Do CEO Bonus Plans Serve a Purpose?

Wayne R. Guay is Professor of Accounting and John D. Kepler is a doctoral candidate at The Wharton School of the University of Pennsylvania. This post is based on a recent paper by Professor Guay, Mr. Kepler, and David Tsui, Assistant Professor of Accounting at the University of Southern California’s Marshall School of Business. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).

In our paper, Do CEO Bonus Plans Serve a Purpose?, we examine the financial incentives provided by executive bonuses and the role of bonus plans in managers’ compensation packages. The vast majority of U.S. executive compensation plans incorporate bonus payouts, and boards devote considerable time and expense to designing these often complex plans. However, prior academic studies present very different views regarding the importance of bonuses in CEOs’ overall incentive schemes. Although early literature argued that annual bonus plans influence CEOs’ investment, financing, and financial reporting decisions, more recent literature estimates the monetary incentives from bonuses and concludes that bonus-based incentives are approximately 50 to 100 times smaller than equity-based incentives and therefore largely irrelevant. This latter view, if correct, raises the question as to why bonus compensation is so pervasive at the CEO level and why boards devote so much time and energy to designing these plans.

We shed light on this issue by examining detailed data from public disclosures of executive bonus plans between 2006 and 2014 for the 750 largest public firms in the U.S. We find that the actual performance sensitivity of bonuses is considerably larger than estimates in prior studies, and is comparable in scale to equity incentives for many CEOs early in their tenures. The typical CEO in our sample receives about $300,000 to $450,000 in bonus for a 10 percent increase in shareholder value, which is about one-sixth to one-tenth of the corresponding equity portfolio sensitivity (about $3 million). For CEOs early in their tenures, who tend to have smaller equity portfolios, the gap between cash- and equity-based incentives is considerably narrower—annual cash-based incentives are about one-third to one-quarter of total equity portfolio incentives among these executives.

Our findings suggest that boards design incentive compensation contracts at the start of the CEO’s tenure with a relatively balanced mix of cash- and equity-based incentives. Over time, however, equity holdings tend to accumulate because CEOs’ annual equity grants typically exceed their stock sales. In contrast, boards do not appear to substantially adjust bonus plan incentives over time in response to CEOs’ growing equity holdings. Thus, for longer-tenured CEOs, equity portfolios come to dominate overall incentives.

We conjecture several reasons why boards may continue to provide CEOs with cash-based bonus plans even after the incentive effects become relatively minor. One possibility is that the annual cash-based payouts can provide executives with cash flow to fulfill their consumption demands. Although annual salary can also fulfill this role, U.S. tax laws discourage non-performance-based cash payments to executives in excess of $1 million. Thus, cash-based bonuses that are somewhat weakly tied to performance may serve to fulfill CEOs’ liquidity demands while avoiding the firm-level tax penalty that would be incurred for providing similar levels of non-performance-based cash salary.

Boards likely also face pressure from various constituencies to conform compensation plans to certain norms. For example, compensation consultants and proxy advisory firms such as Institutional Shareholder Services (ISS) and Glass Lewis tend to focus heavily on CEOs’ annual pay when evaluating the incentives inherent in executive compensation plans, especially in relation to other CEOs in their peer group. Surprisingly, and in sharp contrast to the incentive-contracting literature in economics, these advisors largely ignore equity holdings when assessing whether a given CEO has strong pay-for-performance incentives. There is evidence that boards modify compensation plans to satisfy the preferences of proxy advisory firms, and therefore bonus plan design may reflect this focus on annual pay over portfolio incentives.

Finally, because most executive compensation plans cover many participants, boards and CEOs may feel that it is important for leadership purposes and executive morale to hold the CEO accountable for the same bonus plan payouts that are borne by other senior executives. Lower-level executives typically receive a greater proportion of their annual pay in the form of bonus payouts and have smaller accumulated equity portfolios, suggesting that bonuses are likely to represent a more important component of these executives’ incentives.

We find evidence consistent with several of these possible explanations. First, consistent with bonuses providing a source of liquidity, we find that that CEOs with stronger preferences for liquidity receive more of their incentive pay in the form of bonus (as opposed to equity). Second, consistent with external influences on bonus plan design, we find that cash-based incentives are significantly positively related to bonus incentives for peer firm CEOs. However, we do not find evidence that boards directly adjust bonus plans in response to other forms of external pressure, such as “say on pay” votes, proxy advisor voting recommendations, or greater shareholder monitoring. Finally, as an indication that boards design executive bonus plans to create incentives for the firm’s top management team as a whole rather than each executive individually, we find that boards tend to provide very similar bonus plans across all of the firm’s top executives. For example, the CEO and the fifth-highest-paid executive share an identical set of performance targets at approximately 75 percent of firms in our sample. We also find that although boards often adjust bonus plans following CEO turnover, these changes are typically implemented across the entire top management team rather than solely for the CEO.

Collectively, our results help reconcile the perceived importance and widespread use of executive bonus plans with conclusions from prior literature that CEOs’ financial incentives arise almost exclusively from their equity portfolios. We document that the performance sensitivity of CEO cash compensation is much greater than estimates in prior studies, and that bonuses provide a significant portion of many CEOs’ total financial incentives early in their tenure. However, our results also suggest that the evolution of equity portfolio incentives over the CEO’s tenure has little effect on the design of the cash bonus plan. Rather, our results point toward cash-based bonuses providing the CEO with liquidity and the top management team as a whole with important performance-based incentives.

The complete paper is available for download here.

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