Back to the bonus?

For the past thirty years, governments, boards and shareholders have taken steps to move companies towards a pay-for-performance model. This model is meant to align the interests of management and shareholders by rewarding executives when the company performs well, and scaling down remuneration when the company performs poorly. By linking pay to personal and company performance, executives have an incentive to maximize shareholder value.

In 2014, the High Pay Centre commissioned a report from Incomes Data Services to explore the link between executive pay and company performance at FTSE 350 companies. The report contains the following summary of conclusions:

  • “the statistical correlations between changes in two key annual bonus performance metrics, pre-tax profit and earnings per share (EPS), and subsequent bonus payments were insignificant;
  •  98.7 per cent of the change in annual bonuses could not be explained by changes in pre-tax profit;
  • 99 per cent of the change in annual bonuses could not be explained by changes in EPS;
  • there was no noticeable correlation between the relative ranking of long-term incentive plan (LTIP) share awards and the relative ranking of changes in total shareholder return over three years;
  • there was no noticeable correlation between the relative ranking of long-term incentive plan (LTIP) share awards and the relative ranking of changes in EPS over three years.”

(Source: New High Pay Centre report: Performance-related Pay is nothing of the sort | Publications | High Pay Centre pages 5-6)

Governments have spent countless hours legislating a link between pay and performance. Companies have invested countless dollars designing incentive plans to link pay and performance. Yet, the statistical evidence indicates that the link between what an executive earns and how a company performs is tenuous.

Governments have spent countless hours legislating a link between pay and performance. Companies have invested countless dollars designing incentive plans to link pay and performance. Yet, the statistical evidence indicates that the link between what an executive earns and how a company performs is tenuous.

In the name of linking pay to performance, executive compensation schemes have become more and more complicated. We have seen companies move away from the standard option grant to a more elaborate system of share instruments. These instruments tend to be subject to long-term vesting criteria, and each type has its own intricate set of rules and restrictions at each company. The result is that even when remuneration reports are read in minute detail, it is often difficult to understand exactly how an executive is paid, and how that pay is linked to performance.

Given the evidence, maybe we should rethink the pay-for-performance model. Executive remuneration is ballooning at a rate that cannot be explained in any way by performance. For schemes that are not actually achieving their goal, long-term incentive plans are needlessly technical and complex.

Instead of further complicating executive remuneration structures, perhaps it is time to go back to the basics: the bonus. A bonus is simple and straightforward. If the bonus is capped, there are no surprises when it comes to maximum pay-outs. Properly structured, bonus policies can create a coherent link between pay, and company or executive performance. If a company wants executives to also be shareholders, it can enact a minimum shareholding policy requiring executives to use a portion of their annual bonus to purchase shares on the market.

What do you think? Should we move away from long-term incentives back to the standard bonus? Or is there a way to simplify the pay-for-performance scheme while ensuring it actually achieves its goal?                                    

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