Executive compensation continues to be large and, in many cases, controversial. But do the bonus packages offered to top corporate managers work as intended—and if so, how?
That’s a question of interest to John Kepler, an assistant professor of accounting at Stanford Graduate School of Business. “I’ve always been interested in the costs and benefits of different incentive schemes and how these motivate people to take different actions,” Kepler says. “For example, how well does a compensation package align managers to shareholder interests? It’s an economically and practically important area to research.”
In two recent studies, Kepler and colleagues studied key dimensions of bonuses. First, research that Kepler did with Wayne Guay at the Wharton School and David Tsui at USC Marshall School of Business found that cash bonuses — long regarded as less motivating than equity-based awards—have a much larger effect on individual and collective incentives than previous studies suggest.
Second, a collaboration with Stanford GSB associate professor of accounting Brandon Gipper, Wharton’s Matthew Bloomfield, and Tsui revealed that bonuses can be used to shield top managers from legacy costs incurred before their arrival, encouraging them to make strategic investments in growth and other areas without fear of monetary penalty.
Cash bonuses work
When it comes to traditional thinking on executive bonuses, cash hasn’t been king.
The conventional wisdom, according to Kepler, is that equity-based rewards are the holy grail of compensation. “Boards typically load up executives with equity,” he says, “and then all of a sudden they’ve got incentives to act in shareholders’ best interests.” It makes sense, given that ownership of equity makes the executives shareholders who benefit from strong business performance as their stock holdings rise in value.
But what about the cash bonuses included in the vast majority of compensation plans?
Some previous studies suggested cash bonuses “don’t really have much bite,” as Kepler notes. But their conclusions—that bonuses don’t serve to enhance performance beyond incentives provided by equity—may have been flawed. “The problem is that past papers had lots of errors in how they measured whether cash bonuses truly provided incentives,” Kepler says. “And boards spend a lot of time on compensation design, so it’s important to know whether and how these bonuses work.”
Consequently, Kepler studied executive bonus contracts in a sample drawn from the 750 largest public U.S. firms (S&P 750) between 2006 and 2014, including the performance measures (such as earnings) and goals involved in awards. The researchers also collected data on sample firms’ actual perforrmance, to compare to the bonus-related targets.
In contrast to previous work, this research found that bonus plans have significant impact on executives’ incentives to boost corporate performance. “We find the bonuses are actually providing an order of magnitude more incentives than previous studies suggest for a lot of these top executives, in terms of creating shareholder value,” Kepler says. “Even for some CEOs of top public companies, especially early in the executive’s tenure, they provide meaningful incentives.” His study found that the median CEO receives about $12,000 in bonus per $1 million of net income for the firm, a much larger amount than previous studies found.
The research also found that bonus plans ultimately facilitate better cooperation across top management teams, because they hold senior executives collectively responsible for key performance measures and promote “mutual monitoring” and other collaborative behavior among team members.
“The analogy we’ve used is that these incentives get a team of executives at a company all rowing in the same direction,” Kepler says. “So bonuses are especially valuable early in senior executives’ careers and help get management teams focused on the right goals.”
Bonuses and cost-shielding
A second study built on those findings.
“Bonus plans are pretty ubiquitous,” Kepler says, pointing to his original research. “But academically it’s still an open question about the types of problems they solve.”
Specifically, he and collaborators observed that many executive bonus structures don’t use a business’s bottom-line net income to gauge performance. Instead, they use figures higher up on the income statement, such as earnings before interest, taxes, depreciation, and amortization (EBITDA)—or even sales.
“We developed some predictions about why that might be the case,” Kepler says. To test their predictions, the researchers studied executive compensation contracts from over 1,400 publicly traded firms between 2006 and 2017, with focus on performance measures used for bonus compensation.
They found that tying bonus-related performance to non-bottom-line financials largely helped address issues related to timing: that is, the time lag between when an executive makes an investment in the business’s future and when that investment pays off. If there’s a timing mismatch, boards will sometimes disregard costs of certain investments when calculating bonuses — as a way to encourage investments in projects worth pursuing, especially the kind that are designed to promote long-term growth.
“They don’t want to penalize executives for costs incurred today that might not yield benefits until later on,” Kepler says.
The logic is similar to that behind the grace period observers give new coaches of major sports teams when they’re recruiting talented young players. It might take a year or more for talented draft picks to reveal their true worth, at which point the coach should be held accountable for those earlier choices.
Kepler found that new CEOs, especially those hired from outside a business, are most likely to be shielded by the board—through bonus-plan structure—from the impact of large costs already in place when they arrive. “The new executive didn’t have any say in the legacy costs of the prior management team,” Kepler says. “So boards take that into account in compensation.”
In line with this, the study found the use of EBITDA for bonus determination declines about 50% over a 10-year tenure, meaning less cost-shielding of top executives over time.
Overall, Kepler’s findings point to the importance of context for designing executive bonus systems.
“Boards or consultants often ask, ‘What’s best practice for compensation plans?'” he says. “I tell them they really need to understand the challenges a company is facing at a certain point in time, for incentive design.”
A new top executive might need to be shielded from large legacy costs through a bonus tied to revenue growth, for example. Or a management team facing a large strategic challenge—like growth during a global pandemic—might be incentivized by cash bonuses to collaborate more effectively.
“When it comes to executive compensation, including bonus plans,” Kepler says, “there’s no one-size-fits-all solution.”
This piece was originally published by the Stanford University Graduate School of Business.