ACCT3031 Chap.8 Remuneration, Incentives and Agency Problems
Remuneration, Incentives and Agency Problems
Executive pay is meant to align managers with shareholders, but it can also create the problems it is meant to solve.
This chapter explains the components of an executive package and how share options pay off, the disclosure required by s300A, the advisory vote and the two strikes rule, the remuneration committee's role, the unintended consequences of incentive pay and the Lehman Brothers case, where pay driven by revenue outran the board's oversight of risk.
It connects directly to the risk chapter, because the shape of an incentive can encourage the very risk-taking a board is supposed to control.
What this chapter covers
- 01
Pay as an answer to the agency problem
- 02
Components of an executive package
- 03
How share options pay off
- 04
Section 300A and the advisory vote
- 05
The two strikes rule
- 06
Remuneration committees
- 07
Unintended consequences and Lehman Brothers
Worked example · free
Calculate the gain on exercised share options
- +1Cost of exercise: 5,000 shares at $12 is $60,000.
- +1Market value received: 5,000 shares at $18 is $90,000.
- +1Gain: $90,000 minus $60,000 is $30,000, or $6 a share across 5,000 shares.
- +1At $11 the price is below the exercise price, so the options would not be exercised and the gain is nil.
Key terms
- Share option
- A right, but not an obligation, to buy shares at a set exercise price at a later date.
- Directors' fee pool
- The maximum total that shareholders approve for non-executive directors' fees, which the board then divides.
- Spill meeting
- A meeting held within 90 days after a passed spill resolution at which directors must stand for re-election.
- Remuneration committee
- A board committee of at least three members with an independent majority that recommends pay policy and packages to the board.
- Ratcheting
- The upward drift in average executive pay that occurs when committees benchmark against peers and target the top quartile.
Remuneration, Incentives and Agency Problems FAQ
Does the remuneration committee decide what executives are paid?
It recommends; the full board decides. The committee should have at least three members with an independent majority and an independent chair, and no director should take part in setting their own pay. The Module 8 quiz treats the claim that the committee sets executive pay as false, and its charter should say it has no delegated decision-making authority.
What happens under the two strikes rule?
A first strike occurs when 25% or more of votes oppose the remuneration report. If the next report also draws 25% or more against, shareholders vote at the same AGM on a spill resolution, and if at least half of the eligible votes cast support it, a spill meeting must be held within 90 days.
Why can incentive pay encourage too much risk?
Pay linked to short-term profit or share price rewards executives when risky strategies succeed but does not make them bear equal losses when they fail. At Lehman Brothers, pay set mainly by net revenue encouraged maximising short-term revenue and avoiding writedowns, while risk measures played a secondary role in compensation decisions.
How are non-executive directors paid compared with executives?
Non-executive directors receive fees from an aggregate pool that shareholders must approve, which sets the upper limit, and the board decides how the pool is divided. Executives are paid under employment contracts set by the board, usually through salary, bonuses, options and longer-term equity, and executive directors normally receive no extra board fee.
What must a remuneration report disclose?
Section 300A requires a separate remuneration section in the directors' report. It covers the board's policy on pay, how that policy relates to company performance, the performance conditions and why they were chosen, the proportions of pay that are and are not performance based, and the value of options granted and exercised.
Assessment move
Practise the option gain and the two strikes sequence until you can do both without notes, then prepare a short evaluation of one incentive design that names both its alignment benefit and its risk cost. Use Lehman as evidence that formal committees and good ratings do not prove pay is governed well.
When you read a remuneration report, find the measures that drive the bonus and ask what behaviour they reward over one year and over five.
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