Our research and consulting experience leads us to conclude that almost all CEO and executive bonus plans are deeply flawed and contribute to highly counterproductive incentives and actions that end up reducing the long-run value of most companies.
Ultimately, however, the advantages of bonus-based reward plans are only going to be as good and as effective as the designers of those plans make them. While bonus plans can be structured to provide incentives focused on specific operational objectives that will lead to value creation, poorly designed plans can provide strong incentives to destroy rather than create value. For example, annual bonus plans can destroy value by providing incentives to withhold effort, shift earnings and cash flow unproductively from one period to another, and to manipulate earnings counterproductively in other ways. Bonus plans also often create incentives for the organization to destroy information critical to the effective coordination of disparate parts of large complex firms. More importantly, bonus plans too often reward participants for misrepresenting—or “lying about”—the profit potential of their business units. All of these diminish the opportunity for performance in an organization, thereby leading to the destruction of firm value.
In this paper, we describe many of the problems associated with traditional executive bonus plans and offer our suggestions for how these plans can be vastly improved. We proceed as follows. In the section “How Executive Bonus Plans Cause Problems: Overview,” we describe typical bonus plans and provide an overview of the potential problems. In the next three sections, we then discuss problems (and solutions) associated with “Using the Wrong Pay-Performance Relations,” “Using the Wrong Targets, Benchmarks, or Standards,” and “Using the Wrong Performance Measures.” In the section “Failure to Make Ex Post Adjustments to Performance Measures and Compensation,” we discuss ex post adjustments to bonuses (including subjective assessments and claw backs). In the section “Bankers' Bonuses and the Financial Crisis,” we discuss the role of banking bonuses and the 2007-2008 financial crisis. The Conclusion section summarizes our recommendations.
Figure 1 illustrates these basic components of a “typical” annual bonus plan. Under the typical plan, no bonus is paid until a lower performance threshold or hurdle is achieved, and a “hurdle bonus” is paid at this lower performance threshold. The bonus is usually capped at an upper performance threshold; after this point increased performance is not associated with an increase in the bonus. The thresholds are routinely determined by the firm's annual budgeting process. The range between the lower and upper-performance thresholds (labeled the “incentive zone” in the figure), is drawn as linear but could be convex (bowl-shaped) or concave (upside-down bowl-shaped). The “pay-performance relation” (denoted by the heavy line) is the func
{"title":"CEO bonus plans—And how to fix them","authors":"Kevin J. Murphy, Michael C. Jensen","doi":"10.1111/jacf.12629","DOIUrl":"https://doi.org/10.1111/jacf.12629","url":null,"abstract":"<p>Our research and consulting experience leads us to conclude that almost all CEO and executive bonus plans are deeply flawed and contribute to highly counterproductive incentives and actions that end up reducing the long-run value of most companies.</p><p>Ultimately, however, the advantages of bonus-based reward plans are only going to be as good and as effective as the designers of those plans make them. While bonus plans can be structured to provide incentives focused on specific operational objectives that will lead to value creation, poorly designed plans can provide strong incentives to destroy rather than create value. For example, annual bonus plans can destroy value by providing incentives to withhold effort, shift earnings and cash flow unproductively from one period to another, and to manipulate earnings counterproductively in other ways. Bonus plans also often create incentives for the organization to destroy information critical to the effective coordination of disparate parts of large complex firms. More importantly, bonus plans too often reward participants for misrepresenting—or “lying about”—the profit potential of their business units. All of these diminish the opportunity for performance in an organization, thereby leading to the destruction of firm value.</p><p>In this paper, we describe many of the problems associated with traditional executive bonus plans and offer our suggestions for how these plans can be vastly improved. We proceed as follows. In the section “How Executive Bonus Plans Cause Problems: Overview,” we describe typical bonus plans and provide an overview of the potential problems. In the next three sections, we then discuss problems (and solutions) associated with “Using the Wrong Pay-Performance Relations,” “Using the Wrong Targets, Benchmarks, or Standards,” and “Using the Wrong Performance Measures.” In the section “Failure to Make Ex Post Adjustments to Performance Measures and Compensation,” we discuss ex post adjustments to bonuses (including subjective assessments and claw backs). In the section “Bankers' Bonuses and the Financial Crisis,” we discuss the role of banking bonuses and the 2007-2008 financial crisis. The Conclusion section summarizes our recommendations.</p><p>Figure 1 illustrates these basic components of a “typical” annual bonus plan. Under the typical plan, no bonus is paid until a lower performance threshold or hurdle is achieved, and a “hurdle bonus” is paid at this lower performance threshold. The bonus is usually capped at an upper performance threshold; after this point increased performance is not associated with an increase in the bonus. The thresholds are routinely determined by the firm's annual budgeting process. The range between the lower and upper-performance thresholds (labeled the “incentive zone” in the figure), is drawn as linear but could be convex (bowl-shaped) or concave (upside-down bowl-shaped). The “pay-performance relation” (denoted by the heavy line) is the func","PeriodicalId":46789,"journal":{"name":"Journal of Applied Corporate Finance","volume":"36 3","pages":"95-110"},"PeriodicalIF":0.7,"publicationDate":"2024-11-21","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"https://onlinelibrary.wiley.com/doi/epdf/10.1111/jacf.12629","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"142707869","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"OA","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
{"title":"CEO incentives—It's not how much you pay, but how","authors":"Michael C. Jensen, Kevin J. Murphy","doi":"10.1111/jacf.12621","DOIUrl":"https://doi.org/10.1111/jacf.12621","url":null,"abstract":"","PeriodicalId":46789,"journal":{"name":"Journal of Applied Corporate Finance","volume":"36 3","pages":"80-91"},"PeriodicalIF":0.7,"publicationDate":"2024-11-09","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"142707568","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
{"title":"Just say no to Wall Street: Putting a stop to the earnings Game","authors":"Joseph Fuller, Michael C. Jensen","doi":"10.1111/jacf.12622","DOIUrl":"https://doi.org/10.1111/jacf.12622","url":null,"abstract":"","PeriodicalId":46789,"journal":{"name":"Journal of Applied Corporate Finance","volume":"36 3","pages":"75-79"},"PeriodicalIF":0.7,"publicationDate":"2024-11-06","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"142707534","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
{"title":"Value maximization, stakeholder theory, and the corporate objective function","authors":"Michael C. Jensen","doi":"10.1111/jacf.12627","DOIUrl":"https://doi.org/10.1111/jacf.12627","url":null,"abstract":"","PeriodicalId":46789,"journal":{"name":"Journal of Applied Corporate Finance","volume":"36 3","pages":"41-51"},"PeriodicalIF":0.7,"publicationDate":"2024-10-17","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"142707700","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
{"title":"Active investors, LBOs, and the privatization of bankruptcy","authors":"Michael Jensen","doi":"10.1111/jacf.12623","DOIUrl":"https://doi.org/10.1111/jacf.12623","url":null,"abstract":"","PeriodicalId":46789,"journal":{"name":"Journal of Applied Corporate Finance","volume":"36 3","pages":"67-74"},"PeriodicalIF":0.7,"publicationDate":"2024-10-17","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"142707488","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
{"title":"The modern industrial revolution, exit, and the failure of internal control systems","authors":"Michael Jensen","doi":"10.1111/jacf.12624","DOIUrl":"https://doi.org/10.1111/jacf.12624","url":null,"abstract":"","PeriodicalId":46789,"journal":{"name":"Journal of Applied Corporate Finance","volume":"36 3","pages":"52-66"},"PeriodicalIF":0.7,"publicationDate":"2024-10-17","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"142707487","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
<p>When I joined the University of Rochester's Graduate School of Management (now the Simon School) as a newly minted assistant professor in January 1984, my thesis advisors from the Chicago Economics Department warned me to be wary of Michael Jensen, the most prominent and influential faculty member at the school. Their well-intended warnings proved unnecessary: in short order, Mike became my mentor, co-author, colleague, and life-long (if not always uncomplicated) friend.</p><p>By the early 1980s, Mike and Bill Meckling's 1976 paper “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure” was already generally recognized as establishing the leading paradigm for empirical corporate finance. Largely missing from the Jensen-Meckling treatise, however, was the role that executive incentive contracts play, or could play, in limiting the cost of agency conflicts between managers and shareholders. Mike became highly intrigued by executive compensation and, along with colleague Jerry Zimmerman (co-founding editor of the <i>Journal of Accounting and Economics</i>), organized the “Conference on Management Compensation and the Managerial Labor Market” in April 1984, whose proceedings were published as a special issue of the <i>JAE</i> in 1985. The conference—and the Jensen-Meckling paradigm—helped launch executive compensation as a legitimate topic of academic research in accounting, finance, and economics.</p><p>My personal contribution to the April 1984 conference was using time-series data with executive fixed effects to uncover a statistically positive pay-performance <i>elasticity—</i>which I measured as the percentage change in compensation associated with a percentage change in the value of the firm. While acknowledging the statistical significance, Mike kept pushing on the question of the <i>economic significance</i> of my finding: was the estimated elasticity really large enough to provide meaningful incentives? We developed a construct we called the <i>pay-performance sensitivity</i> that measured the “effective ownership share” akin to the manager's ownership share in Jensen-Meckling, but included all the sources of incentives we could find useful data about (including stock and option holdings, bonuses, and year-to-year salary adjustments, as well as the probability of performance-related terminations). In our 1990 <i>Journal of Political Economy</i> article, we concluded that the wealth of a typical CEO changes by only $3.25 for every $1000 change in shareholder wealth, hardly enough to get CEOs to take projects that increase shareholder wealth and avoid projects that decrease shareholder wealth.1</p><p>Mike and I considered as many explanations as we could find or think of for what we believed were unexpectedly low observed pay-performance sensitivities, including risk aversion, limits to credible contracting, imperfect performance measurement, and CEO production functions. We concluded that the most plausible explanat
{"title":"Mike Jensen on CEO pay","authors":"Kevin J. Murphy","doi":"10.1111/jacf.12625","DOIUrl":"https://doi.org/10.1111/jacf.12625","url":null,"abstract":"<p>When I joined the University of Rochester's Graduate School of Management (now the Simon School) as a newly minted assistant professor in January 1984, my thesis advisors from the Chicago Economics Department warned me to be wary of Michael Jensen, the most prominent and influential faculty member at the school. Their well-intended warnings proved unnecessary: in short order, Mike became my mentor, co-author, colleague, and life-long (if not always uncomplicated) friend.</p><p>By the early 1980s, Mike and Bill Meckling's 1976 paper “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure” was already generally recognized as establishing the leading paradigm for empirical corporate finance. Largely missing from the Jensen-Meckling treatise, however, was the role that executive incentive contracts play, or could play, in limiting the cost of agency conflicts between managers and shareholders. Mike became highly intrigued by executive compensation and, along with colleague Jerry Zimmerman (co-founding editor of the <i>Journal of Accounting and Economics</i>), organized the “Conference on Management Compensation and the Managerial Labor Market” in April 1984, whose proceedings were published as a special issue of the <i>JAE</i> in 1985. The conference—and the Jensen-Meckling paradigm—helped launch executive compensation as a legitimate topic of academic research in accounting, finance, and economics.</p><p>My personal contribution to the April 1984 conference was using time-series data with executive fixed effects to uncover a statistically positive pay-performance <i>elasticity—</i>which I measured as the percentage change in compensation associated with a percentage change in the value of the firm. While acknowledging the statistical significance, Mike kept pushing on the question of the <i>economic significance</i> of my finding: was the estimated elasticity really large enough to provide meaningful incentives? We developed a construct we called the <i>pay-performance sensitivity</i> that measured the “effective ownership share” akin to the manager's ownership share in Jensen-Meckling, but included all the sources of incentives we could find useful data about (including stock and option holdings, bonuses, and year-to-year salary adjustments, as well as the probability of performance-related terminations). In our 1990 <i>Journal of Political Economy</i> article, we concluded that the wealth of a typical CEO changes by only $3.25 for every $1000 change in shareholder wealth, hardly enough to get CEOs to take projects that increase shareholder wealth and avoid projects that decrease shareholder wealth.1</p><p>Mike and I considered as many explanations as we could find or think of for what we believed were unexpectedly low observed pay-performance sensitivities, including risk aversion, limits to credible contracting, imperfect performance measurement, and CEO production functions. We concluded that the most plausible explanat","PeriodicalId":46789,"journal":{"name":"Journal of Applied Corporate Finance","volume":"36 3","pages":"92-94"},"PeriodicalIF":0.7,"publicationDate":"2024-10-09","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"https://onlinelibrary.wiley.com/doi/epdf/10.1111/jacf.12625","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"142707472","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"OA","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
{"title":"Two CEO pay challenges that Mike Jensen has left us to keep working on","authors":"Stephen F. O'Byrne","doi":"10.1111/jacf.12626","DOIUrl":"https://doi.org/10.1111/jacf.12626","url":null,"abstract":"","PeriodicalId":46789,"journal":{"name":"Journal of Applied Corporate Finance","volume":"36 3","pages":"111-116"},"PeriodicalIF":0.7,"publicationDate":"2024-10-08","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"142707467","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
{"title":"Misreading Michael Jensen: The case of Nicholas Lemann's Transaction Man: The Rise of The Deal and The Decline of The American Dream","authors":"Don Chew","doi":"10.1111/jacf.12618","DOIUrl":"https://doi.org/10.1111/jacf.12618","url":null,"abstract":"","PeriodicalId":46789,"journal":{"name":"Journal of Applied Corporate Finance","volume":"36 3","pages":"16-24"},"PeriodicalIF":0.7,"publicationDate":"2024-09-26","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"142707971","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
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