Goals and Firm Performance
For the past decade, it has been common practice among the largest U.S. public firms to link CEO compensation to specific performance targets. Pay for performance plans—part of the trend toward greater corporate transparency—are designed to incentivize CEOs to “do the right thing,” increase firm value, and maximize shareholder value. But in practice, new research finds, there is a dark side to the pay for performance approach.
“In our research, we uncovered an unintended consequence of pay for performance plans: by identifying specific performance targets, firms inadvertently give CEOS incentives to manage their reported performance so they hit their targets,” explains Radhakrishnan Gopalan, associate professor of finance at Olin.
This ability of CEOs to manage their reported performance leads to what the researchers call the "dark side" of executive incentive contracts. It can happen in two ways: CEOs who realize that they are going to fall short of their performance targets may take actions to hit or surpass their targets; and CEOs who suspect that they will exceed their targets by a wide margin may underreport their performance to prevent inflation of their performance targets in the future. In either case, a CEO's actions can have unintended negative consequences for the firm.
“There's no evidence of fraud in our findings," explains Todd Milbourn, professor of finance. "What we refer to as the 'dark side' of performance-driven compensation is really a focus on the unintended consequences that happen when you're trying to meet a particular goal.” Milbourn says that steps to meet performance goals typically involve cutting spending on R&D or advertising to boost short- term profits. Such trade-offs can negatively affect broader firm goals and shareholder value over the long term.
“Our paper is not meant to point fingers and say, ‘Here’s what you’ve done wrong.’ It’s to say, Here are some places where pay-for-performance plans are clearly working, executives are responding to these kinds of things. But we also want to signal where there are potential problems and where the next refinement in the design of CEO compensation could be.” — Todd Milbourn
Until this study, obtaining reliable data on compensation packages linked to specific performance targets was difficult because the Securities and Exchange Commission (SEC) does not require firms to report this information separately from company proxy statements. Using the latest technology to sift through all the fine print and footnotes in company filings, the researchers identified specific performance targets that they could compare with actual performance as reported by Compustat. Information on cash, stock, and option grants awarded to the top five highest-paid executives for the 750 largest firms by market capitalization over the period 1998-2012 was also part of the massive database that the professors compiled for analysis.
For board compensation committees and talent acquisition departments:
- Make sure that performance goals set in compensation plans are really the measure your firm wants to maximize.
- Beware of the unintended consequences that may result from executive behavior and that may compromise the firm, such as cutting expenses in R&D.
- Don’t focus on singular measures in performance contracts. There is less potential for gamesmanship when multiple performance measures must be met before a company pays its executives a related bonus.
Innovative data collection is just one of the unique aspects of this research. The professors also applied advanced statistical techniques to test the data – a first in this field of financial research. This allowed them to compare the number of firms that narrowly failed to meet their earnings-per-share (EPS) targets to the number that met their EPS targets by a very small number — often by only a penny above the EPS goal.
Gopalan says in such a large sample, the companies' results should be randomly distributed on either side of their EPS targets. Instead, they found that the group of firms that just beat their EPS target was disproportionately large compared to the group that just failed to meet their targets. The results raised a red flag—and after more analysis, Gopalan said the evidence was clear. "The reason why a large number of firms beat the target by as little as a penny is that their CEOs were actively managing their reported performance."
“If pay-for-performance were more linear, not linked to specific targets at regular intervals, firms would achieve the necessary level of transparency while avoiding the obsession with one particular number and all the consequences of the dark side associated with reaching that number.” — Radha Gopalan
Although Gopalan and his co-researchers concede that such manipulation is not illegal, they are concerned about the consequences it sets in motion. "To what extent does this pay feature result in management taking actions that may not be in the best interest of long-term shareholder value?"
The finance researchers offer a remedy to what they see as a flaw in compensation packages tied to specific performance targets. Dr. Gopalan:
"Our paper offers a prescription as to what not to do and hence what to do when designing CEO compensation plans. Focusing on specific performance metrics alone is not a bad thing, but when you link pay to those performance metrics, it is important to use a more continuous, linear relationship that does not focus on specific, short-term targets that you want the CEO to achieve. Linking pay to those targets comes with a negative dark side that you can avoid. Incentivize the CEO to focus on the metrics that you [the board of directors and shareholders] care about, with bonuses tied to multiple performance measures."
Photo credit: Justin Ladia, Heartland Archery,Winnipe; Flickr Creative Commons
“Compensation Goals and Firm Performance”
Radhakrishnan Gopalan, Associate Professor of Finance, Olin Business School, Washington University in St. Louis
Todd Milbourn, Hubert C. & Dorothy R. Moog Professor of Finance, Olin Business School, Washington University in St. Louis
Co-authors: Benjamin Bennett, Assistant Professor, Air Force Institute of Technology; Carr Bettis, Research Professor of Finance, W.P. Carey School of Business, Arizona State University
Under review, The Journal of Financial Economics