The real issue with CEO pay

Do bonuses pay off?

Executive bonuses have never been more popular – but many experts doubt they have significantly elevated performance.

By Jason Murphy

In its latest study of Australian CEO pay packets, the Australian Council of Superannuation Investors (ACSI) found that 2015 was a tough year for the typical chief executive of a top 100 Australian company. Average fixed pay dropped 3.3 per cent to A$1.86 million and remained lower than before the global financial crisis.

However, ACSI also found something it didn’t expect: a rise in the prevalence of executive bonuses. Some 93 per cent of the ASX top 100 paid their CEO a bonus – more than at any time since 2008. ACSI also calculated for the first time just how much of their possible bonuses the ASX top 100 CEOs actually received.

The answer: the median bonus was 76 per cent of the maximum.

For ACSI CEO Louise Davidson, that suggests bonus hurdles are not being properly set. Releasing the figures in August 2016, she posed the question: “Are bonuses really just fixed pay dressed up as at-risk pay?”

Davidson is not the only one asking that question. Around the world, the issues of whether executive bonuses help drive firm performance and how best to structure them are being debated as hotly as ever. While many Australian firms may have tightened the purse strings, the 2016 CEO Pay Trends report from Equilar shows this is not the case in the US and the High Pay Centre’s latest survey of FTSE100 CEOs in the UK reveals their pay packets are similarly continuing to rise.

Bonuses minus performance

Proxy advisers, who help direct shareholders in voting on executive remuneration, continue to see practices they believe have little to do with shareholder value. Bonuses are high among them.

“Bonuses are being paid when clear financial performance isn’t there,” says Vas Kolesnikoff, head of Australia and New Zealand research at proxy adviser Institutional Shareholder Services (ISS).

“Companies are setting performance targets that are a bit loose or not overly rigorous.”

A 2016 analysis of executive bonuses in Australia by professional services firm EY appears to support Kolesnikoff’s claim. In high-performing firms, executives received 68 per cent of the maximum short-term incentive, but low-performing firms awarded barely less – 57 per cent of the maximum. A similar pattern can be observed around the world, EY reports.

In theory, bonuses for meeting performance indicators can efficiently drive performance, says KPMG Australian national leader on executive remuneration Ben Travers. However, boards need to choose appropriate indicators and set the right conditions.

“It shouldn’t be a gimme,” he says.

“I will not work any harder or any less hard in any year, in any day because someone is going to pay me more or less.” John Cryan, Deutsche Bank

Travers is concerned that many executive incentives use hurdles that are too similar to each other, instead  of being linked to each organisation’s unique strategy. KPMG has found that 68 per cent of top Australian companies use a three-year performance period, and 65 per cent of companies use only two hurdles for allocating long-term incentives. That suggests bonuses are being designed simply to meet compliance laws or match the market remuneration rate.

“If you are telling the market you are doing something, then your remuneration strategy should be tied to paying for [that],” says Travers.

“If you are a fast-growing company that is out there trying to get new customers or revenue … it could be tied to that.”

University of Sydney researcher Dr Kym Sheehan shares a similar view, saying executive remuneration is all about the art of measurement.

“What gets measured gets done,” she says. Yet bonuses based on underlying measures of financial performance can be problematic, Sheehan argues, if the costs of executing the strategy – such as redundancies and writedowns – are removed from financial measures in order to award bonuses.

Pushing the right incentive button

Bonuses and other performance-based pay elements have been expanding ever since the 1990s, when analysts began to argue that senior executives were getting more money for little risk. Now, some 25 years later, the questions being asked are whether companies can ever define performance rigorously enough to make bonuses relevant, and whether executives actually respond to them. Some management thinkers have decided the answer to these questions is “no”.

University of Queensland executive remuneration expert Julie Walker, for instance, says that while a performance-based reward system may make routine work more productive, it doesn’t enhance problem-solving. Executives involved in solving problems put more importance on intrinsic reward, the personal satisfaction of doing a job well.

“They are not laying bricks,” says Walker. “They’re changing things; they’re making a difference.”

“Bonuses are largely ineffective in influencing the right behaviours.” Craig Newman, Woodford Investment Management

Two professors at the London Business School, Dan Cable and Freek Vermeulen, made a similar argument in a February 2016 article on the Harvard Business Review website. They pointed to work by researchers such as Duke University professor Dan Ariely and his colleagues that suggests the standard of creative problem-solving actually deteriorates if pegged to a performance-based incentive system.

The two researchers further cited the case of Deutsche Bank CEO John Cryan, who told Bloomberg in 2015 that he had “no idea” why his contract included a bonus. Said Cryan: “I promise you I will not work any harder or any less hard in any year, in any day because someone is going to pay me more or less.”

Other organisational leaders have come to similar conclusions. In August 2016, UK-based Woodford Investment Management announced it was scrapping staff bonuses entirely.

“Drawing on our experience of various bonus-led remuneration models, we concluded that bonuses are largely ineffective in influencing the right behaviours,” said Woodford CEO Craig Newman.  

If that’s the case, the challenge for business is not only recalibrating performance goals, but also finding new ways to motivate those tasked with hitting the targets.

Professional Development: Reviewing and rewarding performance: Learn to rate employee performance objectively by applying a five-category rating scale.

Executive pay under the microscope

Political pressure on executive pay and bonuses has been mounting in several countries:

  • In the UK, prime minister Theresa May has pledged to reform executive pay law by granting more power to shareholders. “I will make shareholder votes on corporate pay not just advisory but binding,” she said in July 2016.
  • In Germany, there was controversy in April 2016 over payment of bonuses to former Volkswagen chief executive Martin Winterkorn after the company admitted to cheating on emissions tests and Winterkorn stood down. One VW investor told the Financial Times that the car maker should have withheld bonus payments until the investigation of the scandal was complete.
  • In the US, the Dodd-Frank Act gives shareholders an “advisory vote” on executive compensation and severance packages. In the pipeline is a new rule to force US public companies to report the ratio of CEO pay to the pay of the median employee. A further proposed rule would prohibit incentives that encourage “inappropriate risks” in certain financial institutions; the wording suggests risk may be encouraged “by providing excessive compensation, fees or benefits”. The election of Donald Trump as US president has raised doubts over existing and proposed US laws. While his transition team pledged to “dismantle” the Dodd-Frank Act, Trump has been reported as calling high CEO salaries a “joke” and a “disgrace”.

Read next: Should businesses just get rid of performance reviews?

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February 2017
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