June 18, 2014 at IFS, Chengdu

Executive Annual Bonuses and Defined Benefit Pension Plans

-- A Brief Literature Review

Jun Yang, Indiana University 1

Motivation Motivation Hypotheses Data Results Conclusions 2

Executive Annual Compensation

• • • • • • Base salary; Annual bonuses (

non-equity incentive plan compensation

and discretionary bonuses); Stock awards; Option awards; Other compensation ( matching contributions under its 401(k) savings plan and Nonqualified Deferred Compensation Plan, the cost of long-term disability premium, perquisites and related tax gross-up and severance ); Pension (change in present value of pension reported).

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14000 12000 10000 8000

Mean ($000)

6000 4000 2000 0 1994

Compensation Components (Mean)

1997 2000 bonus stock 2003

Year

option 2006 total 2009 2012

10000 9000 8000 7000 6000

Median ($000)

5000 4000 3000 2000 1000 0 1994

Compensation Components (Median)

1997 2000 bonus stock 2003

Year

option 2006 total 2009 2012

Bonus and Equity as Fraction of Total Pay (Mean)

0,7 0,6 0,5 0,4

Fraction

0,3 0,2 0,1 0 1994 1997 2000 bonus fraction 2003

Year

2006 equity fraction 2009 2012

Bonus and Equity as Fraction of Total Pay (Median)

0,7 0,6 0,5 0,4

Fraction

0,3 0,2 0,1 0 1994 1997 2000 bonus fraction 2003

Year

2006 equity fraction 2009 2012

Annual Bonuses

• • • • • Executive compensation based on short-term performance; It is about 150% of salary payment and 20% of total CEO compensation; According to the IRS code 162 (m), Annual Incentive Plan (AIP) Compensation is performance based, thus tax deductible; AIP compensation is typically determined based on short-term performance: – Quantitative:

EPS, revenue

, operating income, net income, FCF; – Qualitative: Individual, strategic, customer, safety, employee; Payoff structure: – minimum payout,

target payout

, and maximum payout, and – corresponding performance metrics: performance threshold,

performance target

, and performance stretch.

Structure of a typical Annual Incentive Plan

Maximum Bonus Target Bonus Minimum Bonus Performance Threshold Performance Target Performance Stretch

Literature on Annual Bonuses -- Performance Measures

• • • • Murphy (1999) is the first to provide detailed information on performance measures in annual incentive plans. – A survey of 177 publicly traded US corporations conducted by Towers Perrin in 1996–1997; – Internal performance metrics are problematic if executives can participate in setting performance goals. Murphy (2000) compares internal and external performance measures and finds that firms using internal measures have less variable incentive payouts and a higher likelihood of earnings smoothing.

Lambert and Larcker (1987) contrast accounting and market performance measures used in compensation plans in terms of the signal-to-noise ratio. Ittner, Larcker, and Rajan (1997) and De Angelis and Grinstein (2010): more complex firms tend to choose non-explicit measures over explicit measures, and market measures over accounting measures. 10

Literature on Annual Bonuses -- Pay-Performance Link

• • • • • Indjejikian and Nanda (2002) infer that the design of annual incentive plans is largely consistent with the predictions of the agency theory. Abode (1990) shows that when the increase in compensation is linked to the increase in after-tax gross return or stock return, future performance of after-tax gross return or stock return is enhanced.

Anderson, Dekker, and Sedatole (2008): benefits of pay-for-performance will be attenuated if managers are given the opportunity to influence performance goals. Kim and Yang (2012): firms tend to set performance targets lower than market expectations.

In a field study, Merchant and Manzoni (1989): achievable performance targets might actually be more desirable in terms of resource planning, corporate reporting, and, when combined with other system elements, even motivation. 11

Related Literature on Annual Bonuses -- Earnings Management

• • • Earning management round kinks ( threshold and stretch goals) in the payoff structure: – Healy (1985) finds that firms shift earnings to a later period using discretionary accruals when performance exceeds the stretch goal of the annual incentive plans. – Gaver, Gaver, and Austin (1995) and Holthausen, Larcker, and Sloan (1995) further document that managers adjust earnings upward when performance would otherwise miss the threshold goal.

Huang, Marquardt, and Zhang (2013) show that firms avoid issuing equity when EPS result is about to fall below the EPS target in the CEO’s annual incentive plan.

Kim and Yang (2014) show discontinuity of performance (EPS and revenue) distribution around annual incentive targets: firms tend to just beat the target.

– The board of directors makes discretionary adjustment to performance ex post to award CEOs more annual bonuses (either to beat the target or to reserve earnings for future).

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Defined Benefit (DB) Pension Plans

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Defined Benefit (DB) Pension Plans

• • • • • Defined Benefit (DB) pension plans retirement income for approximately one third of all employees in the private sector; are an important source of These arrangements are intended to provide retirement security to employees, as benefits are linked to predictable annuities throughout the retirement period; Sponsors promise a fixed retirement income to employees (independent of the performance of the pension assets), based on compensation and the number of years of service; Sponsors make contributions pension assets to the pension fund, manage the and need to comply to specific funding requirements; DB Pensions are governed by ERISA (1974); Most of the

investment risk

by the sponsoring company. associated with pension assets is born 15

DB Pension Plans (2)

• • Over the years, fewer and fewer companies adopted DB pension schemes; Those already sponsoring DB plans, even the financially healthiest ones, started a steep transition into defined contribution (DC) types of arrangements. – Many firms state that they freeze the DB pension plans to save costs or to reduce the volatility of pension liabilities ; – Most often, the shift was implemented through

outright freezes of pension benefit accruals

, accompanied by an increased adoption of other retirement arrangements.

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SERPs

(Supplemental Executive Retirement Plans)

• •

Executive pension

includes regular tax deductible pension and non tax deductible pension: Regular pensions: – Tax deductible; – – – Secured, funded; With upper limit on benefit amount ($195,000 annually in 2011); Insured by the Pension Benefit Guaranty Corporation (PBGC) up to a limit (about $54,000 per beneficiary, as of 2011); SERPs: – Mostly unfunded and unsecured, as contributions made to such plans are not tax deductible; • Some firms offer

lump-sum payout options

and provide

voluntary funding

for SERP claims.

– – No dedicated assets to cover executive pension liabilities; Not subject to the limitation on maximum benefit amount.

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SERPs (2)

• • Changes in the pension plan value for NEOs were only disclosed in the summary compensation table starting on December 15, 2006.

“The average annual increase in plan value is about $1.6 million, which is almost 13% of the CEOs total annual compensation and 36% greater than salary . The total value of the CEOs DB pension plan averages almost $11 million on average and constitutes almost 12% of the CEOs total wealth held in the firm.”

-- Cadman and Vincent (2011);

“Annual increases in pension entitlements represent about 10% of overall CEO compensation, and about 13% for CEOs aged 61–65” –

Sundaram and Yermack (2007).

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SERPs (3)

• • • Executive pension obligations exceed

$1 billion

at some companies: GM ($4.4 billion liability), GE (a $3.5 billion); AT&T Inc. ($1.8 billion); Exxon Mobil Corp. and IBM (about $1.3 billion each); and BOA and Pfizer Inc. (about $1.1 billion apiece).

Benefits for executives now account for a significant share of pension obligations in the U.S., an average of 8% at the companies above. – Sometimes a company's obligation for a single executive's pension approaches $100 million .

These liabilities are financial filings.

largely hidden

, because corporations don't distinguish them from overall pension obligations in their federal

“Hidden Burden: As Workers' Pensions Wither, Those for Executives Flourish --- Companies Run Up Big IOUs, Mostly Obscured, to Grant Bosses a Lucrative Benefit --- The Billion-Dollar Liability” By Ellen E. Schultz and Theo Francis, WSJ, June 23, 2006.

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Pension Benefit Formula

– – – The number of service years, capped at 30 typically; • Does not change after freeze; • Increased by 1 year normally; • There are jumps for various reasons: – To compensate forgone increases in pension at prior employers; – – Cancellation of one of multiple pension plans; Manipulation to boost pension benefit; Covered compensation • Base salary + annual bonuses; • e.g., average of the N highest pay over the last M years (N={2,3}, M={3, 5, T}); A multiplier (1.5-2.0%) • May jump at age hurdles.

Putting all 3 factors together, DB pension benefits increase substantially over time, and typically capped at 50-60% of covered pay.

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Form and Structure of CEO Pensions

Sundaram and Yermack (2007) • • • • • Minimum CEO retirement age 55 60 62 65 Other to obtain full pension benefits 3% 11% 9% 76% 1% • • • •

Items included in calculation of average compensation Salary Bonus Restricted stock awards Long-term incentive plans 100% 94% 4% 4%

• • • • Years of compensation 1 3 4 5 averaged to calculate annual payout 5% 39% 3% 54% 21

Incentive to Manipulate Input Variables

• • • Companies with multiple plans (regular vs. SERPs; pilots vs. flight attendants vs. mechanics) tend to freeze them all in a similar manner the majority of the time. – When they don’t, the less affected plans tend to be union negotiated plans.

If pension freeze is foreseeable under a firm’s strategic plan, top executives could exercise their influence on the inputs of the pension benefit formula: –

To award bigger bonuses which will boost their pension benefits;

– To jump the number of service year; Executives also have incentives to boost annual bonuses prior to anticipated departure (e.g., retirement).

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Annual Bonuses, Executive Age, and Pension Benefit

(examples) • • One of Exxon Mobil Corp.'s two supplemental pension plans for executives uses the three highest bonuses in the past five years prior to retirement to calculate the executive's pension. Thanks to this, a $4 million bonus to CEO Rex Tillerson in 2008 helped push the total value of his pension to $31 million from $23 million; Reaching a milestone birthday also can enhance an executive's pension. Altria Group Inc. CEO Michael E. Szymanczyk's pension rose $12.9 million when he turned 60 last year ; this triggered a subsidy built into the pension formula, boosting its total value to $23.5 million.

“Pensions for Executives on Rise --

Arcane Techniques, Generous Formulas Boost Payouts as Share Prices Fall”

By ELLEN E. SCHULTZ and TOM MCGINTY 23

Related Literature -- Why Pension Freeze?

• • • • A firm freezes its pension plan mainly to reduce the costs of providing such a plan. The average age of a firm’s work force increases, freezing defined benefit pension and switching to a defined contribution pension plans can save the cost by up to 2.5% for the firm per year: – Rauh, Stefanescu, and Zeldes (2012); DB plans are more likely to be frozen when credit balances are high relative to income, legacy costs are substantial and funding ratios are low: – Munnell and Soto (2007); The decision to terminate a pension plan is driven partly by taxes, as terminations typically coincide with low tax years: – Petersen (1992); Freezing DB plans does not increase market value of a firm: – McFarland, Pang, and Warshawsky (2009).

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Related Literature -- Effect on Corporate Decisions

• • Pensions affect corporate decisions: Pensions affect investment decisions: Rauh (2006): – – Capital expenditures and investment decline with mandatory contributions to DB pension plans, even when controlling for correlations between the pension funding status itself and the firm’s unobserved investment opportunities; Stronger for financially constrained firms. Pensions affect leverage decisions: – Shivdasani and Stefanescu (2009): additional 9% leverage taking into account pension assets and liabilities; – Jin, Merton and Bodie (2006): investors recognize pension assets and liabilities and incorporate them in determining the cost of equity capital for these firms.

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Related Literature -- Inside Debt

Incentive alignment of managers with lenders vs. shareholders: • Sundaram and Yermack (2007); – – – – Corporate vs. personal leverage; CEO compensation exhibits a balance between debt and equity incentives; the balance shifts systematically away from equity and toward debt as CEOs grow older; CEOs with high debt incentives manage their firms conservatively; and Pension compensation influences patterns of CEO turnover and cash compensation.

• Anantharaman, Fang, and Gong (2012): lower yield and less restrictive covenants; • Edmans and Liu (2011): inside debt affects effort and risk shifting (theory).

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Related Literature - Manipulation of Pension Assumptions

• Management can manipulate pension assumptions, especially before large and anticipated corporate events (Berstresser, Desai, and Rauh, 2006): – Managers are more aggressive with assumed long-term rates of return when their assumptions have a greater impact on reported earnings; – Firms use higher assumed rates of return when they prepare to acquire other firms, when they issue equity, when they are near critical earnings thresholds and when their managers exercise stock options.

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The Link between the Two Strands of Literature

• • •

What is the connection between executive annual bonuses and executive pensions?

Do firms boost executive annual bonuses prior to freezing DB pension plans?

To be presented next week

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