The objective of a properly designed executive compensation package is to attract, retain, and motivate CEOs and senior management. Despite substantial heterogeneity in pay practices across firms, most CEO compensation packages contain five basic components: salary, annual bonus, payouts from long‐term incentive plans, restricted option grants, and restricted stock grants. In addition, CEOs often receive contributions to defined‐benefit pension plans, various perquisites, and, in case of their departure, severance payments It has been seen that the increase in executive compensation has far outweighed the rise of regular employee compensation the objective of this paper is to investigate the pay-for-performance link in executive compensation.
In the context of executive compensation, an analysis needs to be undertaken both from an economic as well as a regulatory policy perspective. To provide a holistic understanding both global as well as Indian Organisations are considered for the analysis.

From the economic perspective we look into the following
• Executive Compensation and Agency Problem
• Executive Compensation and Risk Management
• The sensitivity of CEO wealth to firm performance
• The relation between CEO incentives and firm value
• Explaining CEO compensation: Rent extraction or competitive pay?
From the regulatory and legal perspective
• Regulatory controls as under o SEC o SEBI
• Tax Code Changes o Tax Law 162(m) signed in 1993 of the Federal tax Code
• Legal Provisions o Amendments to the Companies Act ,1956 o Natural law
• Disclosure Rules
• Say On Pay
• Clawbacks
Further to look into the recent empirical studies to understand the present industry situation.
• Disclosure Rules
The Securities and Exchange Commission (SEC) has focused its regulatory efforts since the
Securities Acts of 1933, including the aforementioned changes of 1942 and 1978, predominantly on disclosure rules. Under the assumption that disclosure of executive compensation packages effectively shames boards into doing right by their shareholders and employees, a steady stream of decisions by the SEC over more than 70 years made disclosure of compensation policies more transparent, more comprehensive, and more comparable from firm to firm. Put more formally, transparent disclosure reduces the costs of shareholder monitoring of corporate board decisionmaking, and in theory, reduces agency issues between them.
This culminated in the 2006 rule, where the SEC created the “Compensation Discussion and Analysis (CD&A)” filing, in which companies are expected to disclose all prior and potential payments, of any form or function. Notably, perks, severance, and retirement packages, as well as payout ranges for incentive plans, must be clearly spelled out.28
Today the United States has perhaps the most comprehensive executive compensation disclosure rules of any country.
Yet, as disclosure increased over time, so has executive pay, implying that disclosure rules are, in the end, ineffective. For one thing, even with a well-constructed disclosure scheme, corporate boards and their compensation consultants may seek increasingly opaque forms of compensation (such as time on the company jet), which are more costly, dollar for dollar, than simply paying the executive what it is they think he or she is worth in cash, just to avoid the public outrage that follows disclosure of seemingly exorbitant remuneration.
Second, as compensation consultant James F. Reda pointed out to The New York Times, compliance to the 2006 rules. has been further limited by a large loophole that excuses companies from providing details on performance targets if publishing them would put the firm at a competitive disadvantage. Namely, if a competitor knows a firm’s performance benchmark, and knows that in a bad year executive bonuses will be meager or foregone, the competitor could move in to steal away the firm’s executives with better offers. Of course, many companies have claimed this loophole.

• Say On Pay
Given the challenges regulating executive compensation levels through rule-based tax penalties and disclosure policies, a superior approach to combat ill-designed or inappropriately generous pay packages may be in the offing: Shift additional power to shareholders through binding or advisory votes on compensation issues so that they may effectively prod the board to refine poorly designed proposals to better represent shareholder interests.30 These “say on pay” powers are increasingly common in Europe but are rarely granted by firms in the United States. In 2006, a campaign led by the American
Federation of State, County, and Municipal Employees attempted to push more than 60 companies to accept advisory say on pay votes
The most important development in regards to United States adoption of this rule was the inclusion of a say on pay requirement into the American Recovery and
Reinvestment Act of 2009.
Whether say on pay requirements in the United States will achieve the desired goal of shaming boards into enacting responsible compensation policies depends a great deal on the particulars of American firms. On the one hand, as previously mentioned, the United States has far more comprehensive disclosure rules than European countries. So active investors are perhaps in a better position to judge the merits of compensation packages here, and to use dissenting say on pay votes to better align pay to their own aims. But on the other hand, the US market is more diverse, with more players holding small, non-controlling interests in firms, making it more difficult for them to coordinate responses during proxy season.

• Clawbacks

Another safeguard widely gaining prominence is the
“clawback” provision, in which deferred compensation is forfeited—or previously paid compensation is recovered— on a variety of grounds. Traditional clawbacks, or “bad boy” provisions, forfeited an executive’s stock options, unvested stock, or in some cases severance payments in the event of misconduct such as violating noncompete clauses or ethics codes. Following the accounting scandals earlier this decade, and in order to prevent managers from extracting undue rents through the manipulation of financial statements, Sarbanes-
Oxley was written to include a tougher clawback provision,
Section 304, that allowed the return of the prior year’s CEO and CFO bonuses in the event of a financial accounting restatement that resulted from noncompliance with reporting requirements due to “misconduct.”39 The SEC announced its first individual Section 304 settlement in 2007, for a recordbreaking
$468 million in bonuses, profits, and penalties, due to options backdating by William McGuire, the former chairman and CEO of UnitedHealthGroup, Inc.40 American publicly owned firms have been introducing their own clawback provisions in increasing numbers. In a 2008 survey by The Corporate Library, 329 of the 2,100 businesses surveyed adopted clawbacks for financial misstatements, compared to just 14 of 1800 firms surveyed in 2003. Fortyfour percent of the provisions are “fraud-based,” triggered if the executive engaged in misconduct causing a restatement.
And 39 percent are “performance-based,” a stronger form in which all executives’ incentive payouts are returned if they are based on incorrect financials.41 The adoption of these clawback policies comes as financial restatement rates in the
United States plummet. A study from Glass, Lewis & Co. LLC found that in the first quarter of 2008, there were 21 percent fewer restatements than the same period in 2007.42 Though correlation has not been effectively studied, improved financial accounting and auditing systems mandated by Sarbanes-
Oxley, combined with the extra security of these clawback policies, may have been effective at reducing the incentive to misstate earnings in order to maximize compensation payouts.
But today’s clamor regarding excessive executive compensation is generally not in response to accounting fraud. Rather, outrage is directed at firms, particularly in the financial industry, in which gargantuan incentive bonus schemes are not, in fact, tied to long-term firm performance, or which may have only upside potential, with no downside risk. Professor Raghuram Rajan, of the University of Chicago
Business School, describes Wall Street’s compensation design problem in terms of huge annual bonuses that encourage the creation of “fake alpha,” or excess returns that are based on huge, hidden tail risks.43 True alpha, or excess investment returns without additional risk, is a rare find, often only in the hands of extremely talented individuals
(such as Warren Buffet), so fake alpha is a great temptation for lesser performers. And so long as bonuses are handed out annually without any downside potential, traders and managers are incentivized to chase fake alpha, in the hope that the investment does not implode until after the bonuses have been paid out. Rajan uses the example of AAA-rated collateralized debt obligations (CDOs), which generated
50–60 bps higher return than similarly rated corporate debt.
The traders who created these CDOs were remunerated for these excess returns, without regard for the fact that these excess returns came with the tail-risk of CDO default.
Rajan’s approach to discourage the pursuit of fake alpha is a strict clawback for traders and managers, triggered not by financial restatements, but by poor financial performance of the assets under their control. A portion of the individual’s bonus would be kept in escrow until the tail risk had passed, so that only true alpha is rewarded.44 One well-known example of this type of individual-performance clawback was the remuneration policy at the Harvard Management Company.
Portfolio managers were paid a base salary, a “neutral” bonus, and an incentive bonus. The incentive bonus could be positive or negative, depending on the portfolio’s return, and large portions were carried forward and reinvested in the portfolio until the following year, rather than paid out immediately. If the fund performed below a certain benchmark the following year, those withheld bonuses were clawed back, and thus downside risk and upside potential were matched, both shortand long-term.45 While the Harvard Management Company generated famously high returns, enough to fund one-third of Harvard
University’s operating expenses annually, the effectiveness of the firm’s remuneration policy is questionable. Recent evidence indicates that even this sophisticated clawback policy could not prevent the portfolio managers from taking on excessive risk. The fund lost $8.1 billion from July 1, 2008 to October 31, 2008, and was at that time, still pursuing shocking bubble-era investments in commodities such as oil, lumber, and land, while holding a tiny fraction of conventional investments and safer fixed-income and low-risk vehicles.46
In sum, regulatory controls on executive compensation often follow a groundswell of public dissatisfaction, and historically in the United States, they have been largely ineffective. In the Appendix, we provide a full review of the current and proposed changes that have followed the recent subprime mortgage crisis, including the rules put in place for TARP recipients, and the SEC’s proposals for all American publicly owned companies. With uneven success of these regulatory approaches, the merits of US government efforts put in place since 2008 remain in doubt.