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Top 8 ways to ruin pay

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Presentation från Kevin J. Murphy 26 september 2012.

Presentation från Kevin J. Murphy 26 september 2012.

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Top 8 ways to ruin pay Presentation Transcript

  • 1. The Top 8 Ways to Ruin Incentive Compensation Kevin J. Murphy September 26, 2012 It’s in the Details 1 The Top 8 Ways to Ruin Incentive Pay 1. Using non-linear pay-performance relations 2. Paying bonuses based on making budget or target 3. Paying bonuses based on year-over-year growth 4. Teaching managers to ignore the cost of capital 5. Failing to K.I.S.S. 6. Too little equity-based compensation 7. Too much equity-based compensation 8. Rewarding short-run increases in stock prices 2 Performance Bonus Performance Measure, X Pay-Performance Relation, w(X-X) Performance Standard, X X Target Bonus The Top 8 Ways to Ruin Incentive Pay 3 Performance Bonus 1. Using Non-Linear Pay-Performance Relations 4
  • 2. Performance Bonus Creating Linear Bonus Plans 5 -$300 -$200 -$100 $0 $100 $200 $300 -$3m -$2m -$1m $0 $1m $2m $3m Bonus($000) Performance ($mil) HOW (IN PRACTICE) TO IMPOSE NEGATIVE BONUSES? Creating Linear Bonus Plans Cumulative Performance Deferred Compensation Bonus Banks 6 $0 $100 $200 $300 $400 $500 $600 -$3m -$2m -$1m $0 $1m $2m $3m Salary+Bonus($000) Performance ($mil) Creating Linear Bonus Plans Is this really a bonus? Suppose current salary is $300K Reduce salary to $100K, and increase bonus opportunity 7 -$300 -$200 -$100 $0 $100 $200 $300 -$3m -$2m -$1m $0 $1m $2m $3m Bonus($000) Performance ($mil) Digression on Risk Taking 8
  • 3. $0 $100 $200 $300 $400 $500 $600 -$3m -$2m -$1m $0 $1m $2m $3m Salary+Bonus($000) Performance ($mil) Is this really a bonus? Suppose current salary is $300K Reduce salary to $100K, and increase bonus opportunity Digression on Risk Taking 9 Typical budget process: Managers submit budgets for targeted output the next year Budget projections reviewed and negotiated with higher levels 8= 784A0A27H A4BD;C8=6 8= M=0; 1D364C C0A64C 5>A 34?0AC<4=C 38E8B8>= 0=3 MA< Bonuses based on performance vs. budgeted performance What’s wrong with this picture? 2. Paying Bonuses Based on Meeting Budget 10 Typical budget process: Managers submit budgets for targeted output the next year Budget projections reviewed and negotiated with higher levels 8= 784A0A27H A4BD;C8=6 8= M=0; 1D364C C0A64C 5>A 34?0AC<4=C 38E8B8>= 0=3 MA< Bonuses based on performance vs. budgeted performance What’s wrong with this picture? “People try to ensure that they never end up below budget by aiming low. Management could stretch it from the top down by not accepting low budgets, but that has other negative long-term repercussions. It creates a climate of distrust. Subordinates (on any level) aim low because they know superiors (on any level) will bargain to raise the target. Superiors bargain to raise goals for the budget because they automatically assume subordinates have aimed low. This begins a group dynamic of mutual !  "! !!  )% #  ! *! !  capabilities of the organization or the real opportunities of the ! !  %  *!  ! !" !   !" ! !$ ! different levels in the organizational hierarchy.” Adizes (1989) 2. Paying Bonuses Based on Meeting Budget 11 Tying bonuses to budgets: Distorts budgeting process, destroys information Pays people to lie: Managers taught to under-promise and over-deliver Creates climate where people at all levels become comfortable in lying to customers, suppliers, investors, regulators, etc. Not just “negotiation”: no one has incentive to tell the truth! How do we solve this problem? 2. Paying Bonuses Based on Meeting Budget 12
  • 4. Performance Bonus Performance Measure, X Pay-Performance Relation, w(X-X) Performance Standard, X X Target Bonus General Theory of Performance Standards 13 XBonuses are based on X- X is the performance measure X is the performance standard Examples: EPS vs. prior-year EPS ROA vs. Peer-Group ROA 0B7 N>F EB >BC >5 0?8C0; Net Income vs. Budgeted Net Income General Theory of Performance Standards 14 Paying based on X- rather than X creates problems when managers can affect X X Distinguish “internal” from “external” standards A modest hypothesis 15 8 #+#<10 8 Insulate execs from common shocks (or luck) 8 Good for cyclical businesses 8 Problems 8 Sabotage 8 Collusion 8 Choice of peer group 8 Works best when peers are “external” 8 Performance vs. industry peers 8 Not performance vs. co-workers Relative Performance 16
  • 5. 8 #+#<10 8 Fair and reasonable 8 Agreement Reached 8 Problems 8 Paying people to lie 8 Sand-bag or over-negotiate 8 Defer good performance 8 Minimize deviations from budget Budget-based bonuses 17 8 #+#<10 8 Fair and reasonable 8 We did it last year 8 Problems 8 This year’s X is next year’s X-bar 8 Defer good performance 8 Positive but small improvements 3. Paying bonuses based on year-over-year growth 18 Three Ways to CreateValue: 1. Invest in projects that earn more than the cost of capital >=DB4B 10B43 >= 022>D=C8=6 ?A>MC 86=>A4 C74 2>BC >5 20?8C0; A4@D8A43 C> ?A>3D24 C70C ?A>MC 4.Teaching Managers to Ignore the Cost of Capital  "=2A40B4 ?A>MCB 5A>< 4G8BC8=6 20?8C0; 2. Divert assets from projects earning less than the cost of capital Isn’t it obvious that capital has a cost? Would CEOs really get this wrong? 19 -  '?4A0C8=6 (A>MCB 0?8C0; 70A64 -  '?4A0C8=6 (A>MCB >BC >5 0?8C0; 0?8C0; -  )4CDA= >= 0?8C0; >BC >5 0?8C0; 0?8C0; 4.Teaching Managers to Ignore the Cost of Capital Alternative performance measure: 2>=><82-0;D4 3343 - 0 : 0 2>=><82 (A>MC EVA recognizes that capital has a cost EVA provides incentives to create value EVA “externalizes” the budget 20
  • 6. 4.Teaching Managers to Ignore the Cost of Capital Advantages of EVA EVA recognizes that capital has a cost EVA provides incentives to create value EVA “externalizes” the budget Disadvantages of EVA (typical HR perspective) EVA provides bad “line of sight” for incentives EVA is too complicated Stern-Stewart recommend up to 164 adjustments to GAAP >=BD;C8=6 MA<B 2><?4C4 >= C748A 50E>A8C4 039DBC<4=CB 21 Bonus = 2%(Net Income - 11% Book Equity) 4.Teaching Managers to Ignore the Cost of Capital A Mickey Mouse Example: Disney’s bonus plan (pre-1998): Uses Net Income instead of “Net Operating Income after Tax) Uses Book Equity instead of Capital (Debt + MarketValue of Equity) Uses 11% instead of the true cost of capital Disney’s plan recognizes that capital has a cost Disney’s plan provides incentives to create value Disney’s plan “externalizes” the budget 22 5. Failing to K.I.S.S. (Keep it Simple, Stupid!) Compare EVA to Mickey Mouse Example TInkering provides incentives to focus on short-run results The Spouse Test Resist urge to “tinker” with plans, even when out of date Executives must believe current actions will be rewarded/punished Bonus = 2%(Net Income - 11% Book Equity) 23 6.Too little equity-based compensation FirmValue ShareholderValue Stock Price What (if anything) makes shareholders special? Short-run vs. long-run measure The Governing Objective vs. Stakeholder Theory Advantages of equity-based compensation Closer to what “owners” want 24
  • 7. 7.Too much equity-based compensation Risk-averse executives place little value on equity Cost vs.Value of Stock Options U.S. Problem:Too many options to too many people Risk-averse executives can have too much wealth in equity Broad-based equity programs: pros and cons 25 Bonus Net Income Problem: Managers smooth earnings at expense of long-run value Solution:Tie pay to shareholder value, =>C C> 022>D=C8=6 ?A>MC 8. Rewarding Short-Term Increases in Stock Prices Old School: Mitigate earnings management through stock-based pay 26 8. Rewarding Short-Term Increases in Stock Prices New School: Equity-based pay may be part of the problem 27 Though no one designed it this way, the “earnings game” creates a non-linear pay-performance relation that creates incentives to: 8manipulate earnings to meet or beat the analysts short-term forecast 8manipulate analysts forecasts 8take actions to meet those forecasts even when those actions destroy ;>=6 AD= MA< E0;D4 8tell the market what the market wants to hear (or what managers want C74< C> 740A A0C74A C70= C4;;8=6 C74 CAD4 BC0CDB >5 C74 MA< 8. Rewarding Short-Term Increases in Stock Prices 28
  • 8. Once executives start lying in the “earnings management” game, it’s hard to stop because the game cascades forward 8Pushing expenses to next period, and pulling revenues from next period, make it harder to meet next period’s target. 8Eventually, the day of reckoning comes in the form of earnings restatement, write-offs, and lawsuits 8. Rewarding Short-Term Increases in Stock Prices 29 (EPSq - Median Forecast EPSq)/Priceq How do you stop it? Solution: Tie pay to long-run shareholder value, not to stock prices? Is this enough? 30 Good News and Bad News on incentive compensation Good News: It works Conclusion You get what you pay forBad News: It works Bottom Line: It can be improved, but it’s in the details 31