Home > Compensation > How to fix the Ceo and other main executives cash bonus. (I)

How to fix the Ceo and other main executives cash bonus. (I)

When dealing with the bonus schemes, there are certain topics to be tackled if manipulation of earnings and certain risk behaviors are to be avoided, if the company wants to be sure all profitable projects (once considered the cost of capital) are approved, ….in brief, if incentives are to be established in an efficient manner.

We will avoid very particular bonuses, (such as retention, referral, sign-in or others). 1

We will mainly refer to performance cash bonuses, where some general comments can be made, following Murphy and Jensen (2), our main source in this post:

a)      Bonus plans need to be understood by managers, as to what actions generate the performance target.

b)      Bonus plans may contain subjective elements, so that implementation may be made “ad person”.

c)      Unlike equity awards, (only a few managers may actually affect the stock price with their actions), bonus plans can be applied widely through the organisation, and sometimes are more tangible and motivating.

How a bonus plan can be designed: different types.

The elements of a plan are:

–         Performance measures.

–         Thresholds: normally Lower and Upper performance thresholds are fixed, and in-between a Performance Target is determined. The lower one is a hurdle, and the upper one is a cap.

–         Structure of Pay-Performance relationship, (slope of pay function). It can be linear, convex or concave.

Thresholds: these plans, because of the hurdles, incentive managers to move metric units, (let`s assume “profits”) from one period to other, to lie in budget negotiations, …, consequently to value destruction. Apart from that, caps undermines retention efforts for talent.

Pay Performance relationship: convexity  introduces an incentive to increase the volatility in profits, whereas concavity has the opposite effect, (which is directly connected with taking too many or too few risks, so with an inefficient result).

Introducing linearity in the slope of the function, and eliminating upper and lower threshold, (salary reductions, deduction from a Bonus bank, cumulative performance bonuses, etc) is Principle 1 as depicted by Murphy and Jensen. It can be as simple a plan as a percentage of the metric, (Net Profit, Ebitda, etc).

a) Negative bonuses through Cumulative performance measures: negative results need to be made up before any profit is considered in a successive period. It allows only for small losses to be compensated.

b) Bonus banks: the bank is created in years in which bonus is positive, so that it is not fully paid, and a part, (or part of the base salary if no bonus is achieved), is kept in a bank account. If there is no cap, and bonus excess over the cap level is kept in the bonus bank, the measure is more palatable. The amount in the bank account is then used to compensate negative bonuses eventually being calculated in subsequent years.

c) Reduced salaries compensated by a bonus under the eventual threshold is also a way to introduce negative bonuses.

Using budgets to settle performance threshold: an incentive to lie.

Lower and upper thresholds for performance targets are generally established as a percentage of the budget target, so that the budget building process becomes a negotiation for bonus; there is an incentive to lie, to hide and destroy information, and to declare low growth capacity, so as to maximize bonuses.

Murphy and Jensen turn this into their Principle 2: separate the bonus from budget targets, so as to increase integrity and productivity.

Using the wrong benchmark or standard.

When performance is measured relative to a benchmark, there is always a possibility that managers affect not performance but the benchmark; the benchmark may be others` managers performance, which can be damaged by the executive; it can also be the case of a peer industry group, where managers may have the power to determine the peer group, while staying in a low growth industry. So Principle 3 follows: the executives under the plan should not be able to affect the peer group or standard against which relative performance (otherwise superior to absolute measurements) is going to me measured.

It is not a good idea to use prior year results as a benchmark: managers clearly learn to manage prior-year results so as to maximize bonuses. This constitutes Principle 4.

In general, Principle 5 states that benchmarks should not be under the managers` control or influence. The benchmark should then be externalized: in LBOs, the debt service could be used; using Cash-flow minus a charge for the use of capital allows to avoid budget targets; timeless standards may also be used to avoid that situation, (for instance where the metric is “Profit minus an absolute amount” that rises every year, so that the incentive is clearly to increase the profit performance.

(We will follow this analysis in a next post to be delivered soon).

1 Bonus Program Practices, a Survey of members of Worldatwork, 2005.

2 Ceo Bonus Plans: and how to fix them, by Kevin J. Murphy and Michael C. Jensen, November 19, 2011.

3 Sistemas de Retribución variable e indicadores de Control de Gestión, by Ramon Prat y Luis Muñiz, Partida Doble Review, number 135.

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