1. the debate. Whereas academics in the 1990s, such


compensation is a controversial subject and evoked considerable debate on
whether CxOs of public companies are paid correctly for their services to the
organization both in terms of magnitude and relation to performance (Donatiello, Larcker and Tayan, 2016,
p. 1). Even
though CxO compensation is hardly a new topic, its relevance is established on
the urgent concern over economic inequality (Lowenstein, 2017, p. 58).

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CxO compensation has risen 937% from 1978
to 2016. In contrast, a typical worker’s compensation only has risen 11.2% over
the same period. As a result of this trend, CEOs in America’s largest firms
made an average of USD 15.6 million in compensation or 271 times the annual
average pay of the typical worker (Mishel and Schieder, 2017, p. 1).

Besides exorbitant pay, however, the main
drivers for criticism on CxO compensation on the one hand are flawed
compensation practices and on the other hand CxOs that make use of that for
their own benefit (Bebchuk and Fried, 2006, p. 6). Such criticism becomes even more relevant in cases top executives
depart with golden parachutes of millions of euros although they did not manage
to save their firm from significant crises or even insolvency – just as Thomas
Winkelmann, former Air Berlin CEO, recently did (Fockenbrock, 2017).

At the World Economic Forum in 2017, Rajeev
Vasudeva, CEO of Egon Zehnder, summarized CxO compensation being a complex
subject that must be put into perspective. When talking about CxO compensation,
generally, the top executives of huge private-equity firms, such as S&P 500
firms are meant. Furthermore, it must be considered that there might be a huge
disparity in the magnitude of CxO compensation between different countries (Cramer, Hanley and Vasudeva, 2017).

The fact that CxO compensation is a complex
subject becomes virtually clear when taking into consideration the development
of the debate. Whereas academics in the 1990s, such as Jensen and Murphy (1990), called for paying CxOs for performance, more than 20 years later, Cable and Vermeulen (2016) even took up an opposing position. In the end, however, the
approach should be favored that allows best alignment of CxOs and shareholders’


In this paper, the challenges and actual
issues of CxO compensation shall be identified and, thereby, an implication for
potential changes in compensation practices shall be derived.


The research connected to this paper is
primarily based on a literature review. To lay the foundation for the following
research, CxO compensation is introduced as an agency problem in the first
instance. Thereafter, the objectives and characteristics of CxO compensation are
explained. Based on this, critical aspects of CxO compensation are identified.
Due to the complexity of the subject, the focus of this paper primarily lies on
assessing common compensation practices in terms of effectiveness rather than
the level of CxO compensation.

Main part

CxO Compensation as an Agency

From an academic perspective, CxO
compensation is based on one of the most fundamental principles in economics –
the principal-agent problem (Jensen and Meckling, 1976, p. 308). In this framework, shareholders are viewed as owner of the firm
and act as principals who retain boards of directors and senior executives as
their agents to operate the firm on behalf of the owners. Under this model,
shareholders charge corporate boards with the general oversight of the firm. (Kolb, 2012, p. 24). The perfect agent is one who would operate the firm as
shareholders would do if they were in possession of the required managerial
skills and in the managerial authority to do so. However, the central tension
of principal-agent theory is that owners and managers of the firm are persons
with their own desires, goals and ends for which they strive. As a consequence,
shareholders see themselves confronted with an inescapable agency problem (Kolb, 2012, p. 25).

Generally, there are two ways for the
principal to confront this agency problem: either the principal continuously
monitors the agent’s behavior and corrects if necessary or the principal can
establish incentives to induce the agent to behave in the principal’s interest,
which is assumed to be more feasible in practice (Jensen and Meckling, 1976, p. 308;
Kolb, 2012, p. 26).

Given that compensation is a factor to influence
human behavior, CxO compensation packages are designed in a way that seek
alignment with shareholders’ interests and that induce CxOs to perform to the
best of their abilities, thus increasing the value of the firm (Kolb, 2012, p. 28).

Characteristics of CxO

In principle, CxO compensation can be
viewed as an instrument aiming at attracting, retaining and motivating
corporate executives to increase shareholder value (Donatiello, Larcker and Tayan, 2016,
p. 1). When
setting up a CxOs compensation package, which is one of the key duties of the
board of directors, several factors must be considered in order to support achieving
organizational goals, reflecting actual business performance, paying
competitively and rewarding executives for value provided (Becker and Rowley, 2012, p. 13;
Kolb, 2012, p. 27). In
this regard, compensation packages should be arranged in accordance with the
principle of arm’s-length contracting – contracting between CxOs attempting to
get the best possible deal for themselves and boards seeking to get the best
possible deal for shareholders (Bebchuk and Fried, 2006, p. 5).

Most commonly, CxOs are appointed for their
position for specific period of time (Schwab and Thomas, 2006, pp.
246–248). In
exchange for their services to their firm, CxOs are promised compensation that
comes in various forms such as base salary, short and long-term incentives,
perquisites as well as severance and change-in-control agreements.


As it is indicated by its name, base salary
forms the foundation of an CxO’s compensation package. It is the least complex
component of an CxO’s compensation package since it is a fixed amount that a firm’s
CxO is rewarded despite its performance. The amount of base salary paid to an CxO
commonly derives from the market and the value of the position and the person
in it to the organization. In principle, base salary represents a less
considerable portion of the total amount of CxO pay. However, the amount of
base salary may significantly impact the total amount of CxO pay. This results
from the fact that base salary often forms the foundation for determining variable
components of the compensation package (Bowers, 2012, pp. 42–43).



Short-term incentives, also referred to as
annual incentives, are intended to influence CxOs’ performance and/or behavior by
awarding CxOs for the achievement of the companies short-term strategy (Teesdale and Somelofske, 2012, p.
51; Center on Executive Compensation, 2017). Short-term
incentive plans typically have pre-established performance levels. A floor that
corresponds with the minimum performance level that must be achieved before an
incentive can be earned – also referred to as threshold. A target that
represents the expected level of performance. And a cap that corresponds with
the total incentive opportunity that may be earned for superior performance –
also referred to as maximum. Both floor and cap are typically set in relation
to the target (Ippolito and Kleger, 2012, p. 97).


Long-term incentives tend to be one of the
most relevant component of an CxO’s compensation package both in terms of magnitude
and long-term orientation (Wise and Wu, 2012, p. 63). They are designed with the intention to retain high-performing CxOs,
encourage desired behavior and to align CxOs’ interests with those of the
firm’s shareholders (Moyniha, 2012, p. 81). Long-term incentives are often based on equity components. In this
regard, for example, restricted stock awards, performance shares or performance-vested
restricted stock are granted. Whereas concession of performance shares and
performance-vested restricted stock is strongly linked to an CxO’s performance,
for restricted stock awards performance commonly plays a less important role (Wise and Wu, 2012, pp. 67–68).


Perquisites, which are defined as a privilege, gain, or profit
incidental to regular salary or wages (Merriam-Webster,
2017) most commonly involve but are not
limited to transportation benefits and financial planning benefits.
Transportation benefits, for example, include private use of corporate
aircrafts or provision of a corporate car. Transportation benefits are offered
to ensure that CxOs travel safe and are focused on business topics with minimal
distraction. Financial planning benefits are predominantly used to offer
personal security and peace of mind to the CxOs (Ahmed,
2016, pp. 1–2).

Even though perquisites represent a less significant
part of the compensation package they have become highly controversial in
recent years, especially in the United States. This is basically due to the
fact that perquisites do not seem to comply with the pay-for-performance
principles at first glance (Sabow and Dufresne, 2012, pp. 129, 131). In fact, perquisites
are designed to maximize the performance and to optimize the work-life ratio of
the executive team while providing risk mitigation for the firm and its
shareholders by providing CxOs with added security (Ahmed, 2016, p. 1).

Severance Payments and Change-in-Control Agreements

Severance payments and
change-in-control agreements are fairly common and both are designed with the
intention to pay an CxO when leaving the company for specific reasons (Balsam, 2007, p. 267).

Severance payments are made
in cases a CxO leaves the company or is fired without cause (Balsam, 2007, p. 267). The
main reason for defining severance payments as part of a CxO’s compensation
package is to encourage CxOs to take over specific business risks that are
associated with their position by providing financial security in case those
risks turn out unfavorably. Furthermore, severance agreements may encourage CxOs
to take steps that are rather in the shareholder’s interest than their own  (Olson, Tabaczynski and Weinberg,
2010, p. 126).

In contrast, change-in-control
agreements – also known as golden parachutes – are made with the intention to
pay CxOs in case they lose their position as a consequence of an acquisition in
which their company is acquired by another company and, therefore, also to
counter the incentive to fight takeovers (Balsam, 2007, p. 267).

If a severance or
change-in-control agreement has been included in the CxO’s contract, signing of
the separation agreement between the firm and the CxO or consummation of the change
in control both typically result in a payment that equals explicit compensation.
In this regard, payments that amount to a multiple of base salary, plus
short-term incentives and, potentially, long-term incentives are made.
Furthermore, any stock options or restricted shares are vested with immediate
effect (Balsam, 2007, pp. 269–270).

Critical Aspects of CxO

In literature, CxO
compensation is heavily discussed. The reasons for criticism on CxO compensation
are manifold and mostly based on morality and fairness or on pragmatic grounds (Pizzigati and Anderson, 2009).
Besides exorbitant pay, the main drivers for criticism on CxO compensation on
the one hand are flawed compensation practices and on the other hand CxOs that make
use of that for their own benefit (Bebchuk and Fried, 2006, p. 6).

CxO compensation is often characterized
being tied to performance to induce CxOs to behave in the shareholders’ interest
(Kolb, 2012, p. 28). While
the increase in shareholder’s wealth in public firms is generally the
contribution of hundreds or thousands of people it would be unfair to claim
that the increase in value of the firm was only attributable to a small number
of top executives (Donatiello, Larcker and Tayan, 2016, pp. 1–2). Besides,
it might be hardly possible to measure contribution of CxOs to an increase in
shareholder value while the majority of their tasks is of strategic nature (Cable and Vermeulen, 2016, p. 5). As a
matter of fact, the nature of CxO tasks, among other things, founds the
assumption that pay-for-performance is unsuitable to be applied for CxO
compensation (Cable and Vermeulen, 2016, pp. 2–4). A
quote of Deutsche Bank CEO John Cryan in a panel discussion upholds this
assumption. Cryan mentioned that he couldn’t understand why his compensation
was tied to performance and maintained he would not work any harder or less if
his compensation was fixed (Evans, 2015).

A considerable
counter-effect of applying financial incentives to create extrinsic motivation is
a decline in intrinsic motivation.2 Intrinsic motivation, however, is fundamental for innovation and
creativity which are key elements of the CxO’s day-to-day work (Cable and Vermeulen, 2016, pp. 4–5).
Besides, financial incentives bear the risk that people exclusively focus on
the specific target(s) while ignoring other circumstances that might be of high
relevance as well. This phenomenon was first described by Steven Kerr (1995, p. 769) in
his article ‘On the Folly of Rewarding A while hoping for B’. With regard to
financial incentives, another foundation for criticism directly refers to the
metrics that trigger concession of performance-contingent compensation. Often, CxO
contracts involve only few
and poorly defined
triggers and the frequency of changes that is attached to these triggers is
merely adequate to align with the constantly changing challenges the company is
confronted (Turner, 2010, pp. 97–98).

Another critical aspect of CxO
compensation refers to perverse incentives. Perverse incentives result from
incentive structures that lead to less desirable consequences such as fraud,
crime and the destruction of firm value. In general, there are two forms of bad
behavior that result from perverse incentives: ‘option games’ and ‘earnings
management’ (Kolb, 2012, p. 140). When
a large portion of a CxO’s compensation package is contingent on performance,
there is an increased likelihood that CxOs will game the metrics in their own
favor. This finding is also confirmed by different studies which show that the likelihood
of earnings manipulations, shareholder lawsuits and product safety problems are
positively correlated with contingent pay schemes (Cable and Vermeulen, 2016, p. 5).

In addition to that,
another critical aspect often being found in compensation practices refers to
the CxO’s relationship to the board of directors and the ability to influence
the board’s decisions with regard to compensation – resulting in significant
doubt that boards deal with CxOs at arm’s length. This is evidenced, for
example, by widespread reluctance of directors to fire CxOs for poor
performance. However, in the context of departing CxOs – independent of the CxO
having performed good or bad – directors often grant gratuitous payments and
benefits to CxOs in addition to payments and benefits being required by the
contract anyhow (Bebchuk and Fried, 2006, pp. 12–15).


In this paper, it was shown
that the issues of CxO compensation are manifold. Besides exorbitant pay, the
main drivers for criticism on CxO compensation are flawed compensation
practices and CxOs that make use of that for their own benefit. CxO
compensation is purportedly understood as an instrument to overcome the principal-agent
problem that is immanent to modern corporations. Compensation packages widely
involve performance-contingent and equity-based components with the objective
of aligning shareholder’s and managers’ interests but, in fact, there is
significant doubt that this inevitably serves the shareholders well. This is
primarily based on the finding that performance-contingent compensation tends
to immanently have significant shortfalls in its ability to induce the desired behavior
of CxOs and, in addition, that there are serious difficulties in appropriately
measuring CxO performance.


Despite all criticism, compensation is and
will remain essential for attracting and retaining high-performing CxOs in
modern corporations. To relief the issues that have been identified with regard
to the current compensation practices, a change in the understanding of CxO compensation
should be established. This change should result in an understanding that
considers CxO compensation rather being key for motivation and inducing desired
behavior but a foundation for collaboration and taking risks that are attached
to the CxO position. Such understanding would enable establishing a framework in
which focus shifts from extrinsic motivation towards intrinsic motivation. A
radical step for this to be accomplished could be promising CxOs an appropriate
base salary and, in addition, restricted stock that is vested until retirement,
as it was proposed recently by Clifford in his book ‘The CEO Pay Machine: How
it Trashes America’ (Clifford, 2017 cited Lowenstein,
2017, p. 59).

1 In this paper, the term CxO refers to the Members of the Managing
Board, including the CEO and CFO, as well as other high-ranking executive
officers in public firms who are part of the C-Suite.

2 Cable and Vermeulen (2016, p. 5) referred in their paper to
a meta-analysis of 128 independent studies according to which one
counter-effect of the application of financial incentives to executives to
create extrinsic motivation is a decline in intrinsic motivation.