Risk-taking in new project selection: Additive effects of bonus incentives and past performance history

The goal of this study is to investigate how past project performance history and bonus incentive pay schemes affect managers' propensity to select more or less risky projects. Performance history is manipulated via past positive outcomes (i.e. beating a target profit rate) and negative outcomes (i.e. missing a target profit rate). Two types of bonus incentive pay schemes (hurdle bonus and graduated bonus) were employed in the study. The findings are consistent with prospect theory that predicts that prior bad outcomes (negative performance history) motivate greater risk-taking than prior good outcomes (positive performance history). In addition, we find evidence that hurdle and graduated bonus incentive schemes also affect risk taking. Overall, we find an additive effect of these two factors, such that the greatest (least) risk taking occurred when participants had negative (positive) prior experience coupled with a graduated (hurdle) bonus scheme.     

Why Capital Efficiency Measures Are Rarely Used in Incentive Plans, and How to Change That

Despite the wide acceptance of DCF valuation and its corollary that value is created only by earning more than the cost of capital, very few companies use performance measures that focus on corporate efficiency in using capital—measures such as return on capital (ROC) or economic value added (EVA)—as the main basis for their top management incentive programs. In this article, the authors begin by documenting the surprisingly limited use of such measures in management incentive plans. Next they analyze three often cited problems—difficulty in retaining managers, discouragement of growth investment, and complexity—that could account for the limited use of such measures. Third and last, they suggest a number of adjustments to standard capital efficiency measures that are designed to address these problems and, in so doing, to give corporate directors more confidence in using measures like EVA to reward and hold managers accountable for value-adding performance.
In illustrating the problems encountered when using such performance measures, the article uses case studies of three long-time "EVA companies"—Briggs & Stratton, Herman Miller, and Manitowoc—to highlight the difficulty of using a "bonus bank" (or "clawback") system to hold managers fully accountable for earning a minimum return on capital. After presenting empirical data that shows "delayed productivity" of invested capital, the authors suggest that conventional capital efficiency measures can discourage value-increasing growth.
The article concludes by recommending that although measures like EVA used in combination with negative bonus banks provide the right incentives, EVA capital charges should be phased in gradually to reflect the delayed productivity of capital. At the same time, corporate boards should consider providing bonus bank "relief" when market and industry factors have excessively large negative effects on the performance measures and bonus awards.     

How “Competitive Pay” Undermines Pay for Performance (and What Companies Can Do to Avoid That)

Almost all proxy statements say that the company's pay programs are designed to achieve pay for performance and to provide competitive pay. While companies assume that these objectives are perfectly compatible, attempts to provide competitive pay often have the effect of undermining pay for performance. As currently practiced, competitive pay means that the company's target pay levels match the pay levels of its peer companies regardless of past performance. By targeting the dollar value of an equity award each year, competitive pay plans effectively reward poor performance in a given year by increasing equity grant shares in the following year—and, conversely, such plans penalize superior performance in one year by reducing the number of shares in the next. Likewise, the target share of the annual incentive award increases with poor performance and decreases with superior performance. In this fashion, the competitive pay approach distorts incentives and weakens the link between cumulative pay and cumulative performance. The authors show that the focus on competitive pay is a modern development that replaced the sharing formulas that governed executive pay in the first half of the twentieth century. Companies adopt the competitive pay model because they believe it does a better job of achieving the three main objectives of executive pay: strong incentives; retention; and limited shareholder cost. While competitive pay directly addresses retention risk, it can greatly weaken management incentives. Furthermore, boards tends to rely on competitive pay data to set target compensation because they have no meaningful measure of incentive strength and the actual cost to shareholders. Without quantitative measures of incentive strength and shareholder cost, boards run the risk of retaining poor performers and losing superior performers. Using a case study of Dow Chemical, the authors show how companies can measure the incentive strength of their executive pay plans, and how a simple pay plan using annual grants of performance shares can provide “perfect” pay for performance.     

Top Management Incentives and Corporate Performance

There is little agreement about either the effect of executive compensation on corporate performance or the best way to measure the strength of executive incentives. With little guidance from academic research, managers and directors continue to rely heavily on the percentage of pay "at risk" as a proxy for incentive strength.
Starting with the premise that managers, like investors, are motivated by prospective changes in their wealth, this article presents a measure of incentive strength called "wealth leverage" that reflects the sensitivity of an executive's company-related wealth—total stock and option holdings plus the present value of expected future compensation, including future salary, bonus and stock compensation—to changes in shareholder wealth. After estimating top management's wealth leverage at 702 companies, the authors conclude that: 1) the median company has significant wealth leverage; 2) almost all corporate wealth leverage comes from their accumulated stock and option holdings, not from current compensation; and 3) companies with higher wealth leverage significantly outperform their industry competitors.     

Is U.S. CEO Compensation Broken?

This article addresses four major concerns about the pay of U.S. CEOs: (1) failure to pay for performance; (2) excessive levels of pay; (3) failure to index options and other equity-based pay, resulting in windfalls; and (4) too much unwinding of incentives. The authors' main message is that most if not all of these concerns are exaggerated by the popular tendency to focus on the annual income of CEOs (consisting of salary, bonus, and stock and option grants) while ignoring their existing holdings of company equity.
Taking into account the effect of stock price changes on CEO wealth leads the authors to a number of interesting conclusions. First, the pay-for-performance relationship is strong and has grown significantly in recent years. Second, what may appear as above-normal growth in annual pay levels may be necessary to compensate CEOs for the increased risk associated with their growing level of equity-based incentives. Third, conventional (that is, unindexed) stock and options, when viewed as a combination of market risk and firm-specific risk, may provide an optimal solution to two conflicting demands: shareholders' demand for executive rewards tied to company performance and executives' preference to diversify their wealth. Finally, there is little evidence of widespread CEO unwinding of incentives, and levels of CEO equity ownership in the U.S. remain impressively high.     

CEO Bonus Compensation and Bank Default Risk: Evidence from the U.S. and Europe

We investigate the link between the incentive mechanisms embedded in CEO cash bonuses and the riskiness of banks. For a sample of U.S. and European banks, we employ the Merton distance to default model to show that increases in CEO cash bonuses lower the default risk of a bank. However, we find no evidence of cash bonuses exerting a risk‐reducing effect when banks are financially distressed or when banks operate under weak bank regulatory regimes. Our results link bonus compensation in banking to financial stability and caution that attempts to regulate bonus pay need to tailor CEO incentives to the riskiness of banks and to regulatory regimes.     

The case of the unpopular pay plan

Three years after launching the team-based Quality For All program, Top Chemical Company CEO Sam Verde was searching for a team-based compensation system that would reflect his company's new philosophy. With a committee gathered to discuss the issue, Verde confronts the fact that changing pay plans is an issue few people can agree on. "Very simply," explains vice president for compensation Gilbert Porterfield, "the plan is designed to give employees working on teams real incentives for constant improvement and overall excellence. The variable aspect of the system pays employees for the performance of their group." This doesn't sit well with the others. "It's going to punish teams like mine for the failings of others instead of rewarding us for the work we do and have already done," says packaging team representative Ruth Gibson. Another committee member feels that team-based anything is a "motivational happy land that doesn't square with how people really work." While Verde likes the proposed pay plan, he has doubts over whether his employees will accept the risk. Upper management has no problem basing 60% of its pay on TopChem's performance. But getting line employees to risk part of their salaries--even as little as 4%--on the ups and downs of the chemical industry may be more trouble than it's worth. Four experts on compensation reveal where Top Chemical went wrong in its plan and how Sam Verde might bring about change successfully.     

Differences in CEO compensation under large and small institutional ownership

I examine the influence of large and small institutional investors on different components of chief executive officer (CEO) compensation, using US data for 2006–2015. An increase in large institutional ownership reduces total pay and current incentive compensation (i.e., options, stocks, bonus pay), whereas small institutional investors lower long‐term incentive pay (i.e., pension, deferred pay, stock incentive pay). These findings are consistent with managerial agency theory and the substitution of incentive pay by institutional monitoring. The effects are stronger for higher ownership levels and firms with weak governance, less financial distress, long‐tenured CEOs, multiple segments, and more free cash flow.     

Subjective Performance Indicators and Discretionary Bonus Pools

Key indicators of managerial performance are frequently subjective, that is, they are difficult to specify and/or verify for contracting purposes. When a principal must rely on subjective information to create incentives for a group of agents, discretionary bonus pools are shown to be optimal mechanisms. Despite their optimality, however, discretionary bonus pools entail an additional agency cost relative to the benchmark of optimal contracts based on objective and verifiable information. Our analysis identifies circumstances under which this additional agency cost is small, for example, the subjective information signals are precise, or the number of agents participating in the bonus pool increases. When incentive schemes can be based on both objective and subjective performance indicators, the relative weights to be placed on alternative signals are shown to differ from the ones predicted by models with objective signals only. We also demonstrate that correlation in measurement errors has a different impact on the structure of optimal incentive schemes when the performance indicators are merely subjective.     

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.     

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.     

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.     

Optimal job design in the presence of implicit contracts

We characterize the optimal job design in a multitasking environment when the firms use implicit contracts (i.e., bonus payments). Two natural forms of job design are compared: (i) individual assignment, where each agent is assigned to a particular job and (ii) team assignment, where a group of agents share responsibility for a job and are jointly accountable for its outcome. Team assignment mitigates the multitasking problem but may weaken the implicit contracts. The optimal job design follows a cutoff rule where only the firms with high reputation concerns opt for team assignment. However, the cutoff rule need not hold if the firm can combine implicit incentives with explicit pay‐per‐performance contracts.     

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.     

THE DESIGN OF MULTI-YEAR STOCK OPTION PLANS

Despite the explosion in the corporate use of stock options, the incentives created by stock options are not well understood by either the boards who grant them or the executives who are meant to be motivated by them. A major source of confusion stems from the corporate practice of using multi-year stock option plans. Such multi-year grants create subtle, potentially important links between current performance and future grants that can significantly dilute incentives for better performance.
For example, so-called "fixed value" plans provide very weak, even perverse, incentives ex ante since the value of future option grants is completely insulated from current performance. Under such plans, an executive's reward for superior performance is to receive fewer options, and to receive more options for substandard performance. In contrast, the fixed number plan creates an intrinsic link between changes in this year's stock price and changes in the value of future option grants.
The author also reports the findings of new empirical research that shows that stock option plans, taken as a whole, have a pay-to-performance correlation that is eight times stronger than that of salary and bonus. But, consistent with the analysis above, fixed value option plans have pay-to-performance that is only six times that of salary and bonus, as compared to ten times for fixed number plans.     

Piecewise linear incentive scheme and participative budgeting

This paper studies the economic incentives of participative budgeting through the design of incentive schemes within the agency theory framework. In particular, a piecewise linear incentive scheme (PLIS), an optimal version of Weitzman's New Soviet Incentive Scheme (NSIS), is derived. The characteristics of PLIS are: first, unlike NSIS, the bonus (penalty) rates of the optimal PLIS vary according to the agent's type in order to improve the principal's welfare, second, a penalty may be imposed on the overfulfillment of the agent's performance in order to maintain incentive compatibility, and finally, it is shown that if the coefficients are constant as in NSIS, there is no need for participative budgeting. Also, PLIS is compared with a quadratic incentive scheme. Both incentive schemes achieve the optimal solution, but each incentive scheme has its own advantage over the other depending on the situation.     

Performance choice,executive bonuses and corporate leverage

This study examines the causal link between a firm's leverage decisions and the characteristics of its CEO bonus plans. Results from a simultaneous equations model strongly suggest that highly levered firms are less likely to use return on equity (ROE) or ROE-based accounting performance measures to determine executive bonuses. Estimates also indicate that firms with fewer debt covenants, higher interest rates on debt, and a greater proportion of executive pay in the form of stock options are less likely to adopt ROE-based measures for use in CEO bonus plans. These findings lend strong support to the efficient contracting hypothesis. The conflicting interests of corporate stakeholders, especially between stockholders and creditors, encourage firms to tie executive pay to performance metrics like return on assets (ROA) that will strike the optimal balance between the agency costs of debt and the agency costs of equity.Data availability: all data are available from public sources.     

成员激励对团队知识创造的影响机制研究——基于知识隐性程度的调节作用

团队成员激励是影响团队创造力提升的重要变量之一.采用层次回归分析法进行实证分析,结果表明:团队成员激励的个体成长与晋升、团队环境与气氛维度对团队知识创造均呈现出显著的正相关,团队成员的工作环境与物质奖励维度对团队知识创造的知识内隐化、外显化、组合化维度的影响显著,对知识社会化维度的影响不显著.知识隐性程度部分调节团队成员激励对团队知识创造的影响.     

Performance Incentives within Firms: The Effect of Managerial Responsibility

We show that top management incentives vary by responsibility. For oversight executives, pay‐performance incentives are $1.22 per thousand dollar increase in shareholder wealth higher than for divisional executives. For CEOs, incentives are $5.65 higher than for divisional executives. Incentives for the median top management team are substantial at $32.32. CEOs account for 42 to 58 percent of aggregate team incentives. For divisional executives, the pay–divisional performance sensitivity is positive and increasing in the precision of divisional performance and the pay–firm performance sensitivity is decreasing in the precision of divisional performance. These results support principal–agent models with multiple signals of managerial effort.     

National differences in incentive compensation practices: The differing roles of financial performance measurement in the United States and the Netherlands

This paper describes the findings of a study aimed at providing an international replication of a US-based study by Gibbs et al. [Gibbs, M., Merchant, K., Van der Stede, W., & Vargus, M. (2004). Determinants and effects of subjectivity in incentives. The Accounting Review, 79(2), 409–436; Gibbs, M., Merchant, K., Van der Stede, W., & Vargus, M. (2006). The structure of incentive contracts: Evidence from auto dealerships. Working Paper, University of Chicago, University of Southern California, London School of Economics and University of Texas-Dallas] focused on the incentive compensation practices of firms in the automobile retailing industry. The purpose was to determine the extent to which these practices and their effects were similar across countries. Theory provides conflicting predictions as to whether international practices should reflect a situational “best fit” or “global best practices.” We collected a dataset comparable to that of Gibbs et al. from Dutch automobile retailers. The findings reveal dramatic differences in practices across the two countries. As compared to the US firms, the Dutch firms are much less likely to provide their managers with incentive compensation in any form. Where Dutch firms do offer incentive compensation, the payouts are smaller and their bonus awards are less likely to be based on profit measures of performance. But where the Dutch firms use incentive compensation, their performance/reward functions are more complex. Moreover, unlike in the US firms, in the Dutch firms the effects of the use of incentive compensation on net profit and pay satisfaction are negative.