The problem with CEO bonuses

…and it's not what you think

a woman

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Recent commentary (most of it criticism) about executive remuneration misses the point. The size of the packages being given to CEOs may be bloated and obscene (or not), but for shareholders that isn't (or shouldn't be) the main game.

Now investing can be scary if you don't know what you're doing and if you take silly risks. Of course, some education and sensible investing can reduce the risk of loss – over the medium and long term – very significantly.

Heads I win, tails you lose

Strangely – or perhaps not when you understand the way the game is played – financial advisors and company executives don't face a similar risk. In analytical parlance the situation is 'asymmetrical' – the risk and return for these professionals isn't even close to balanced… there's very little risk, but a bounty of riches on offer.

The remuneration of brokers and financial advisors is a story for another day.

Company CEOs are another group who don't necessarily have their incentives aligned with their constituency – in this case the best interests of shareholders. Not only are they paid a very sizeable pile of cash as salary, but most are eligible for an amount equal to or significantly above that salary as a bonus, for hitting certain performance benchmarks.

The case against bonuses

There's nothing wrong with bonuses – on the contrary, they can be an effective way to remunerate senior executives. The problem isn't with incentives per se, but with the way we use them.

For starters, research has conclusively shown that extrinsic incentives (i.e. monetary rewards) only produce better results for simple, focussed, tasks. They simply don't work for complex tasks. For a wonderful (and funny) summary that will put this into perspective, check out this excellent talk from Dan Pink.

Arguably, this research could be a sufficient reason to actually remove all monetary bonuses. As you read this, your ideological bent will have you agree from a fairness perspective or disagreeing from a free-market one. But – for our purposes – neither of these viewpoints is useful. As Pink himself says, this is not a question of preferences or philosophy – it is scientific fact.

Be careful what you wish for

Even if we accept that bonuses are necessary, we routinely reward the wrong things.

If you've ever worked in management, you will have heard the cliché that 'what gets measured gets done' – and it is pervasive because it's true.

For company boards (and their shareholders) this should be scary. Not because the goals set by remuneration committees are unachievable – but specifically because they are achievable. If you pay an executive to hit a certain profit target, he or she will do everything in their power to achieve it.

'Worry about next year, next year'

On the surface, this sounds reasonable – even desirable – until you think about the next year and the year after. The problem is that an executive remunerated on this year's result will be incentivised – consciously and subconsciously – to ignore next year until this year is 'in the bag'. If they're not going to be around next year, the incentive to worry is even less.

Now, no CEO will ever deliberately damage a subsequent year's performance just to deliver on the current year's goals – but with performance metrics (and often board pressure) set for the current year, it's a mentally very tough CEO who can avoid being pulled and pushed into an all-pervasive short-termism.

The majority of executive goals are both short-term and financial in nature. This year's profit and sales are among the most prominent. Remunerating a CEO on Total Shareholder Return – share price appreciation plus dividends – is becoming more popular. While it is supposed to align the interests of management and shareholders, it runs the very real risk of creating CEO infatuation with the share price rather than the underlying health of the business.

A real alignment of interests

It's time for a change. It's time to focus on those things that matter to the long-term health of a business. There are very few businesses that can be successful over time without a healthy and positive culture, without investment for the long-term through marketing and innovation and without a 'cause' – a common understanding of how the organisation makes a difference for its customers, community, staff and shareholders.

The problem is that none of these things will make the business more profitable this year. In fact, the opposite is almost guaranteed. Show me a CEO with the guts to miss an annual earnings target because they were investing for the future, and I'll show you a company with a better than average chance of long term success.

It can be done (Nasdaq: AMZN) is one such business. Amazon's share price fell 13% on October 25, 2011 after the company met Wall Street's earnings expectation, but shared plans to spend more in future to support long term growth. The shares fell another 9% in the following couple of months. Investors shouldn't have been surprised. Amazon CEO Jeff Bezos recently told Wired  "If everything you do needs to work on a three-year time horizon, then you're competing against a lot of people. But if you're willing to invest on a seven-year time horizon, you're now competing against a fraction of those people, because very few companies are willing to do that".

Foolish take-away

For all of the recent noise about so-called shareholder 'say on pay', we're all asking the wrong question. The issue isn't 'how much', but 'what for' – what goals are being set, and over what time horizon. It's a quantum shift, but that sort of thinking will drive sustainable change and growth – and real returns for shareholders.

Change will come slowly, but here's a simple first step: If an executive hits his or her goals this year, they should qualify for a bonus. That bonus should then be paid in ten equal instalments, yearly for the next decade, but only in years in which the company meets pre-agreed targets. If that doesn't focus the CEO mind on long-term investment and internal talent development – and on true long-term shareholder returns – nothing will.

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Scott Phillips is a Motley Fool investment analyst. Scott owns shares in You can follow him on Twitter @TMFGilla. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691).

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