The Financial Times published an article this weekend blaming the bonus culture for a decline in productivity and investment in the US and the UK. The theory is that because we reward managers highly for achieving short-term targets, we are incentivizing them to focus on short-term gain to the detriment of long-term growth. Managers are better rewarded for boosting profits in the short-term than they are for making decisions to reinvest in the business so that it continues to be profitable in the future.
Support for this theory can be seen from the fact (as reported by the Wall Street Journal and Keith P. Bishop at Allen Matkins) that a study has found that S&P 500 indexed companies spent a median of 36% of their operating cash flow on dividends and buybacks in 2013, up from 18% in 2003. At the same time, the proportion spent on plants and equipment decreased. Management has an incentive to boost returns to shareholders now, while under-investing in the future of the business.
This problem is compounded by the fact that we have defined the ‘long-term’ under executive incentive plans as three to five years. How many capital projects can be planned, executed and become fully operational and profitable within three years? Three years is simply not enough time to achieve the type of reinvestment needed to grow the economy.
The High Pay Centre has published a report calling for an end of the long-term incentive, arguing that it has resulted in the escalation of executive pay with no corresponding escalation in company performance. Instead, companies should only pay executives an annual cash bonus.
The danger with this approach is that if we eliminate all long-term incentives, we compound the problem of executives focusing on the short-term interests of shareholders to the detriment of the future well-being of the company. Thus, those of us who advocate for a “back to the bonus” shift must be sure that we also focus on how bonuses should be structured in order to best align management’s incentives with the company’s long-term interests. We must avoid a situation where executives are paid the right amount of money to do the wrong job. Performance metrics should include measures taken to improve the long-term profitability and productivity of the business. Additionally, the long-term should be longer than a three to five year horizon. If we are to see a real shift in how companies deploy their capital, we must start to reward the long-term investment decisions we want to see.