A MARGINAL ANALYSIS OF THE BENEFIT‐COST RELATIONSHIPS OF EXECUTIVE COMPENSATION PLANS*

CORPORATIONS typically employ a variety of devices to remunerate executive talent. The purpose of this study is to identify the reward and cost associated with each plan in the executive-compensation package and to compare pay plans in terms of their relative cost efficiency. All comparisons are made on an after-tax basis, to recognize explicitly the differences in tax treatment of the various plans and the progressive nature of personal taxes. In addition, comparisons involving differences in timing employ a discounted-cash-flow computational framework. Additional adjustments in the calculations recognize the possibility of the employee's death before receipt of deferred rewards and the uncertain nature of stock-based remuneration. The expected after-tax present value of the relevant monetary flows forms the basis for comparison on both the benefit and cost side of the transaction. The analysis is performed in two distinct phases. First, the benefit-cost relationship for each of a series of pay plans is expressed in equation form and analyzed in detail with a sensitivity analysis to identify the relative importance of parameters such as age, subjective opportunity rates, and marginal tax rates in each set of equations. A set of typical pay plans is then compared on the basis of their cost efficiency in rewarding a group of typical corporate executives. The analysis is extended to consider the possibility of allowing the executive to select his own benefit package from a set of equal-cost pay plans. In addition, the analysis considers the tax implications of executive pay by tracing the effect on federal tax revenues of an increment to the executive's reward under each pay plan. The study was conducted prior to the 1969 tax-reform legislation and hence is based on the prior tax law. The new tax treatment of many pay alternatives, while altering the absolute values of benefit and cost, changes the conclusions based on relative costs very little. The results of the analysis indicate that the lowest cost per dollar of reward in the compensation package is achieved by pay plans that provide for the deferral of payment until retirement. The advantage of such plans lies in their potential for tax savings either as a result of favorable tax treatment granted to a particular plan or the more-general tax savings promised by the lower tax rates expected to apply to income in the post-retirement years. In addition, since the firm normally has opportunities for investment which promise returns in excess of the returns available to individuals, deferral has a higher value to the firm than its corresponding cost to the employee. Salary and bonus, the traditional remuneration plans that predominate in realworld pay packages, are found to be generally inefficient in providing a low-cost package of rewards. Their importance in the pay package, therefore, appears to be primarily a function of such considerations as the practical need of the employee for current cash. Stock options and other equity-based pay plans are found to be very inefficient in economic terms. Since lower-cost compensation plans can be designed to provide