Would Bonus Caps Boost Company Performance?

Research released recently in the Review of Financial Studies from the University of Melbourne and the University of California, Berkeley has concluded that statutory limits on performance bonuses might be beneficial to organisations.

Executive incentives work up to a point

The reasoning was that the Directors as representatives of shareholders want to pay for particular executive actions, not the outcomes of those actions.

Making variable pay contingent on outcomes, for example paying bonuses for the achievement of a particular level of organisation performance, is imperfect – luck or market conditions will also affect performance, potentially on a greater scale than the CEO’s leadership. Such measures may in fact encourage the wrong kind of behaviours and will in many cases lead to the organisation paying more than it needed to retain and reward their CEO.

“Bonus payments based on results can create an inappropriately simple relationship between executives and Boards,” explained one of the paper’s authors, Dr Peter Cebon from the University of Melbourne.

“This discourages CEOs from pursuing strategies where the results are harder to measure, such as building organisational capabilities, or pursuing high-value, high-risk innovations. Those strategies are often much more valuable in the long-run.”

Unfortunately, the authors of the research note that although Directors can observe the executives’ actions, those observations aren’t verifiable to enforce a formal contract.

This doesn’t mean that Boards can’t pay based on CEO initiatives, but rather that such an arrangement must involve an informal contract – a series of promises to pay an executive more if their performance is sustainable and focused on the long term. The executive will only find such contracts credible if the Board has not reneged on prior contracts.

The problem is that situations can arise where the performance of the company is poor, yet the executives may have been doing the right thing – for example the global financial crisis. The temptation for the Board is to renege on the contract and pay no bonus due to company performance. This reduces the credibility of the informal contract, which forces the introduction of formal contracts with verifiable metrics based on firm outcomes – often with high incentive values. Discretion and judgement is therefore critical.

The research postulates that if there were external limits (in the form of a cap, high taxation on variable remuneration or via social norms) on the amount of variable remuneration able to be offered under formal contracts, it would make formal contracting less profitable, reducing the temptation to renege on the theoretically more optimal informal contract.

The increased use of these informal contracts would then in theory encourage desired CEO initiatives no matter the situation, which would be more conducive to fostering activities in an organisation that lead to continued sound performance over the long term, such as investment in innovation, leadership and culture.

The authors created a model to test their theories considering factors such as the patience of the CEO and Board, the quality of the Board and the bargaining power of the CEO. They found that under certain circumstances, companies will achieve a higher profit if there is an externally imposed cap on variable CEO pay than if there is not.

Because all companies are different, the effect of an external limit on executive remuneration would be organisation specific. Caps would be more valuable where a long-term strategy is more important, particularly if volatility is high.

The model also depends on the assumption that the Board is capable of assessing what is going on in the organisation. If limits were introduced, then a skilled and fully engaged Board would become more valuable.

Egan Associates would not advocate formal limits on variable reward, but we would make a number of observations on the research. It has underlined:

  • It is important that Directors understand the business in order for an efficient incentive structure to be introduced. We also note that capability is defined by the report as tenure and experience in the industry. We would reiterate our view that long-tenure should not be automatically excluded from re-election – it is important that Boards, while introducing diversity, maintain some Directors that understand the business thoroughly. Independence of thought is often more important than independence in formal definition.
  • Discretion (the informal contract) in employee incentive plans remains a key accountability of the Board. Metrics are never perfect and pay must pass the “common sense” test. Has the leadership of the CEO warranted his or her incentive payment?

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