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Bonuses: How to influence Managerial Behavioral Frank Hartmann Gerard Mertens EURICI

Bonuses: How to influence Managerial Behavioral Frank Hartmann Gerard Mertens EURICI. Financial Times today (28-01-2010). Pay-for-performance: Does it pay off ? Some trends in executive compensation. Seven year period review (2002-2008)

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Bonuses: How to influence Managerial Behavioral Frank Hartmann Gerard Mertens EURICI

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  1. Bonuses: How to influence Managerial Behavioral Frank Hartmann Gerard Mertens EURICI Eurici (28-01-2010) Hartmann & Mertens

  2. Financial Times today (28-01-2010) Eurici (28-01-2010) Hartmann & Mertens

  3. Pay-for-performance: Does it pay off ? Some trends in executive compensation Eurici (28-01-2010) Hartmann & Mertens

  4. Seven year period review (2002-2008) • basic salary executive directors rose by 88% on average • (short-term) bonus tripled • value of long-term bonus more than doubled as well Eurici (28-01-2010) Hartmann & Mertens

  5. Executive director’s remunerative package is made up of: • Basic pay • Short-term bonus • Long-term bonus • Pension and other benefits • Severance pay • Other prerequisites. Eurici (28-01-2010) Hartmann & Mertens

  6. concerning remuneration, we observe a significant discrepancy between the Chief Executive Officer and his (her) fellow executive directors, which appears to remain stable over the period examined (2002-2008): • The average base salary of fellow executives is 75% of the CEO’s base pay • for the average bonus this is 60% Trends in executive compensation Eurici (28-01-2010) Hartmann & Mertens

  7. companies increasingly pay out (annual) bonuses in excess of the (pre-agreed) target bonus rates two thirds of CEOs received payments in excess of the target bonus companies are increasingly awarding bonuses beyond the actual maximum the annual report lacks (proper) explanation or substantiation of why such excessive bonus payments should be warranted makes this a remarkable trend arrival of new CEOs tends to trigger greater pay rises and bonus increases (mainly large caps) Trends in executive compensation Eurici (28-01-2010) Hartmann & Mertens

  8. Relationship pay for performance • is there a (positive) relationship? • it is a company’s market capitalization that is a particularly prominent factor where the level of remuneration is concerned • Bonus: On the short run there is a positive relationship between remuneration and corporate performance (both in equity and accounting returns) • LTIP: on the long run there is no positive relationship, but we find an inverse relationship! • Dutch-listed companies have so far made little use of relative performance assessment, so that so-called windfall profits cannot be ruled out Eurici (28-01-2010) Hartmann & Mertens

  9. Number of Companies with RTSR 2005-2007 Eurici (28-01-2010) Hartmann & Mertens

  10. From this I conclude that executive management remuneration can be scrutinized for it’s lack of: • Transparancy • Fairness (both internal and external) • Effectiveness Eurici (28-01-2010) Hartmann & Mertens

  11. Shareholder voting on executive compensation in The Netherlands Source: Rematch, 2007 Eurici (28-01-2010) Hartmann & Mertens

  12. Employee incentives Source: The Economist Eurici (28-01-2010) Hartmann & Mertens

  13. Problems with employee incentives Eurici (28-01-2010) Hartmann & Mertens

  14. Problems with employee incentives Eurici (28-01-2010) Hartmann & Mertens

  15. Problems with employee incentives • “At Enron, failure – even of the type that ends up on the front page of The Wall Street Journal – doesn’t necessarily sink a career” • “If we’ve broken a paradigm, it’s the compensation paradigm. We pay people like entrepreneurs. A lot of companies talk about intrapreneurship and ask people to take risks, but if those people succeed they get nothing more than an small bonus and if they fail they get fired.” Eurici (28-01-2010) Hartmann & Mertens

  16. Problems with employee incentives Eurici (28-01-2010) Hartmann & Mertens

  17. Summary of problems with employee incentives • Pay for failure • Executives are being overpaid • Managers are being rewarded to destroy value : short term orientation • Directors are more attuned to the interest of the CEO than to the interest of the shareholders • Pay consultants are hired by the directors and have no incentive to drastically reshape incentive contracts Eurici (28-01-2010) Hartmann & Mertens

  18. How to improve current practices: solutions brought forward in the current debate • Should equity arrangements focus executives’ attention more on the long term? • Should performance criteria include non-financial targets? • Should compensation be designed to reduce executives’ ability to use inside information to time equity transactions as well as to manipulate the stock price around these transactions? • So-called “hands-off arrangements” Eurici (28-01-2010) Hartmann & Mertens

  19. Solutions Eurici (28-01-2010) Hartmann & Mertens

  20. Solutions • Specific recommendation • Variable pay should somehow be spread over time and be contingent upon future performance • Why? • We should prevent managers to take actions that are profitable in the short run, but that have a high chance of causing losses in the long run • So, the central incentive question for us to answer is: • What metrics and incentives will motivate managers to take into account the longer-term consequences of their decisions? Eurici (28-01-2010) Hartmann & Mertens

  21. Solutions • Longer term rewards • Extend the evaluation period for managerial performance evaluation • Advantages • Cognitive: managers will think more about the future consequences of current decisions • Motivational: managers will become more prudent to avoid future loss of bonus (ex ante) • Fairness: managers do not receive rewards when their decisions appear to have been faulty (ex post) • Disadvantages • Cognitive: managers will face complex decision contexts • Motivational: managers will change their effort to projects with short duration (ex ante) • Fairness: managers will not receive rewards with bad outcomes even if their decisions were right (ex post) • Bonus clawbacks/bonus deferrals • Advantages • Less opportunistic behavior (reduction of incentive effect) • Disadvantages • Lower effort levels (reduction of incentive effect) • More risk taking Eurici (28-01-2010) Hartmann & Mertens

  22. Discussion • Is it possible to develop independent remuneration policies in a competitive market (for managers). • How to address the trade-off between functional and dysfuntional effects of bonuses? • Is regulation the solution to the current crises? • What is the role for team incentives? Eurici (28-01-2010) Hartmann & Mertens

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