then, of course, the common compensation in peer firms—to also benchmark with other organizations—and the compensation structure within the focal firm. So does the remuneration align with the structure that is present in a firm? So overall, evaluation criteria might support or might be supported by independent compensation experts, as independent as possible.
The supervisory board is responsible for the appropriateness of the compensation but also for the structure of the compensation. So there are different things that they should consider when developing the compensation scheme, and there are certain guidelines given here in Germany by law. So there are guidelines on the fixed and the variable pay components—the fixed components, which are independent of the performance, but also the variable components. So for instance, for the variable component, it should underlie a multi-year assessment. So it's not that only a single year, but let's say a weighted average or something like this should be used for more than one year. The variable component should also reflect the development of the firm, being it positive or negative. So executives should participate in positive and negative developments. Even if the executive is laid off, then the severance payment might be capped so that it's a maximum of two years' compensation that you get if you are laid off as an executive.
So in sum, the structure of the compensation should be in the way that is more long-term oriented and based on the sustainable growth of the company, rather than short-term orientation and short-term variable payment based on one-year developments of a firm.
When having thought about the appropriateness of compensation and the structure of compensation, we could now ask ourselves, okay, what are the tools for executive compensation? So let's deep dive a little bit into the different tools that are available, and we here see the firm performance and the remuneration. And we can see that, for example, there's the possibility of, of course, having kind of a fixed component or fixed salary or remuneration. This is then remuneration is fixed, and it doesn't matter how the organization is performing; the salary or the remuneration stays the same. However, there's also the performance-related remuneration. So the better the performance of the organization is, the higher the remuneration gets at the end. It could also be that there's a performance threshold, so that the remuneration and the firm performance are set at a certain standard or certain bar—we can see here in green—and then the performance-related, or including performance threshold, that is then growing with firm performance—the growing remuneration with growing firm performance. Then it could also be that there is a cap at a certain point. So then firm performance could increase even more, but remuneration is set fixed.
So we see that there are these different mechanisms, and how could they look like? We have already spoken about the fixed component. So there is a fixed, performance-independent salary. This could be seen as a worst-case compensation. So if you are, as a company, performing well enough but not very good, then you get just this fixed component. Then there could be a variable component, cash-based, right? So a variable salary component defined or using predefined targets—so let's say the EBIT or something like this as a reference point—and then people get a cash payout based on this performance. A stock-related variable performance could look in the way that you get directly stocks or stock options, so you do not really get the stock directly but you have the option to buy a stock, a real stock or a virtual stock, at a certain point in time, with or without a defined holding period—a period how long you need to hold that stock before you may sell it.
Then also benefits play a role—company car, or in very large companies perhaps also a plane, then insurance, pension awards—all of this can be potential benefits that also are a pay component. However, all of this needs to be disclosed. So executive payment needs to be disclosed in the annual corporate report, in the compensation part of the report.
So good for the theory, but how does all this look in practice? We have here now the top 10 highly paid DAX CEOs from 2023, and as you can see here, the German DAX index is the index, the stock index with the 30 largest organizations or companies in Germany. And here we have, like from Volkswagen, ranging at number one with €10.32 million per year total compensation for the CEO, and then having on place 10 the Deutsche Telekom CEO with €7.53 million compensation per year. On average, the overall DAX index or the overall DAX CEOs, they have an annual or total compensation of €5.69 million in total.
So what can be clearly seen here is that there are a lot of very, very highly paid—as a reminder, annually paid—compensations in the DAX companies.
Comparing now the CEO compensation packages across countries in the same year in 2023, we can see that in the United States the compensation clearly is the highest. And we can differentiate here between long-term variable compensation, short-term variable compensation, and fixed compensation, ranging from darker green to light green, with a fixed compensation. Germany and the German DAX companies—we already saw the actual numbers but are here ranked on the third place, second having Switzerland. But we can clearly see how far behind the second place in Switzerland is here behind the United States. Interestingly, the fixed component seems to be very similar across these different countries or regions, right? Compared to especially the variable and here the long-term variable component, which mostly differs across—the share, the ratio of the long-term variable component compared to the fixed one differs tremendously across these different countries and indices represented by these countries.
So we can now look at the second type of guidelines and regulatory guidelines for remuneration here for the supervisory board. Prior we looked at how the supervisory board can follow guidelines for the executive board. Here we are looking at how the general meeting is discussing about guidelines for the supervisory board remuneration.
For the general meeting, the remuneration specified is by the resolution of the general meeting or in the Articles of Association, so it could also be written down and fixed. So let's again look at the appropriateness of compensation and different evaluation criteria.
The general meeting could use as evaluation criteria, for example, individual responsibilities, again the firm's economic situation and outlook, but also the scope of tasks. So is the person a chair, a deputy chair, in a committee or a committee chair, or has a membership?
So overall, the compensation shall be reported individually in the corporate governance report, subdivided accordingly to components, to comply or explain.
After looking at the appropriateness of the compensation, let's take a look at the structure of the compensation and its different components. There can be a fixed component—fixed salary for supervisory board members. There can also be an activity-based component, so if they attend certain meetings of the complete board or of separate committees, if they attend, they can get an activity-based component. And there may also be a variable, performance-related component—performance determined here meaning the performance of the organization.
In sum, the compensation should be oriented toward the sustainable growth of the enterprise, and thereby reflect also the long-term development of the organization, for supervisory board members giving incentive to behave accordingly.
So we now looked at different regulatory guidelines like evaluation criteria and of course also structures of compensation for the executive and the supervisory board members. But how can we compare them, or how does it look if we're comparing the remuneration of these two types of boards?
The supervisory board members, for example, they get an average €160,000 remuneration. The executive board members, however, it's more about a €3.32 million remuneration on average.
Deep diving into the remuneration of the supervisory board members, we could see that there are a lot of remuneration standards or positions in place here, like for example the highest percentage with the fixed remuneration in darker green, 50% here, and then followed by the variable or long-term remuneration with 20%. Then there is also a variable or short-term remuneration, an attendance fee, or other remuneration forms.
Contrasting this to the executive board members, we could see that the type of remuneration kind of differs because here it's divided between fixed, variable cash, and variable stock remuneration, with 44% in the variable cash, 26% in the variable stock-related remuneration, and around 30% in the fixed remuneration. So besides the pure numbers or the average of euros per year as remuneration, we can see here that the percent of fixed remuneration differs significantly between the supervisory board with 50% and the executive board members with only 30%.
Okay, so we have seen that people in these positions earn quite a lot of money, right, and that they are compensated for their activities. So there are criticisms about this—we have seen this before in the introductory example of the discussion in the media. So there is concern about this, right, and there are here on this slide a few selected points of concern about the regulation about executive compensation. So first of all, we have short-termism, we have the gambling effect, and we have possibilities of manipulation. Let's look at these three different points of concern here in greater detail.
So what does short-termism mean? If we have short-term stock options, right, if an executive can directly sell the stock options after leaving the organization or so, that means perhaps that the executive board member is not making decisions in the long-term interest of the firm, but just on the short run, so that the share value goes up and he or she can get an individual payment, and being not responsible for the long-term development of the organization. So this might ignore long-term commercial viability and organizational health.
In fact, there might be a gambling effect, so that you do something to push the stock potential and ignore downside risks. Or you can manipulate things, so there might be some creative accounting, some accounting tricks to make the organization in the current period, the current annual financial year, more worth, so that the stock price might go up, and thereby stock options might be much more worth. Combined with more short-term stock options and performance-based contracting, those people might be led or might be misled towards manipulating things.
They might also be selective with regards to the information that they share, right, so that they do not share everything fully and honestly and truthfully, so that thereby also a misinterpretation or misvaluation by the public occurs, and thereby stock options or stock prices might go up.
But there are also possible countermeasures, right? So we could refine and redefine stock-related incentives. So we introduce perhaps holding periods, as already explained earlier, so that an executive member may not sell the stock options directly. We could also introduce a stock holding level, so the amount of stock that the people get—there's a minimum of them that they should hold for a given time. We could tie a stock value to a stock index. We could introduce also a loss participation, and we could introduce a cap on stock-related payment.
We could also introduce incentives that are health-related—health-related means organizational health, right. So here we could reduce stock-related incentives and tie compensation more to organizational health, and there might be different criteria or indicators that the supervisory board may use in order to assess management and how management contributed to organizational health—for instance, the market position, the performance with regards to innovation, so comparing, for instance, granted patents of the organization compared to the competitors; productivity, compared also to a benchmark in industry; how good people were that were recruited, how good recruitment processes, how effective they were; and how good we could retain staff—so different health-related measures that could also be included into payment and payment criteria.
The next slide provides a comparison of global trends in long-term incentive plans for executives across three regions. So we have Europe here, we have the United States, and we have Asia-Pacific. So arrows will be used to indicate whether each type of incentive—we have here stock options, restricted stock or service-based stock, and performance-based awards—are increasing or decreasing in popularity or importance in each of these three regions.
So let's have a look at the first option, the stock options. Stock options give executives the right to buy company shares at a predetermined price after a specified period. If the company's stock price increases, the executives can purchase shares at a lower price and potentially then sell them off for profit. So they can align their financial rewards with the company's stock performance. However, and this is indicated here by the decreasing gray arrow, stock options have fallen out of favor in recent years due to concerns that they can incentivize short-term thinking, so that they boost more short-term share prices instead of thinking about long-term sustainability. And the arrows here are indicating that in Europe and the United States, the option of stock option is clearly decreasing, whereas in Asia-Pacific it's a less decreasing trend.
The second incentive plan can be seen as the restricted stocks or the service-based stocks, and they are referring to shares that are granted to executives with restrictions, so not unrestricted as in the stock options, often related to time. So executives must stay with a company for a set period before they fully own the shares, and this is also known as vesting. And as we can see here with the green flashes, this type of incentive is becoming more popular across Europe, the United States, and Asia-Pacific, because it encourages the executives to remain within the company to foster loyalty and of course also long-term commitment. And based on the file size or the flash size, we can see that this option is increasing especially in Asia-Pacific.
And then as a third variant, we have the performance-based awards. The performance-based awards are incentives linked to the achievement of specific performance metrics, like for example revenue growth, profitability, or also sustainability goals. Executives receive these awards only if they meet or exceed these targets that have been set before, which are typically aligned with the company's strategic goals. And as we can see here with the flashes, we can see that in Europe and in Asia-Pacific, these performance-based awards are increasing in popularity, also in the United States but with less value.
What did we learn in this video? We learned that incentives, both monetary and non-monetary, are crucial for aligning executive behavior with corporate goals to balance short-term performance with long-term sustainability. And we also learned that there is a shift from traditional agency logic to entrepreneurial logic, and this emphasizes responsible long-term growth over immediate financial returns, with a focus on performance-based rewards. Third, we also saw that global trends and regulatory guidelines aim to ensure transparency and fairness in executive compensation, promoting ethical leadership and sustainable corporate success.
Thanks for watching.How can we design incentive systems to align executive behavior with corporate goals and ethical standards? This is what we are talking about in this video. But first of all, let's have a look at our learning objectives.
In this video, we are reflecting upon the relevance of monetary and non-monetary incentives for ethical organizational behavior. Furthermore, we're getting to know the regulatory guidelines and toolboxes for executives and supervisory board remuneration. In the third step, we're identifying key challenges associated with and measures to increase the effectiveness of board remuneration practices.
So there's a long ongoing debate in the public and also in media about executive remuneration, and there are statements that executive payment has become overly complex—too many cash and share-based awards, long- and short-term targets, and the profusion of measures of success ranging from earnings per share to total shareholder return to return on equity. So many chief executives and other top managers struggle to understand what is in their pay package and how to hit their targets.
So what is the statement here? Payment for executives—for the ones who make the decisions in the firm, for the managers—is too complex. There are too many forms, and how these forms relate then to the target is not clear.
The statement here goes on or includes also other groups. Pay consultants agree with this assessment of the statement above, saying that the link between achievement and reward is frequently opaque. So very often, executives don't understand the plan—their payment plan—because it's too remote from them.
And above all, the amount of top managers and what they earn in the US especially is unjustifiably high. So here we see in the statement in the Financial Times that between 1978 and 2020, adjusted for inflation, the payment rose by 1,129%. So that's roughly 28% faster than the stock market has grown in the same period. So the payment really outcompeted, so to say, the stock market growth, and thereby questions are coming up whether this is fair or not, especially compared to worker payment, which rose by only around about 15% in the same period, according to the Economic Policy Institute.
There's also a statement that in 2022, CEOs were paid 344 times as much as a typical worker, compared to 1965 when they were paid 20 times as much as a typical worker. And this really brings incentives and payment schemes for executives center stage as a measure to align behavior with moral and ethical behavior of organizations. And we could ask whether the payment itself is ethical, and the ratio between CEO payment and worker payment is in focus here.
So incentives are now our focus here in that video as the third pillar of corporate governance—how we can align ethics and organizational behavior in a firm. And again, there are different logics behind incentives, right? So there's an agency logic where we want to ensure that incentives make sure or ensure that board members follow what is—or that their behavior is aligned with the interests of shareholders. And there's an entrepreneurial logic where we say, okay, we should have incentives in a way that they ensure that the company or the executives behave in a way that the organizational chance of survival is as high as possible.
So let's take a look at the agency logic first. Here we want to align board members' interests with the interests of the shareholders. And therefore, we want to align what board members do with the preferences of what the shareholders would want, with their risk preferences but also with their general behavioral interests. And therefore, we would reward board members mainly with stock with regards to the stock performance, because the stock performance and the dividend per stock is what shareholders get. And therefore, if payment is aligned with what shareholders get, payment of executives—their behavior—is as best aligned with shareholder interest as possible. So we use as a key incentive mechanism stock-related compensation, and thereby board members are similar to shareholders—they even become shareholders because they receive stocks, stock options, virtual stocks, restricted stocks—what it is you will hear later about that.
In the entrepreneurial logic, the idea is slightly different, right? So we would align the board members' interest with the long-term interest of the firm—the long-term interest of an entrepreneur. So we want to encourage, to some degree, morally and socially appropriate behavior, and reward board members for the overall health of the organization, for the overall survivability of the organization. And the incentives here would be then more health-related. So health-related means the health of the organization. So we could have a cash bonus that is tied to a certain health indicator for the organization. It could also be stocks, but some with a defined long-term holding period where you only can sell the stocks after a longer period of time. And there could be a non-monetary mechanism to guide behavior, namely culture here.
So let's now have a deeper look at how the regulatory guidelines are formed and what regulatory guidelines are present for executive board remuneration.
For executive board remuneration, it's typically the supervisory board that is setting the guidelines or the regulatory frameworks for their remuneration. So they formulate a remuneration proposal by the remuneration committee and approve then by the entire supervisory board.
On the one hand, we can talk about appropriateness of compensation. So what can be the evaluation criteria of the supervisory board here? For example, individual responsibilities and competencies. So whenever we're thinking about the remuneration of a member of the executive board, it's about to question their responsibilities and competencies. Then, of course, the individual performance and the firm's economic situation and outlook—so what is the current situation of an organization and what might the future look like of the organization? And this is also something the supervisory board could have or could take into consideration when thinking about evaluation criteria. Then, of course, the common compensation in peer firms—to also benchmark with other organizations—and the compensation structure within the focal firm. So does the remuneration align with the structure that is present in a firm? So overall, evaluation criteria might support or might be supported by independent compensation experts, as independent as possible.
The supervisory board is responsible for the appropriateness of the compensation but also for the structure of the compensation. So there are different things that they should consider when developing the compensation scheme, and there are certain guidelines given here in Germany by law. So there are guidelines on the fixed and the variable pay components—the fixed components, which are independent of the performance, but also the variable components. So for instance, for the variable component, it should underlie a multi-year assessment. So it's not that only a single year, but let's say a weighted average or something like this should be used for more than one year. The variable component should also reflect the development of the firm, being it positive or negative. So executives should participate in positive and negative developments. Even if the executive is laid off, then the severance payment might be capped so that it's a maximum of two years' compensation that you get if you are laid off as an executive.
So in sum, the structure of the compensation should be in the way that is more long-term oriented and based on the sustainable growth of the company, rather than short-term orientation and short-term variable payment based on one-year developments of a firm.
When having thought about the appropriateness of compensation and the structure of compensation, we could now ask ourselves, okay, what are the tools for executive compensation? So let's deep dive a little bit into the different tools that are available, and we here see the firm performance and the remuneration. And we can see that, for example, there's the possibility of, of course, having kind of a fixed component or fixed salary or remuneration. This is then remuneration is fixed, and it doesn't matter how the organization is performing; the salary or the remuneration stays the same. However, there's also the performance-related remuneration. So the better the performance of the organization is, the higher the remuneration gets at the end. It could also be that there's a performance threshold, so that the remuneration and the firm performance are set at a certain standard or certain bar—we can see here in green—and then the performance-related, or including performance threshold, that is then growing with firm performance—the growing remuneration with growing firm performance. Then it could also be that there is a cap at a certain point. So then firm performance could increase even more, but remuneration is set fixed.
So we see that there are these different mechanisms, and how could they look like? We have already spoken about the fixed component. So there is a fixed, performance-independent salary. This could be seen as a worst-case compensation. So if you are, as a company, performing well enough but not very good, then you get just this fixed component. Then there could be a variable component, cash-based, right? So a variable salary component defined or using predefined targets—so let's say the EBIT or something like this as a reference point—and then people get a cash payout based on this performance. A stock-related variable performance could look in the way that you get directly stocks or stock options, so you do not really get the stock directly but you have the option to buy a stock, a real stock or a virtual stock, at a certain point in time, with or without a defined holding period—a period how long you need to hold that stock before you may sell it.
Then also benefits play a role—company car, or in very large companies perhaps also a plane, then insurance, pension awards—all of this can be potential benefits that also are a pay component. However, all of this needs to be disclosed. So executive payment needs to be disclosed in the annual corporate report, in the compensation part of the report.
So good for the theory, but how does all this look in practice? We have here now the top 10 highly paid DAX CEOs from 2023, and as you can see here, the German DAX index is the index, the stock index with the 30 largest organizations or companies in Germany. And here we have, like from Volkswagen, ranging at number one with €10.32 million per year total compensation for the CEO, and then having on place 10 the Deutsche Telekom CEO with €7.53 million compensation per year. On average, the overall DAX index or the overall DAX CEOs, they have an annual or total compensation of €5.69 million in total.
So what can be clearly seen here is that there are a lot of very, very highly paid—as a reminder, annually paid—compensations in the DAX companies.
Comparing now the CEO compensation packages across countries in the same year in 2023, we can see that in the United States the compensation clearly is the highest. And we can differentiate here between long-term variable compensation, short-term variable compensation, and fixed compensation, ranging from darker green to light green, with a fixed compensation. Germany and the German DAX companies—we already saw the actual numbers but are here ranked on the third place, second having Switzerland. But we can clearly see how far behind the second place in Switzerland is here behind the United States. Interestingly, the fixed component seems to be very similar across these different countries or regions, right? Compared to especially the variable and here the long-term variable component, which mostly differs across—the share, the ratio of the long-term variable component compared to the fixed one differs tremendously across these different countries and indices represented by these countries.
So we can now look at the second type of guidelines and regulatory guidelines for remuneration here for the supervisory board. Prior we looked at how the supervisory board can follow guidelines for the executive board. Here we are looking at how the general meeting is discussing about guidelines for the supervisory board remuneration.
For the general meeting, the remuneration specified is by the resolution of the general meeting or in the Articles of Association, so it could also be written down and fixed. So let's again look at the appropriateness of compensation and different evaluation criteria.
The general meeting could use as evaluation criteria, for example, individual responsibilities, again the firm's economic situation and outlook, but also the scope of tasks. So is the person a chair, a deputy chair, in a committee or a committee chair, or has a membership?
So overall, the compensation shall be reported individually in the corporate governance report, subdivided accordingly to components, to comply or explain.
After looking at the appropriateness of the compensation, let's take a look at the structure of the compensation and its different components. There can be a fixed component—fixed salary for supervisory board members. There can also be an activity-based component, so if they attend certain meetings of the complete board or of separate committees, if they attend, they can get an activity-based component. And there may also be a variable, performance-related component—performance determined here meaning the performance of the organization.
In sum, the compensation should be oriented toward the sustainable growth of the enterprise, and thereby reflect also the long-term development of the organization, for supervisory board members giving incentive to behave accordingly.
So we now looked at different regulatory guidelines like evaluation criteria and of course also structures of compensation for the executive and the supervisory board members. But how can we compare them, or how does it look if we're comparing the remuneration of these two types of boards?
The supervisory board members, for example, they get an average €160,000 remuneration. The executive board members, however, it's more about a €3.32 million remuneration on average.
Deep diving into the remuneration of the supervisory board members, we could see that there are a lot of remuneration standards or positions in place here, like for example the highest percentage with the fixed remuneration in darker green, 50% here, and then followed by the variable or long-term remuneration with 20%. Then there is also a variable or short-term remuneration, an attendance fee, or other remuneration forms.
Contrasting this to the executive board members, we could see that the type of remuneration kind of differs because here it's divided between fixed, variable cash, and variable stock remuneration, with 44% in the variable cash, 26% in the variable stock-related remuneration, and around 30% in the fixed remuneration. So besides the pure numbers or the average of euros per year as remuneration, we can see here that the percent of fixed remuneration differs significantly between the supervisory board with 50% and the executive board members with only 30%.
Okay, so we have seen that people in these positions earn quite a lot of money, right, and that they are compensated for their activities. So there are criticisms about this—we have seen this before in the introductory example of the discussion in the media. So there is concern about this, right, and there are here on this slide a few selected points of concern about the regulation about executive compensation. So first of all, we have short-termism, we have the gambling effect, and we have possibilities of manipulation. Let's look at these three different points of concern here in greater detail.
So what does short-termism mean? If we have short-term stock options, right, if an executive can directly sell the stock options after leaving the organization or so, that means perhaps that the executive board member is not making decisions in the long-term interest of the firm, but just on the short run, so that the share value goes up and he or she can get an individual payment, and being not responsible for the long-term development of the organization. So this might ignore long-term commercial viability and organizational health.
In fact, there might be a gambling effect, so that you do something to push the stock potential and ignore downside risks. Or you can manipulate things, so there might be some creative accounting, some accounting tricks to make the organization in the current period, the current annual financial year, more worth, so that the stock price might go up, and thereby stock options might be much more worth. Combined with more short-term stock options and performance-based contracting, those people might be led or might be misled towards manipulating things.
They might also be selective with regards to the information that they share, right, so that they do not share everything fully and honestly and truthfully, so that thereby also a misinterpretation or misvaluation by the public occurs, and thereby stock options or stock prices might go up.
But there are also possible countermeasures, right? So we could refine and redefine stock-related incentives. So we introduce perhaps holding periods, as already explained earlier, so that an executive member may not sell the stock options directly. We could also introduce a stock holding level, so the amount of stock that the people get—there's a minimum of them that they should hold for a given time. We could tie a stock value to a stock index. We could introduce also a loss participation, and we could introduce a cap on stock-related payment.
We could also introduce incentives that are health-related—health-related means organizational health, right. So here we could reduce stock-related incentives and tie compensation more to organizational health, and there might be different criteria or indicators that the supervisory board may use in order to assess management and how management contributed to organizational health—for instance, the market position, the performance with regards to innovation, so comparing, for instance, granted patents of the organization compared to the competitors; productivity, compared also to a benchmark in industry; how good people were that were recruited, how good recruitment processes, how effective they were; and how good we could retain staff—so different health-related measures that could also be included into payment and payment criteria.
The next slide provides a comparison of global trends in long-term incentive plans for executives across three regions. So we have Europe here, we have the United States, and we have Asia-Pacific. So arrows will be used to indicate whether each type of incentive—we have here stock options, restricted stock or service-based stock, and performance-based awards—are increasing or decreasing in popularity or importance in each of these three regions.
So let's have a look at the first option, the stock options. Stock options give executives the right to buy company shares at a predetermined price after a specified period. If the company's stock price increases, the executives can purchase shares at a lower price and potentially then sell them off for profit. So they can align their financial rewards with the company's stock performance. However, and this is indicated here by the decreasing gray arrow, stock options have fallen out of favor in recent years due to concerns that they can incentivize short-term thinking, so that they boost more short-term share prices instead of thinking about long-term sustainability. And the arrows here are indicating that in Europe and the United States, the option of stock option is clearly decreasing, whereas in Asia-Pacific it's a less decreasing trend.
The second incentive plan can be seen as the restricted stocks or the service-based stocks, and they are referring to shares that are granted to executives with restrictions, so not unrestricted as in the stock options, often related to time. So executives must stay with a company for a set period before they fully own the shares, and this is also known as vesting. And as we can see here with the green flashes, this type of incentive is becoming more popular across Europe, the United States, and Asia-Pacific, because it encourages the executives to remain within the company to foster loyalty and of course also long-term commitment. And based on the file size or the flash size, we can see that this option is increasing especially in Asia-Pacific.
And then as a third variant, we have the performance-based awards. The performance-based awards are incentives linked to the achievement of specific performance metrics, like for example revenue growth, profitability, or also sustainability goals. Executives receive these awards only if they meet or exceed these targets that have been set before, which are typically aligned with the company's strategic goals. And as we can see here with the flashes, we can see that in Europe and in Asia-Pacific, these performance-based awards are increasing in popularity, also in the United States but with less value.
What did we learn in this video? We learned that incentives, both monetary and non-monetary, are crucial for aligning executive behavior with corporate goals to balance short-term performance with long-term sustainability. And we also learned that there is a shift from traditional agency logic to entrepreneurial logic, and this emphasizes responsible long-term growth over immediate financial returns, with a focus on performance-based rewards. Third, we also saw that global trends and regulatory guidelines aim to ensure transparency and fairness in executive compensation, promoting ethical leadership and sustainable corporate success.
Thanks for watching.
Transcript
how can we design incentive systems toalign executive Behavior with corporategoals and ethical standards this is whatwe are talking about in this video butfirst of all let's have a look at ourlearningobjectives in this video we arereflecting up on the relevance ofmonetary and non-monetary incentives forethical organizational behaviorfurthermore we're getting to know theregulatory guidelines and toolboxes forexecutives and Superior boardremunerationand in the third step we're identifyingkey challenges associated with andmeasures to increase the effectivenessBo renumerationpractices so there's a long ongoingdebate uh in the public and also inmedia about uh executive remunerationand uh there are statements thatexecutives are paid uh execuive paymenthas become overly complex too many cashand chair based Awards long andshortterm T targets and the profusion ofmeasures of success ranging fromearnings per share to Total shareholderreturn to return on Equity so many ChiefExecutives and other top managersstruggle to understand what is in theirpay package and how to hit their targetsso what is the statement here paymentfor executives for uh the ones who makethe decisions in The Firm for themanagers is too complex there are toomany forms and how these forms relatethen to the Targetis uh yeah is not clear so the thestatement here goes on right or includesalso other groups so pay Consultantsagree with this assessment of thestatement above saying that the linkbetween achievement and reward isfrequently a park so very oftenExecutives don't understand the plan sotheir uh payment plan because it's tooremote from them and above all uh theamount of top managers and what theyearnuh in the US especially is unjustifiablyhigh so uh here we we see in the in thestatement in the financial times thatbetween 1978 and2020 uh adjusted for inflation thepayment Rose by 1,129% so that's uh roughly 28% fasterthan the stock market market has grownin the same period so uh the paymentreally outco competed so to say thestock market uh growth and thereby uhquestions are coming up whether this isfair or not uh especially compared to uhworker payment which rose by only aroundabout 15% in the same period accordingto the uh economy policy Institute umthere's also uh uh a statement that in2022 CEOs were paid 3 45 44 times asmuch as a typical worker compared to1965 when they pay were paid 2 timesmuch more as a typical worker and thisreally brings incentives and paymentschemes for uh Executive Center Stage umas a measure to align uh yeah Behaviorwith um yeah morale and uh yeah ethicalbehavior of organizations and we couldask whether the payment itself isethical uh and the the ratio between CEOpayment and worker payment in fact uh orin focused here so incentives are nowour Focus here in that video as thethird pillar of corporate governance howwe can align uh ethics andorganizational behavior in a firm andagain there aredifferent Logics behind Cent incentivesright so there's an agency logic wherewe want to ensure that um yeahincentives make sure or ensure that uhboard members uh follow what is or thattheir behavior is aligned with theinterests of shareholders and there's anentrepreneurial logic where we say okaywe should have incentives in a way thatthey ensure that uh the company or theexecutives behave uh so in a way thattheorganizational uh yeah chance ofsurvival is as high as possible so let'stake a look at the agency logic first sohere we want to align a set uh boardmembers interests with the interest oftheshareholders and therefore we want uhyeah to align what uh Bard members uh dowith with the preferences of what umyeah the uh the shareholders would wouldwant right with their risk preferencesbut also with their General behavioralinterests uh and therefore we wouldreward board members mainly with stockuh with regards to the stock performancebecause the stock performance and uh thedividend per stock is what shareholdersget and therefore if uh payment isaligned with what shareholders get uhpayment of Executives their behavior isas best aligned with shareholderinterest as possible so we use as a keyincentive mechanism stock ratedcompensation and thereby Bob members aresimilar to shareholders a they evenbecome shareholders because they receivestocks stock options virtual stocksrestricted stocks what is is you hearlater about that in the entrepreneuriallogic uh the idea is slightly differentright so we would uh align the boardmembers interest with the long-terminterest of the firm the long-terminterest of an entrepreneur so we wanttoencourage uh to some degree morally andsocially appropriate behavior and rewardboard members for the overall health ofthe organization for the overhalloverall survivability of the organorganization and the incentives herewould be then more health related sohealth related means the health of theorganization so we could have a cashbonus that is TR tied to a certainHealth indicator for theorganization um it could also be stocksum but some with a defined long-termholding period where you only can sellthe stocks after uh a longer period oftime and there could be uh yeah anon-monetary mechanism to guide Behaviornamely culture here so let's now have adeeper look at how the regulatoryguidelines are formed and whatregulatory guidelines are present forexecutive boardrenumeration so for executive boardrenumeration it's typically thesupervisory board that is setting theguidelines or the regulatory Frameworksfor their renumeration so they formulatea renumeration proposal by therenumeration committee and approve thenby the entire supervisory board so atthe one hand side we can talk about uhappropriateness of compensation so whatcan be the evaluation criteria of thesupervisory board here for exampleindividual responsibilities andcompetencies so whenever we're thinkingabout the renumeration of um a member ofthe executive board it's about toquestion their responsibilities andcompetencies then of course theindividual performance and the firmeconomic situ situation and Outlook sowhat is the current situation of anorganization and what is the future umor what might the future look like ofthe organization and this is alsosomething um the uh yeah supervisoryboard could have um or it could takeinto consideration when thinking aboutevaluation criteria then of course thecommon compensation in peer firms so toalso Benchmark with other organizationsand the compensation structure withinthe focal firm so does the renumerationAlign with the structure that is presentin a firm so so overall evaluationcriteria might support or might besupported by independent compensationexperts and um like as independent aspossible so um the supervisory board isresponsible for the appropriateness ofthe compensation but also for thestructure of the compensation so thereare different things that they shouldconsider when uh developing thecompensation scheme and there arecertain guidelines givenhere in Germany by law so there areguidelines on the fixed and the variablepay components so the fixed componentswhich are independent of the performancebut also the variable components so forinstance for the variable component itshould uh underly a multi-yearassessment so it's not that only asingle year but uh let's say weightedaverage or something like this should beused for more than one year the uhvariable component should also uhreflecting the development of the firmbeing at positive or negative soExecutives should participate inpositive and negative developments eventhe executive is uh laid off right thenthe severance payment might be uh yeahcapped so that it's a maximum of twoyears compensation that you get if uhyou are laid off as an executive so insome the structure of the compensationshould be in the way that is morelong-term oriented and uh yeah based onthe sustainable growth of the companyrather than short-term orientation andshort-term variable payment based onone-ear developments of a firm so whenhaving thought about the appropriatenessof compensation and the structure ofcompensation we could now ask ourselfokay what are the tools for executivecompensation so let's Deep dive a littlebit in uh the different tools that areavailable and we here see the firmperformance and therenumeration and we can see that forexample there's the possibility of ofcourse having kind of a fixed componentor fixed salary or renumeration this isthen um yeah renumeration is fixed andit doesn't matter how the organizationis performing is performing um thesalary or the renumeration stays thesame however there's also theperformance related renumeration so uhyeah the better the performance of ofthe organization is the higher therenumeration gets at theend it could also be that there's aperformance threshold so that therenumeration uh and the firm performanceare set at a certain uh certain standardor certain bar we can see here in greenand then the performance related um orincluding performance threshold that isthen um yeah growing with firm performthe growing renumeration with growingfirm performance then it could also bethat there is a cap at a certain pointso then um yeah firm performance couldincrease even more but renumeration isset fixed so we see that there are thesedifferent mechanisms and how could theylook like so um we have have alreadyspoken about uh the fixed component sothere is a fixed performance independentsalary uh this could be seen as a worstcase compensation so if you are as acompany performingwell enough then uh but not very goodthen you get just this fixed componentthen there could be a variable componentcash based right so a Valery salary uhcomponent defined or using predefinedtargets so uh let's say the abbit orsomething like this as a reference pointand then people get uh a cash uh payoutbased on this performance a stockrelated uh VAR performance could look inthe way that you get directly stocks orstock options so you do not really getthe stock directly but you have theoption to buy uh a stock uh a real stockor a virtual stock um at a certain pointin time with or without a definedholding period right a period how longyou need to hold that stock before youmaybe uh May um May sell it then alsobenefits play a role right company caror in in very large companies perhapsalso a plane uh then uh Insurancepension Awards all of this um can be uhpotential benefits that also are a paycomponent however all of this needs tobedisclosed uh so executive payment needsto be disclosed in the annual corporatereward in the uh uh report in thecompensation uh partof the um of the report so so good forthe theory but how does all this look inpractice we have here now the um top 10higher highly paid Dex CEOs from uh2023 and as you can see here um theGerman Dex index is the index the stockindex with the 30 um yeah largestorganizations or companies in Germanyand here we have like from Volkswagenranging at uh number 10 uh number onewith10.32 million EUR per year totalcompensation for the CEO and then havingon um place 10 the doger Telecom CEOwith7.53 million EUR compensation per yearon average the overall Dex index or theoverall Dex CEOs they have an annual ortotal compensation of5.69 million EUR in total so what can beclearly seen here is that there are alot of like very very highly paid as isa remember annually paid compensationsin the Daxcompanies comparing now the CEOcompensation packages across countriesin the same year in 2023 we can see thatin the United States uh States the umcompensation clearly is the highest andwe can differentiate here betweenlong-term um variable um compens ationshort-term variable compensation andfixed compensation ranging from darkergreen to light green with a fixedcompensation Germany and the German Daxum companies we already saw the actualnumbers but are here ranked on uh thethird place second uh having Switzerlandbut we can clearly see um how far behindthe second place in Switzerland is herebehind the UnitedStates interestingly uh the fixedcomponent seems to be very similaracross these different countries orregions right um compared to uhespecially the variable and here thelong-term variable component which uhmostly differs across uh the or theshare the ratio of the long-termvariable component compared to the fixedone differs uh differs yeah tremendouslyacross these different countries andindices represented by these countriesso um we can now look at the second typeof uh yeah guidelines and Regulatoryguidelines um for rumination here forthe sub supervisory board prior welooked at how the supervisory board canum yeah can follow guidelines for theexecutive board here we are looking athow the general meeting is um yeahdiscussing about guidelines for thesupervisory board renumerationso for the general meeting therenumeration specified is by theresolution of the general meeting or inthe Articles of Association so it couldalso be um yeah written down and fixedso let's again look at the approprappropriateness of compensation anddifferent evaluation criteria so thegeneral meeting could use as evaluationcriteria for example uh individualresponsibilities uh Again The Firmeconomic situation and out look but alsothe scope of tasks so is the person achair a deputy chair in a committee or acommittee chair or has it amembership so overall the compensationshall be reported individually in thecorporate governance report subdividedaccordingly to components to comply orexplain so after looking at theappropriateness of the compensationlet's take a look at the structure ofthe compensation and its differentcomponents there can be a fixedcomponent right fixed salary forsupervisory board members there can alsobe an activity based components so ifthey attend certainmeetings uh in uh of the complete boardor of separate committees if they attendthey can get an activity based componentand there may also be a variableperformance related componentperformance determined here uh ormeaning the performance of theorganization and some the uh the uh thecompensation should be uh orientedtoward the sustainable growth of theEnterprise and thereby uh reflect alsouh the the long-term and development ofthe organization uh for supervisoryboard members giving incentive to behaveaccordingly so we now looked atdifferent regulatory guidelines likeevaluation criteria and of course alsoum structures of compensation for theexecutive and the super uh supervisoryboard memb members but how can wecompare them or like how does it look ifwe're comparing the renumeration ofthese two types of boards so thesupervisory board members for example uhthey get an average € 160,000 uhrenumeration the executive board membershowever it's more about a 3.32 millionEUR Reen numeration on average deepdiving into the renumeration of thesupervisory board members we could seethat there are a lot of of um yeahrenumeration um yeah standards or um umpositions in place here like for examplethe highest percentage with the fixedrenumeration in Darker green 50% hereand then followed by the variable orlong-term renumeration with20% then there is also a v variable orshort-term uh renumeration an attendancefee or uh other renumerationforms contrast testing this to theexecutive board members we could seethat the type of renumeration um kind ofdiffers because here it is we uh it'sdivided between fixed variable cache andvariable stock renumeration with44% in the variable cach 26% in thevariable stock related un numeration andaround 30% in the fixed un numeration sobesides the pure numbers or the averageof Euros per year is a renumeration wecan see here that the um percent of offixed renumeration differs uhsignificantly between the supervisoryboard with 50% and the executive boardmembers with only30% okay so we have seen that uh peoplein these positions earn quite a lot ofmoney right um and that they arecompensated uh yeah for their activitiesso there are criticism about this wehave seen this before and introductoryexample of the discussion in in themedia so uh there is concern about thisright and there are here on this slide afew selected points of concern about theregular uh the regul regulation aboutexecutive compensation so first of allwe have short termism right we have thegambling effect and we have we have uhpossibilities of manipulation let's lookat these three different points ofconcern here in Greater detail so sowhat does short termin minism mean so ifwe have short-term stock options rightif uh an executive can directly sell uhthe stock options uh after leaving theorganization or so that means perhapsthat the um uh that the executive boardmember is not um making decisions in thelong-term interest of the firm but justuh on the short run so that the share uhvalue goes up and he or she can get uhyeah an individual payment uh uh andbeing not responsible for the long-termdevelopment of the organization so thismight ignore long-term commercialviability and organizational Health infact there might be a gambling effect sothat you do something uh to to to pushthe stock potential right uh and ignoredownside risks or you can manipulatethings so there might be some CreativeAccounting some accounting tricks someto make the organization in the uhcurrent period the current annualFinancial year um more more worth sothat the stock price might go up uh andthereby uh yeah stock options might bemuch more worth uh combined with yeahmore short-term uh stock options andperformance-based Contracting thosepeople might be yeah leaded or might bemisled towards manipulating things theymight also be selective with regards tothe information that they share right sothat they do not share everything fullyand uh honestly and truthfully uh sothat uh thereby also yeah amisinterpretation or mis valuation uh bythe public occurs and thereby stockoptions or stock prices might go up butthere are also possible counter measuresright so we could uh refine and uhredefine stock rated incentives so weintroduce perhaps uh holding periods asalready explained earlier so that an uhan executive member may not sell thestock optionsdirectly we could also introduce a stockholding level so the amount of stockthat the people get um there's a minimumof them that they should hold for agiventime we could uh tie uh a stock value toa stock index we could introduce also alossparticipation um and we could introducea cap on stock relatedpayment we could also uh uh introduceincentive that are health related healthrelated means organizational Healthright so here we could reduce stockrelated incentives and tie compensationmore to organizational health and theremight be different umuh uh criteria or indicators that thesupervisory board may use in order toassess uh yeah management and uh howmanagement contributed to organizationalhealth for instance the market positionthe performance with regards toInnovation so comparing per for instanceuh granted patents of the organizationcompared to uh the competitorsproductivity compared also to uh uh to abenchmark in Industry uh how good uhpeople were that were recruited how goodrecruitment processes how effective theywere um and uh how good we could retainuh how good we are with with staffretention so different health relatedmeasures that could also be includedinto uh payment and payment criteria sothe next slide provides a comparison ofGlobal Trends in long-term incentiveplans for executives across threeregions so we have Europe here we havethe United States and we have uh AsiaPacific so um errors will be used toindicate whether each type of incentivewe have your stock options uh restrictedstock or service-based stock andperformance-based awards um areincreasing or decreasing in popularityor importance in each of these threeregions so let's have a look at thefirst First Option the uh stock optionsso stock options give Executives theright to buy company shares at apredetermined price after a specific uhspecified period if the company's stockprice increases the executives canpurchase shares at a lower price andpotentially then sell them off forprofit so they can align their financialrewards with the company's stockperformance however and this isindicated here by the decreasing grayerrorstock options have fallen out of favorin recent years due to concerns thatthey can incentivize short-term thinkingso that they boost more shortterm umyeah to to boost short-term share pricesinstead of thinking about long-termsustainability and the errors here areindicating that in Europe and the UnitedStates the option of stock option isclearly decreasing whether in AsiaPacific it's a a less decreasing trendum the second um incentive plan can beseen as the restricted stocks or theservice based stocks and um they arereferring to shares that are granted toExecutives with restrictions so notunrestricted as in the stock optionsoften related to time so Executives muststay with a company for a set of periodbefore they fully own the shares andthis is also known as vesting and as wecan see here where the uh the greenflashes this type of incentives isbecoming more popular across Europe theUnited States and Asia Pacific becauseit encourages uh the executives toremain within the company to Fosterloyalty and of course also long-termcommitment and B based on the file saysize or the Flasher size we can see thatthis option is increasing especially inAsiaPacific and then as a third variance wehave the performance-based awards andthe performance-based awards areincentives linked to the achievement ofspecific performance metrics like forexample Revenue growth profitability oralso sustainability goals so Executivesreceive these Awards only if they meetor exceed these targets that have beenset before which are typically alignedwith the company's strategic goals andas we can see here with the flashes uhwe can see that in Europe and in AsiaPacific these performance-based awardsare increasing in popularity uh also inthe United States but with um lessvalue so what did we learn in this videowe learned that incentives both monetaryand non-monetary are crucial foraligning executive Behavior withcorporate goals to balance short-termperformance with long-termsustainability and we also learned thata shift that there is a shift fromtraditional agency logic toentrepreneurial logic and thisemphasizes responsible long-term growthover Financial or in immediate financialreturns with a focus onperformance-based rewards and third wealso um saw that Global Trends andRegulatory guidelines aim to ensuretransparency and fairness in executivecompensation promoting ethicalleadership and sustainable corporatesuccess thanks for watching
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