The Executive Compensation Controversy - Fondazione Rodolfo ...

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THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISFigure 4.1Typical Cash Compensation PlanNote:It is easy to see how the schedule depicted in Figure 4.1 can lead to risk taking,especially if performance without risk taking would end up below X 1 . Executives anticipatingperformance X < X 1 have nothing to lose (except, perhaps, their jobs) by gambling on aninvestment that might push them past X 1 . Moreover, the schedule depicted can also lead togreater volatilities in realized performance. Suppose an executive can generate constantperformance just below X 1 each year, or alternatively can generate performance well belowX 1 in some years, and above X 1 in alternating years. Executives paid based on the schedule inFigure 4.1 would prefer variable performance to constant performance.The typical schedule depicted in Figure 4.1 generates a treasure trove of dysfunctionalincentives well beyond risk taking. Consider, for example the effect of the “jump” ordiscontinuity of bonus payments at performance level X 1 . Executives who believe theycannot achieve at least this level of performance this year will either stop producing or“save” profits for next year by delaying revenues or accelerating expenses. These are theforces that lie behind the commonly observed practice of managers delaying the deliveryand/or invoicing of sales, or prepaying expenses that would normally be paid in the nextperiod. Such behavior is motivated by the fact that these plans impose no bonus penalty formissing the performance threshold by a lot instead of a little (as the figure shows). And ifexecutives see that they are not going to make the bonus pool this year, they are better off totake an even bigger hit this period (at no cost to them in terms of their bonus) so they can doeven better next period—what accountants for years have called the “big bath” phenomenon.On the other hand, executives who are struggling to make the lower threshold, but still-105-
THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISbelieve they can make that threshold, have incentives (provided by the threshold bonus) to dowhatever is necessary to achieve the lower threshold. Their actions commonly includedestroying value by loading the distribution channel so as to recognize revenues earlier,unwisely reducing R&D and required maintenance expenditures, and offering excessive salesdiscounts for purchases completed prior to the end of the period. Each of these actions shiftsprofits from next period to the current period, but does so at an unnecessary cost to the firm.Similarly, consider the effect of capping bonuses when performance exceeds X 2 .Executives capable of producing well above X 2 in any period have incentives to stopproducing once they “max out” on their bonuses. In addition, they will do their best totransfer performance results that could have been realized this period into the next period.Rational executives will “smooth earnings” by manipulating sales and expenses to make surethat performance lies between X 1 in and X 2 each period. Such manipulation of sales andexpenses almost always is associated with higher long-run costs and/or lower long-runrevenues.The incentive problems apparent in Figure 4.1 largely reflect that fact the payperformancerelation is “non-linear” in the sense that the effect of increased performance onbonuses varies with performance, from zero well below X 1 to virtually infinite close to X 1and zero again above X 2 . These problems can therefore be mitigated by making the payperformancerelation linear over a broader range of performance. Figure 4.2 illustrates howcompensation can be designed to avoid many of the risk-taking and other dysfunctionalincentives inherent in Figure 4.1. First, the cap on bonuses at X 2 is removed incentives towithhold effort or defer profits when the cap is binding. Second, the jump at X 1 is removed tosolve the plethora of problems that arise whenever pay-performance schedules havediscontinuities. Finally, to extend the linearity of the schedule further, the base salary isreduced to below competitive levels, and the target or expected bonus is increased.-106-
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