Budget or target: the choice between input and output strategies

In many competitive environments, players need to commit either to a specific goal they will achieve (an output target) or to the resources they are willing to expend in pursuit of that goal (an input budget). We model this situation as a two‐stage game where players may compete either by setting input and letting their output follow from the environment (“leading input”), or by setting output and letting the input levels required to support the output targets follow (“leading output”). We show that when each player's output is increasing (decreasing) in his rival's input, leading input (output) dominates leading output (input).     

Three Versions of Perfect Pay for Performance (Or The Rebirth of Partnership Concepts in Executive Pay)

During the 19th century and the first half of the 20th, the compensation of non‐founder managers of U.S. public companies was guided by partnership concepts. Andrew Carnegie made his senior staff coowners by selling them stock at book value. And Alfred Sloan gave the senior staff of General Motors a fixed percentage of the company's “economic profit.” But in the years since World War II, such partnership concepts have largely disappeared from executive pay. The current view of executive pay is guided by the concepts of “competitive pay” and pay components. But unlike the partnership models of the past, today's “human resources model” of executive pay fails to provide useful guidance to companies on how to achieve a consistent relationship between pay and corporate performance, as reflected in returns to shareholders. As the author argues, the model's insistence on providing “competitive pay” packages that are (1) based on size (that is, on revenue not profitability) and (2) “recalibrated” every year regardless of past performance has the effect of undermining management's incentives by rewarding poor past value performance with increases (instead of reductions) in sharing percentage, and penalizing superior value performance with reductions (instead of increases) in sharing percentage. In recent years, however, three different model pay plans have been proposed that provide both competitive pay and fixed pay leverage in relation to shareholder value. The author is the source of one of the three “perfect” pay plans. The other two are (1) the Dynamic Incentive Account proposed by Alex Edmans of London Business School and Xavier Gabaix of NYU and (2) the investment manager fee structure developed and used by Don Raymond, the chief investment strategist of the Canada Pension Plan. The author shows that cumulative pay under all three plans can be expressed as a function of cumulative market compensation (that is, the pay earned by one's peers over the life of the plan, thus reflecting pay levels for average performance) and cumulative value added (as reflected, say, in the company's TSR relative to the average of its peers' over the life of the plan)—and in the case of plans with equity‐like leverage, cumulative pay is the simple sum of cumulative market compensation and a fixed share of the cumulative value added. The plans reconcile retention and performance objectives more effectively than current practice because they provide competitive pay only for average performance, while using the partnership concept of fixed sharing of the value added to provide strong incentives.     

SIX CHALLENGES IN DESIGNING EQUITY-BASED PAY

The past two decades have seen a dramatic increase in the equitybased pay of U.S. corporate executives, an increase that has been driven almost entirely by the explosion of stock option grants. When properly designed, equity‐based pay can raise corporate productivity and shareholder value by helping companies attract, motivate, and retain talented managers. But there are good reasons to question whether the current forms of U.S. equity pay are optimal. In many cases, substantial stock and option payoffs to top executives–particularly those who cashed out much of their holdings near the top of the market–appear to have come at the expense of their shareholders, generating considerable skepticism about not just executive pay practices, but the overall quality of U.S. corporate governance. At the same time, many companies that have experienced sharp stock price declines are now struggling with the problem of retaining employees holding lots of deep‐underwater options. This article discusses the design of equity‐based pay plans that aim to motivate sustainable, or long‐run, value creation. As a first step, the author recommends the use of longer vesting periods and other requirements on executive stock and option holdings, both to limit managers' ability to “time” the market and to reduce their incentives to take shortsighted actions that increase near‐term earnings at the expense of longer‐term cash flow. Besides requiring “more permanent” holdings, the author also proposes a change in how stock options are issued. In place of popular “fixed value” plans that adjust the number of options awarded each year to reflect changes in the share price (and that effectively reward management for poor performance by granting more options when the price falls, and fewer when it rises), the author recommends the use of “fixed number” plans that avoid this unintended distortion of incentives. As the author also notes, there is considerable confusion about the real economic cost of options relative to stock. Part of the confusion stems, of course, from current GAAP accounting, which allows companies to report the issuance of at‐the‐money options as costless and so creates a bias against stock and other forms of compensation. But, coming on top of the “opportunity cost” of executive stock options to the company's shareholders, there is another, potentially significant cost of options (and, to a lesser extent, stock) that arises from the propensity of executives and employees to place a lower value on company stock and options than well‐diversified outside investors. The author's conclusion is that grants of (slow‐vesting) stock are likely to have at least three significant advantages over employee stock options:

• ? they are more highly valued by executives and employees (per dollar of cost to shareholders);
• ? they continue to provide reasonably strong ownership incentives and retention power, regardless of whether the stock price rises or falls, because they don't go underwater; and
• ? the value of such grants is much more transparent to stockholders, employees, and the press.

     

Beyond EVA

A former partner of Stern Stewart begins by noting that the recent acquisition of EVA Dimensions by the well‐known proxy advisory firm Institutional Shareholder Services (ISS) may be signaling a resurgence of EVA as a widely followed corporate performance measure. In announcing the acquisition, ISS said that it's considering incorporating the measure into its recommendations and pay‐for‐performance model. While applauding this decision, the author also reflects on some of the shortcomings of EVA that ultimately prevented broader adoption of the measure after it was developed and popularized in the early 1990s. Chief among these obstacles to broader use is the measure's complexity, arising mainly from the array of adjustments to GAAP accounting. But even more important is EVA's potential for encouraging “short‐termism”—a potential the author attributes to EVA's front‐loading of the costs of owning assets, which causes EVA to be negative when assets are “new” and can discourage managers from investing in the business. These shortcomings led the author and his colleagues to design an improved economic profit‐based performance measure when founding Fortuna Advisors in 2009. The measure, which is called “residual cash earnings,” or RCE, is like EVA in charging managers for the use of capital; but unlike EVA, it adds back depreciation and so the capital charge is “flat” (since now based on gross, or undepreciated, assets). And according to the author's latest research, RCE does a better job than EVA of relating to changes in TSR in all of the 20 (non‐financial) industries studied during the period 1999 through 2018. The article closes by providing two other testaments to RCE's potential uses: (1) a demonstration that RCE does a far better job than EVA of explaining Amazon's remarkable share price appreciation over the last ten years; and (2) a brief case study of Varian Medical Systems that illustrates the benefits of designing and implementing a customized version of RCE as the centerpiece for business management. Perhaps the most visible change at Varian, after 18 months of using a measure the company calls “VVA” (for Varian Value Added), has been a sharp increase in the company's longer‐run investment (not to mention its share price) while holding management accountable for earning an adequate return on investors’ capital.     

University of Delaware

During the early '90s, sharehold‐ers and other observers were call‐ing for a stronger link between CEO pay and performance–more spe‐cifically, a link between CEO pay and shareholder value. One result was a dramatic increase in the use of stock options for incentive pur‐poses. But, in the face of a booming stock market during the '90s, the “excesses” in CEO pay became a controversial issue in the business press. And when a number of CEOs cashed out their option holdings just prior to the collapse of their own companies' stock prices, the topic generated even more controversy. This roundtable brings together a small group of people from academia, business, institutional investing, and the courts to discuss problems with executive pay and corporate governance. There was general agreement among the pan‐elists that the board of directors and the compensation committee have a fiduciary responsibility to share‐holders to ensure that executive compensation is appropriate, and that an active, informed, and inde‐pendent board is critical to achiev‐ing that end. Nevertheless, in many cases, shareholders have voted on stock option plans and have almost always approved them–and in this sense they too bear some responsi‐bility for incentive plans that fail to serve their own interest. As one remedy for the problem, both the New York Stock Exchange and the Conference Board have called for boards to hire the compensation consultants who design the compen‐sation plans. But this is not likely to be a complete solution since, as several panelists pointed out, the consultants do not negotiate executive pay con‐tracts. There have also been new regulations on board independence to prevent “friendly” boards from overpaying their CEOs–although, here again, some panelists expressed reservations about the loss of “institu‐tional memory” if these regulations mean giving up board members from a company's major suppliers or lead banks. The loss of such outside ex‐pertise and knowledge of the com‐pany may be even more critical now that board members with any pos‐sible relationship to the firm are pro‐hibited from sitting on various board committees. In general, there was a clear pref‐erence among the panelists for market‐based solutions–with greater reliance on investors' ef‐forts to protect their own inter‐ests–as a meaningful alternative to new regulations designed to ensure the sort of responsible be‐havior that monitoring by inves‐tors is intended to accomplish. Survey data indicate that institu‐tional investors have finally real‐ized that pay packages matter, espe‐cially when they are outrageously high and completely disconnected from financial performance. In such cases, investors are likely to “weigh in” on compensation prac‐tices, and through repeated use, the shareholder voting process could become an effective force for disciplining management. The primary role of the judiciary in all this is twofold: first, to hold corpo‐rate board members accountable for their actions; and second, to protect the integrity of the share‐holder voting process.     

A Look Back at the Beginnings of EVA and Value‐Based Management

One of the pioneers of value‐based management discusses his life's work in converting principles of modern finance theory into performance evaluation and incentive compensation plans that have been adopted by many of the world's largest and most successful companies, including Coca‐Cola in the U.S., SABMiller in London, Siemens in Germany, and the Godrej Group in India. The issues covered include the significance of dividend payouts (are dividends really necessary to support a company's stock price and, if so, why?) as well as the question of optimal capital structure (whether and why debt might not be cheaper than equity). But the most important focus of the interview is corporate performance measurement and the use of executive pay to strengthen management incentives to increase efficiency and value. According to Stern, the widespread tendency of public companies to manage “for earnings”—or in accordance with what he refers to as “the accounting model of the firm”—often leads to value‐destroying decisions. As one example, the GAAP accounting principle that requires intangible investments like R&D and training to be written off in the year the expenses are incurred is likely to cause underinvestment in such intangibles. At the same time, the failure of conventional income statements to reflect the cost of equity almost certainly encourages corporate overinvestment. Stern's solution to this problem is an executive incentive compensation plan in which rewards are tied to increases in a measure of economic profit called economic value added, or EVA, which research has shown to have a significance relation to changes both in share value and the premium of market value over book value. Moreover, by combining such a plan with a “bonus bank” that pays out annual awards over a multi‐year period, boards can ensure that management will be rewarded not for good luck but rather for sustainable improvements in performance.     

A Tale of Leadership in Value Creation

In this prologue to his new book, Curing Corporate Short‐Termism, the founder and CEO of Fortuna Advisors presents a fictional account of a corporate turnaround—a “composite” reflection of the author's many years of consulting experience that dramatizes the pressure to meet near‐term earnings targets and other kinds of “agency” problems facing a public company called Blue Dynamics Corp. The tale begins with the puzzlement of the incoming CEO, Betty Manning, at finding the company's highest‐return business unit starved for investment, even as the low‐return units continue to receive and spend capital with little success. At the core of the company's capital allocation and “underinvestment” problems, she finds a corporate‐wide performance measurement and reward system focused on setting and beating budgets and growth in EPS and ROE. Manning's solution is to divorce the performance and reward system entirely from the budgeting process and implement new annual incentives and target‐setting practices that result in both more reliable budgeting and forecasting and a longer‐term view of value creation. The new measure of economic profit, called BDVA (short for Blue Dynamics Value Added), is based on a customized measure of EBITDA less a capital charge. The adoption of the new measure has the effect of encouraging her team to take a number of decisive steps: make an objective, “fact‐based” case for a strategic acquisition whose price appears to be too high (at least using conventional measures like EPS accretion); pull the trigger on a divestment that appears to have been adding value, but is more valuable outside the firm; and, more generally and most important, guide operating managers toward an ideal balance of overall growth and return on capital.     

The Economics of Organizational Architecture

Drawing on the work of Michael Jensen and William Meckling, the co‐formulators of “agency cost theory,” the authors argue that there are two main challenges in designing the structure of organizations: (1) the “rights assignment” problem—that is, ensuring that decision‐making authority is vested in managers and employees with the “specific knowledge” necessary to make the best decisions; and (2) the “control” or “agency” problem—designing performance‐evaluation and reward systems that give decision‐makers strong incentives to exercise their decision rights in ways that increase the long‐run value of the organization. The authors provide a number of instructive applications and extensions of the Jensen‐Meckling organizational framework. Using a series of short case studies that range from the Barings Brothers' debacle in the early 1990s and the decade‐long restructuring of ITT to the cases of McDonald's and Century 21, the authors demonstrate the importance of designing performance‐measurement and reward systems that are consistent with the assignment of decision rights. In so doing, the authors also work to dispel the widespread notion, popular among advocates of Total Quality Management, that the widespread use of performance measures and incentives undermines efforts to promote teamwork within large organizations. A number of brief case histories of companies like Xerox and Mary Kay Cosmetics are used to show the critical role of performance measurement and individual rewards in reinforcing a quality‐centered corporate culture. As the authors conclude, “It is a mistake to think of the ‘soft’ and ‘hard’ aspects of organizations as mutually exclusive or even as competing.”     

Measuring and Motivating Quantity, Creativity, or Both

We examine how worker productivity differs when compensation is based on quantity, creativity, or the product of both measures. In an experiment in which participants design “rebus puzzles,” we find that combining quantity and creativity measures in a creativity‐weighted pay scheme results in creativity‐weighted productivity scores that are significantly lower than those generated by participants with quantity incentives alone. Follow‐up analysis indicates that relative to participants in the quantity‐only condition, participants in the creativity‐weighted condition produce approximately the same number of high‐creativity puzzles, but produce significantly fewer puzzles overall. Thus, while participants rewarded for creativity‐weighted output tend to restrict their production to high‐creativity efforts, they are unable to translate this focus into a greater volume of high‐creativity output. Implications address a possible explanation for firms' reluctance to incorporate creativity measures within multidimensional performance measurement systems, notwithstanding published suggestions to do so.     

A Look Back at the Beginnings of EVA and Value‐Based Management

In this interview conducted five years ago, one of the pioneers of value‐based management discusses his life's work in converting principles of modern finance theory into performance evaluation and incentive compensation plans that have been adopted by many of the world's largest and most successful companies, including Coca‐Cola, SABMiller in London, Siemens in Germany, and the Godrej Group in India. The issues covered include the significance of dividend payouts (are dividends really necessary to support a company's stock price and, if so, why?) as well as the question of optimal capital structure (whether and why debt might be cheaper than equity). But the most important focus of the interview is corporate performance measurement and the use of executive pay to strengthen management incentives to increase efficiency and value. As Stern never tired of arguing, the widespread tendency of public companies to manage “for earnings”—or in accordance with what he refers to as “the accounting model of the firm”—often leads to value‐destroying decisions. As one example, the GAAP accounting principle that requires intangible investments like R&D and training to be written off in the year the money is spent is likely to cause significant underinvestment in such intangibles. At the same time, the failure of conventional income statements to reflect the cost of equity almost certainly encourages corporate overinvestment. Stern's solution to this problem was an executive incentive compensation plan whose rewards were tied to increases in a measure of economic profit called economic value added, or EVA, which research has shown to have a significance relation to changes both in share value and the premium of market value over book value. Moreover, by combining such a plan with a “bonus bank” that pays out annual awards over a multiyear period, boards could ensure that management will be rewarded not for good luck but for sustainable improvements in performance.     

What Public Companies Can Learn from Private Equity Pay Plans

Studies of private equity pay, including one by current SEC commissioner Robert Jackson, have pointed to restrictions on equity sales as a key difference between private equity and public company pay. In this article, the author argues that there is another very important difference: equity compensation in PE pay plans is typically front loaded, with top executives of portfolio companies often required to buy shares, and receiving upfront option grants on three times the number of shares they purchase. Such front‐loaded equity compensation allows PE pay plans to avoid the unintended effects of the “competitive pay policy” that have been embraced by public companies for the past 50 years. Competitive pay—targeted, for example, to provide 50th percentile total compensation regardless of past performance—has the effect of creating a systematic “performance penalty,” rewarding poor performance with more shares and penalizing superior performance with fewer shares. The author's research shows that, for public companies during the past decade or so, the number of shares granted has fallen by 7% for each 10% increase in share prices—and that, primarily for this reason, the front loaded option grants used by PE firms have provided five times more incentive (“pay leverage”) than the average public company's annual series of equity grants. What's more, to the extent that PE pay has been guided by partnership and fixed‐sharing concepts rather than competitive pay, it is the spiritual heir to the value‐sharing concepts that guided public company pay in the first half of the 20th century. For 60 years, General Motors used value sharing in “economic profit”—10% of GM's profit above a 7% return on capital was the formula for the bonus pool for many years—as the basis for all incentive compensation. The author uses the GM history to highlight four ways to improve public company incentives and corporate governance.     

Why Do Firms Use Incentives That Have No Incentive Effects?

This paper illustrates why firms might choose to implement stock option plans or other pay instruments that reward “luck.” I consider a model where adjusting compensation contracts is costly and where employees' outside opportunities are correlated with their firms' performance. The model may help to explain the use and recent rise of broad‐based stock option plans, as well as other financial instruments, even when these pay plans have no effect on employees' on‐the‐job behavior. The model suggests that agency theory's often‐overlooked participation constraint may be an important determinant of some common compensation schemes, particularly for employees below the highest executive ranks.     

Separating Leadership from Pay

Performance management and incentive systems can play an important role in shaping a company's culture and promoting internal collaboration. Yet, in an uncertain and rapidly evolving world that rewards organizations for agility, performance management systems based on a single individual overall rating are being viewed with growing skepticism; and the once common practice of tying pay directly to such ratings is being reconsidered—and in many cases abandoned. But when carrying out this process of “separating leadership from pay,” companies must commit to providing employees with extensive ongoing feedback, as well as significant opportunities for development and growth that are not linked directly to financial rewards. In place of traditional bonus schemes whose payoffs are tied to individual performance measures, the authors also recommend the use of company‐wide bonus plans—similar in spirit to the General Motors plan described earlier in this issue—that reflect a philosophy of “sharing success” that aims to encourage and reinforce a culture of collaboration and agility. But for compensation plans built around sharing success to be effective, careful attention should be given to the “quality” of the results achieved. This can be accomplished by supplementing the use of Key Performance Indicators—such as, for example, economic profit—with the use of so‐called “boundary” KPIs—such as the percentage of satisfied clients—for which a minimum threshold must be met.     

Agency,Firm Growth,and Managerial Turnover

We study managerial incentive provision under moral hazard when growth opportunities arrive stochastically and pursuing them requires a change in management. A trade‐off arises between the benefit of always having the “right” manager and the cost of incentive provision. The prospect of growth‐induced turnover limits the firm's ability to rely on deferred pay, resulting in more front‐loaded compensation. The optimal contract may insulate managers from the risk of growth‐induced dismissal after periods of good performance. The evidence for the United States broadly supports the model's predictions: Firms with better growth prospects experience higher CEO turnover and use more front‐loaded compensation.     

Dynamic CEO Compensation

We study optimal compensation in a dynamic framework where the CEO consumes in multiple periods, can undo the contract by privately saving, and can temporarily inflate earnings. We obtain a simple closed‐form contract that yields clear predictions for how the level and performance sensitivity of pay vary over time and across firms. The contract can be implemented by escrowing the CEO's pay into a “Dynamic Incentive Account” that comprises cash and the firm's equity. The account features state‐dependent rebalancing to ensure its equity proportion is always sufficient to induce effort, and time‐dependent vesting to deter short‐termism.     

Market Reactions to Tangible and Intangible Information

The book‐to‐market effect is often interpreted as evidence of high expected returns on stocks of “distressed” firms with poor past performance. We dispute this interpretation. We find that while a stock's future return is unrelated to the firm's past accounting‐based performance, it is strongly negatively related to the “intangible” return, the component of its past return that is orthogonal to the firm's past performance. Indeed, the book‐to‐market ratio forecasts returns because it is a good proxy for the intangible return. Also, a composite equity issuance measure, which is related to intangible returns, independently forecasts returns.     

Exploring the Optimal Design of an Employer-Sponsored Sickness-Disability Compensation Insurance Plan When Sickness Presenteeism Is Penalized

We explore the impact of presenteeism, absenteeism, and shirking on the optimal design of an employer-sponsored sickness-disability compensation insurance plan when the employer penalizes sickness presenteeism. We assume an employee's health follows a simple multistate model with a “severely ill” sickness state. To combat absenteeism, the employer randomly verifies an employee's claim of sickness. However, to combat presenteeism, we also introduce the new concept of a presenteeism penalty whereby employees who are found to be at work in the “severely ill” sickness state are sent home and receive a penalized sick pay that is lower than the normal sick pay. Thus sick employees must decide whether to stay at home and receive a sick pay or go to work sick and run the risk of being sent home and penalized. We further assume (1) employees are risk-averse utility maximizers, (2) each employee has a strategy for staying home or working while sick that maximizes his or her lifetime expected discounted utility, and (3) an employee's strategy is unknown to the employer. The primary plan design factors that affect an employee's lifetime expected discounted utility and the employer's discounted expected accounting profits over an employee's working lifetime are the sick pay, the presenteeism penalty, and two health check probabilities. Volterra integral equations are used to derive expressions for an employee's lifetime expected discounted utility and the employer's expected discounted accounting profits over an employee's lifetime under various employee strategies. Laplace transforms are used to derive asymptotic expressions for the solutions to these integral equations. These asymptotic solutions are used to explore the impact of these factors on the optimal sickness compensation insurance plan design.     

A Better Way to Measure Operating Performance (or Why the EVA Math Really Matters)

Most companies rely heavily on earnings to measure operating performance, but earnings growth has at least two important weaknesses as a proxy for investor wealth. Current earnings can come at the expense of future earnings through, for example, short‐sighted cutbacks in investment, including spending on R&D. But growth in EPS can also be achieved by investing more capital with projected rates of return that, although well below the cost of capital, are higher than the after‐tax cost of debt. Stock compensation has been the conventional solution to the first problem because it's a discounted cash flow value that is assumed to discourage actions that sacrifice future earnings. Economic profit—in its most popular manifestation, EVA—has been the conventional solution to the second problem with earnings because it includes a capital charge that penalizes low‐return investment. But neither of these conventional solutions appears to work very well in practice. Stock compensation isn't tied to business unit performance—and often fails to provide the intended incentives for the (many) corporate managers who believe that meeting current consensus earnings is more important than investing to maintain future earnings. EVA doesn't work well when new investments take time to become profitable because the higher capital charge comes before the related income. In this article, the author presents two new operating performance measures that are likely to work better than either earnings or EVA because they reflect the value that can be lost either through corporate underinvestment or overinvestment designed to increase current earnings. Both of these new measures are based on the math that ties EVA to discounted cash flow value, particularly its division of current corporate market values into two components: “current operations value” and “future growth value.” The key to the effectiveness of the new measures in explaining changes in company stock prices and market values is a statistical model of changes in future growth value that captures the expected effects of significant increases in current investment in R&D and advertising on future profits and value.     

Equity‐based incentives and shareholder say‐on‐pay

We study the relationship between CEO pay‐performance sensitivity, pay‐risk sensitivity, and shareholder voting outcomes as part of the “say‐on‐pay” provision of the 2010 US Dodd‐Frank Act. Consistent with our hypothesis, we provide evidence that shareholders tend to approve of compensation packages that are more sensitive to changes in stock price (pay‐performance sensitivity). Our findings are consistent with theoretical predictions that outside owners approve of equity incentives as a means of aligning managers' interests with those of shareholders. We also document that future changes to equity‐based incentives are related to voting outcomes and that shareholders incorporate CFO incentives into their votes. Collectively, these results provide evidence of the importance of equity‐based incentives from the perspective of those most concerned with firm value and of the effectiveness of say‐on‐pay as a governance mechanism.     

Incentives and Investor Expectations

This article argues that the Expectations‐Based Management (EBM) measure proposed by Copeland and Dolgoff (in the previous article) is essentially the same measure that EVA companies have used for years as the basis for performance evaluation and incentive compensation. After pointing out that the analyst‐based measures cited by Copeland and Dolgoff do not provide a basis for a workable compensation plan, the authors present the outline of a widely used expectations‐based EVA bonus plan. In so doing, they demonstrate the two key steps in designing such a plan: (1) using a company's “Future Growth Value”—the part of its current market value that cannot be accounted for by its current earnings— to calibrate the series of annual EVA “improvements” expected by the market; and (2) determining the executive's share of those improvements and thus of the company's expected “excess” return. One of the major objections to the use of EVA, or any single‐period measure, as the basis for a performance evaluation and incentive comp plan is its inability to reflect the longer‐run consequences of current investment and operating decisions. The authors close by presenting a solution to this “delayed productivity of capital” problem in the form of an internal accounting approach for dealing with acquisitions and other large strategic investments.