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.
