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

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

Using the wrong Performance Metric.

 

Dysfunctional compensation introduces incentives for managers to increase their pay, even at the expense of the long-term value of the firm. The perfect measure for a Ceo would be his contribution to the (increased) value of the firm. As this is hardly measurable, performance metrics need to be determined that are correlated with it, even if some side effects are generated:

 

a)      Accounting profit: accounting metrics do not generally recognize all actions by Ceo with an effect on long-term value; they are affected (sometimes materially) by external factors outside the control of managers; and these metrics ignore the cost of capital.

b)      Ratios versus absolute metrics: EPS, RoA, RoE or RoC can lead to value destruction when the manager just focuses in the denominator, (number of shares) instead of in the numerator, (profit or true performance). Thus, the authors propose their Principle 6: performance metrics should not be a ratio.

 

The cost of Capital.

 

Those metrics that do not consider the cost of capital might work well, provided the managers cannot affect the capital allocation decisions. But if they can, the possibility of value destruction appears again.  So, the authors introduce their Principle 7: performance metrics should consider the cost of capital and the volume of capital used. So, Economic Profit can be drafted as:

 

EP = Operation Profit – Capital*Cost of Capital = (Return on Capital – Cost of Capital) * Capital Invested

 

Apart from evident advantages, this procedure externalizes the target, as the cost of capital is settled by capital markets.

 

The definition of Economic Profit, (Eva is nowadays the most common), can vary by three reasons:

 

–         The definition of Operational Profit

–         Concept of capital: assets, equity, etc.

–         The value of the Cost of Capital.

 

Even if this seems complex, the authors propose to get rid of all complexities provided by consultants, and keep the simplicity, introducing the firm`s usual plan in a different way:

 

Bonus = Target Bonus + b (Roa – Threshold Roa)*Assets,

 

(if the firm`s operating profit metric is RoA. This formula fulfills all principles, (where b is a percentage signaling the part of profit shared by the executive/s).

 

Ex-Post adjustments and discretion granted to the Compensation Committee.

 

Denial or adjustment of bonuses allowed in case by whatever circumstance bonuses are not earned by the managers, or are earned at the expense of the long-term value of the firm. The reason is clear, no measurement is perfect or considers every factor affecting the different variables involved  in the bonus calculation. These adjustments should at least come from:

a)      subjective evaluations of the manager, (Principle 8: every bonus plan should include a subjective evaluation of the Ceo/manager);

b)      factors beyond the manager`s control, only to the extent that he cannot control the effects of those factors in the performance of the firm, (Principle 9: managers need to be held accountable for factors out of their control if they can control the impact of those factors on the firm).

c)      Any factor showing the bonus paid in previous years was not due, (when a critical indicator on which the rewards were based is revised). That leads to Principle 10: a system for recovering those bonus needs to be established. Deferral of payments, or Bonus banks may help make this clawback policy palatable.

 

 

Even if the Principles depicted by the authors seem obvious, there is a danger when a newly designed plan according to them is presented to controlling shareholders, or a Compensation Committee that will face the scrutiny or both shareholders and proxy advisors: those plans with no caps, sometimes with no hurdles, could be perceived as an attempt by managers to increase their pay; the case should be made very carefully, with historical comparisons and scenario analysis that can provide assurance to all groups involved that the particular plan is adequate to the company, when it is proposed, and given the challenges it may afford in the near (performance) period.

 

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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