An analysis of changes to a team-based incentive plan and its effects on productivity,product quality,and absenteeism

Using data from three production units of a large manufacturing plant that employs production teams in its assembly operations, this paper examines how changes made to an existing team-based incentive plan affects labor productivity, product quality, and worker absenteeism. The firm switched from a piece-rates contract and an attendance bonus and instituted a two tier incentive plan comprising two different but complementary performance-based bonus schemes: one tier based on individual team performance and the other tier on plant-wide performance. The incentives were introduced concurrently with management control initiatives intended to facilitate cooperation and monitoring among the teams. I find significant productivity gains and improvements in quality and absenteeism associated with the new incentive plan. These findings underscore two important points that have not been emphasized in existing empirical studies of incentive pay: incentive contracts for teams generate superior performance using combination of incentives, and the need to introduce organizational changes to facilitate cooperation and peer monitoring in tandem with incentive pay to capture greater incentive effects in team production.     

Bonus schemes and trading activity

Little is known about how different bonus schemes affect traders' propensity to trade and which bonus schemes improve traders' performance. We study the effects of linear versus threshold bonus schemes on traders' behavior. Traders buy and sell shares in an experimental stock market on the basis of fundamental and technical information (past share price evolution, realized earnings, analysts' earnings forecasts, and evolution of the market index). We find that linear and threshold bonus schemes have different effects on trading behavior: traders make more transactions but of a smaller size under the threshold than under the linear bonus scheme. Furthermore, transaction frequency significantly decreases when bonus thresholds are reached but only after building in a safety margin. Under the threshold scheme, the traders' performance is lower (even when there are no transaction costs) than under the linear bonus scheme as a consequence of poorer market timing. This is especially the case when earning money by trading is relatively difficult (i.e., under low profitability conditions). Nevertheless, under low profitability conditions, traders seem to collect more information about the relationships between share price and market returns, earnings, and earnings forecasts, put more effort into understanding those relationships, and thus eventually learn to perform better.     

Investment horizon,risk, and compensation in the banking industry

This paper examines the relation between the investment horizon of banks and their CEO compensation, and its consequences for risk and performance. We find that banks with short-term investment intensity pay more cash bonus, exhibit higher risk and perform more poorly than banks with longer-term investment intensity. This evidence is broadly consistent with the view that short-term means of compensation encouraged a short-term investment focus, which in turn led to both higher risk and resulted in poorer performance, culminating in the sub-prime crisis. The inverse risk-performance relation suggests pay schemes were incongruent with shareholders’ interest. Moreover, pay arrangements used in banks prior to the subprime crisis exposed banks to the ex-post settling up problem (the clawback problem).     

Accounting fundamentals and CEO bonus compensation

Research indicates that there is a positive association between accounting earnings and chief executive officer (CEO) cash compensation; however, evidence also suggests that this positive association ceases to exist when earnings performance is poor or declining. This latter result has led some critics of corporate compensation policies to conclude that CEOs are not penalized for poor or declining firm performance. The purpose of this study is to further illuminate the pay-performance debate by expanding the traditional executive bonus compensation model to include a set of accounting fundamentals that prior research indicates are related to both current and future firm performance. Our results indicate that there is a highly significant relationship between accounting fundamentals and the level of and change in CEO bonus compensation. Moreover, we find a highly significant relationship between accounting fundamentals and both bonus omissions and bonus reductions. When earnings are negative or declining, we find that the above relationships remain intact. In contrast, when earnings are negative or declining, we find that the relationship between aggregate earnings and bonus compensation is weak or insignificant in most of our analyses. Taken together, our results suggest that the apparently weak relationship between accounting earnings and CEO bonus compensation (particularly when earnings are negative or declining) is partly due to the fact that the bonus compensation model excludes accounting fundamentals which are strongly associated with bonus compensation. Thus, we conclude that (i) bonus compensation is more closely tied to firm performance than critics sometimes claim and (ii) bonus compensation awarded to CEOs when earnings performance is poor is at least partially explained by the presence of favorable accounting fundamentals.     

AN EMPIRICAL INVESTIGATION INTO THE IMPACT OF PROFIT SHARING SCHEMES OF EXECUTIVIES ON THE CONTENT OF CORPORATE SUBMISSIONS ON PROPOSED ACCOUNTING STANDARDS

This paper examines the comments submitted by UK companies on 20 proposed accounting standards to test the hypotheses that executives favor standards that increase, or dampen the variance of, accounting profit numbers on which their incentive remuneration is based. Test results were generally as hypothesised but only the profit variance outcomes were statistically significant. Allowing for political environment changes affected only the profit variance results. There was no evidence that the relative monetary size of bonus payments was a significant lobbying factor. No significant differences were found between the lobbying preferences of companies with or without executive incentive schemes.     

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.     

Balancing difficulty of performance targets: theory and evidence

We examine how firms balance difficulty of performance targets in their annual bonus plans. We present an analytical model showing that managerial allocation of effort is a function of not only relative incentive weights but also the difficulty of performance targets. We find that relative incentive weights and target difficulty can either be complements or substitutes in motivating effort depending on the extent to which managers have alternative employment opportunities. To test the predictions of our model, we use survey data on performance targets in annual bonus plans. Our sample of 877 survey respondents consists primarily of financial executives in small- and medium-size private companies where annual bonuses are important both for motivation and retention. Consistent with our model, we find that relative incentive weights are negatively (positively) associated with perceived target difficulty when concerns about managerial retention are high (low). It follows that performance measures included in annual bonus plans have sometimes easy and other times challenging targets depending on their relative incentive weights and retention concerns.     

Bankers' compensation and fair value accounting

This paper examines the role of certain fair value accounting (FVA) outcomes in compensation of US bank CEOs. The use of FVA in compensation invites an agency cost—the clawback problem—if cash compensation is based on unrealized profits that may reverse in the future. At the same time FVA may be a good measure of current managerial effort and so be cash compensated. We find evidence consistent with a positive link between CEO cash bonus and fair value (FV) valuation of trading assets, managed for short-term profit, as well as (amongst banks with limited trading exposure) a positive link between CEO pay and FV valuations of available for sale (AFS) assets. We find no evidence that trading income is incrementally compensation relevant, indicating that compensation committees avoided the clawback problem for unrealized trading gains. The paper also provides evidence on the link between FVA outcomes and equity-based pay.     

Managerial characteristics and performance of eurozone mutual funds

We investigate the relation between observable managerial characteristics (i.e., gender, age, tenure, professional qualifications, and advanced education) and performance in diversified equity mutual funds domiciled in the eurozone. We find that differences in the fund alphas are statistically significant only in groups based on age, tenure, and professional qualifications (i.e., chartered financial analyst [CFA]). We also find a significant positive relation for age and CFA certification with a fund's risk-adjusted performance and a significant negative relation for tenure. However, we find no significant effect for gender and advanced education (i.e., master of business administration [MBA]). The differences in risk taking are significantly related only with age and tenure; the former has a negative and the latter a positive relation with risk taking.     

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.     

Auditor independence, executive pay and firm performance

This paper investigates whether compensation committees actively intervene to adjust accounting performance‐based incentive schemes for the real, or perceived, reduced earnings credibility signalled by the purchase of non‐audit services. Using a nonlinear, two‐stage least‐squares method that accounts for the simultaneity of executive pay, firm performance and non‐audit fees, we find a significant negative relationship between non‐audit fees and the sensitivity of chief executive officer (CEO) pay to firm performance. Point estimates suggest that the reduced weight applied to accounting performance lowers the incentive component of executive pay between roughly 5 and 8 per cent for the CEO of the ‘average firm’.     

The Use of Management Control Mechanisms to Mitigate Moral Hazard in the Decision to Outsource

Using archival data from the U.S. passenger airline industry, this study examines whether management control mechanisms aimed at mitigating moral hazard explain outsourcing decisions over and above transaction cost economics (TCE) determinants documented in prior research. Consistent with TCE theory, we find that in‐house production efficiencies and our proxy for transaction risk (i.e., deriving from transaction infrequency, transaction complexity, and relationship‐specific investments) significantly explain the extent of outsourcing of aircraft maintenance. We extend TCE insights to show that incentive delta (i.e., the sensitivity of CEO portfolio holdings to stock price changes) strengthens the negative association between production efficiencies and outsourcing while incentive vega (i.e., the sensitivity of CEO holdings to stock return volatility) weakens the negative association between transaction risk and outsourcing. Monitoring strengthens the negative association between in‐house production efficiencies and outsourcing, but has no effect on the transaction risk–outsourcing relation. The results suggest that the use of outsourcing to achieve cost savings is promoted through both incentive contracts and monitoring, but outsourcing to achieve the desired risk level is promoted only through incentive contracts.     

Six Factors That Explain Executive Pay (and its Problems)

The authors start by showing that six factors—responsibility (i.e., position and company size), industry, pay inflation, business risk, performance and company pay policy—explain over 75% of the variation in the pay of top-five U.S. executives for a sample of 75,000 cases during the years 1997–2008. They also show that the current structure of top-executive pay creates a stronger incentive for revenue growth than for shareholder value growth, and that a 10% increase in shareholder value increases incentive compensation by only 3%. Moreover, their research suggests that the “value incentive” of the average U.S. executive is only one third as strong as the incentive that would be provided by simple “sharing” concepts, such as those provided by plans that give executives a fixed percentage of economic profit or annual grants of a fixed number of shares of stock. The article concludes by reviewing some recent research on incentives and company performance and offering suggestions to help investors identify companies with strong and cost-efficient shareholder value incentives.     

Performance effects of setting targets and pay–performance relations before or after operations

This study investigates both theoretically and experimentally whether and how ex post use of relative performance evaluation (RPE) information in determining performance target levels and profit sharing ratio (PSR) levels affects employer profit performance. Our findings show that employers use RPE information, i.e. peer performance, to adjust performance target levels and PSR levels to reflect economic conditions. More importantly, we find that ex post use of RPE information, i.e. peer performance, improves profit performance. However, ex post adjustment of target levels and PSR levels based on peer performance have different performance implications. Specifically, we find that ex post target contracts improve employer residual profit over ex ante target contracts, while ex post PSR contracts do not improve employer residual profit over ex ante PSR contracts. Our supplemental analyses suggest that this difference is likely because employees are more sensitive to prior period compensation determined by ex post PSRs than ex post targets. Compared to ex post targets that are likely perceived to be fair based on peer performance, ex post PSRs based on the peer performance can be used opportunistically by employers and/or are perceived so by employees, which leads to future repercussions manifested in lower employee effort and employer residual profit.     

Governance,efficiency and risk taking in Chinese banking

We employ a hand-collected unique dataset on banks operating in China between 2003 and 2011 to investigate the impact of board governance features (size, composition and functioning) on bank efficiency and risk taking. Our evidence suggests that board characteristics tend to have a greater influence on banks' profit and cost efficiency than on loan quality. We find that the proportion of female directors on the board appears not only to be linked to higher profit and cost efficiency but also to lower traditional banking risk. Similarly, board independence is associated with higher profit efficiency of banks; while the opposite is found for executive directors and in the presence of dual leadership of the CEO/chairperson. Among the control variables, we found that liquidity negatively affects profit and cost efficiency, while positively affecting risk. Interestingly, we find some evidence of an incremental effect of specific board characteristics on efficiency for banks with more concentrated ownership structures and state-owned institutions; while for banks with CEO performance-related pay schemes the effect on efficiency when significant is usually negative. Our results offer useful insights to policy makers in China charged with the task of improving the governance mechanisms in banking institutions.     

Alternative explanations for the association between market values and stock-based compensation expenditure

The relation between stock-based compensation and market values has been tested previously in the literature, but the empirical findings are inconsistent: both negative and positive relations have been documented. The objective of this study is to provide an explanation for why both negative and positive relations between stock-based compensation expenditure and market values can be consistent with rational markets.We argue that stock-based compensation can be used either as a reward for past performance or as an incentive for future performance. We predict that there is a negative relation to market values when stock-based compensation is granted primarily as a reward to chief executives for past performance, while there is a positive relation when stock-based compensation is used to provide incentives for enhanced future performance. This prediction is tested on a sample of 259 firm-year observations for the period 1999–2004 using an instrumental variables approach, where the sample is classified into the ‘reward’ and ‘incentive’ groups on the basis of prior period performance and option characteristics. Our findings are that there is a positive association between stock-based compensation expenditure and market values for the ‘incentive’ group, but we find overall an insignificant relation for the ‘reward’ group. A number of sensitivity tests confirm the main findings.     

Does executive compensation incentivize managers to create effective internal control systems?

We examine the relation between CFO compensation and the effectiveness of internal control structures under SOX, Section 404. Given the growing evidence of an uncoupling of pay from performance, we conduct our analysis using a two-stage regression. In our first stage model, we decompose compensation into its fitted (i.e., explained by firms’ economic characteristics) and residual (i.e., unexplained) components. In our second stage model, we estimate a logit regression of internal control effectiveness on both the fitted and residual components of compensation. Overall, we find that internal control effectiveness is related to the fitted components of compensation, but unrelated to the residual components. These relations exist for aggregate compensation, as well as its individual components (i.e., salary, bonus, equity-based). Our findings suggest that fitted compensation increases the probability of effective internal controls. Conversely, residual compensation does not affect this probability, suggesting that it reflects pay without performance. Our findings inform regulators and standard setters of the often unforeseen costs of increased regulation.     

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.     

Independent directors and the propensity to pay dividends

Using data from 944 public companies in 2006, I examine how a firm's propensity to pay dividends is related to (i) board independence and (ii) independent directors' tenure, number of board seats (busy) and equity incentive compensation. After controlling for the effects of traditional economic, CEO entrenchment and ownership determinants of the propensity to pay dividends, I find evidence of a positive association between the propensity to pay and (i) board independence and (ii) director tenure, and a negative association between the propensity to pay and (i) busy directors and (ii) greater equity incentive compensation in the director pay structure. I find consistent results when the decision is to pay cash dividends or repurchase shares. In further tests, I find that equity incentive compensation in the independent director pay structure is the most pervasive determinant across other dividend measures such as dividend payout, total payout and repurchases. Overall, the findings suggest that the characteristics of independent directors are important determinants of the payout policy. The results also suggest that future corporate governance research could benefit from incorporating characteristics of independent directors rather than limiting governance measures to board independence especially when recent empirical evidence (Linck et al., 2008, 2009) shows convergence, and therefore, narrowing variation in the proportion of outsiders and insiders on a board.     

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.