When it comes time to talk about executive pay, “performance” becomes every company’s favorite word.
It shows up 614 times in Express Scripts Holding’s proxy statement, the document that discloses how much the top brass earns, and 339 times in Monsanto’s. The message at those firms and others is simple and direct: The boss makes money only if the company does well.
Most companies back up that talk by adopting a target for profits. If the firm meets or beats the target, the chief executive gets a bigger bonus. If it falls short, he or she gets less — and maybe nothing.
People are also reading…
It all sounds remarkably shareholder-friendly, and the performance-based system is regularly offered as a defense against critics who say executives are overpaid.
A new research paper co-authored by two Washington University professors, however, finds some problems with performance-based pay. “The dark side is that executives will try to hit the target by hook or by crook,” says Radhakrishnan Gopalan, associate professor of finance at Washington University’s Olin Business School.
Gopalan did the research with Washington U. colleague Todd Milbourn, Benjamin Bennett of the Air Force Institute of Technology and Carr Bettis of Arizona State University.
After sifting through 15 years of pay data from 750 large companies, the researchers discovered that a lot of firms either hit the profit target exactly or beat it by a penny per share. Very few firms fell a penny short.
That looked like evidence of manipulation. If the results were random, the number of outcomes just above target and slightly below should have been roughly equal. When the authors dug deeper, they found that the firms that just beat their targets were more likely to have cut research spending, cut overhead expenses and used abnormal accruals to boost revenue.
In other words, the executives relied on short-term fixes to make sure they got their bonuses. Some of those fixes, such as slashing research, could hurt the company in the long run.
“You can achieve a target by honorable means, by working really hard, or you can achieve it by cutting corners,” Gopalan says.
When a firm has a strong year, the manipulation can go in the opposite direction. Often, this year’s results become a baseline for next year’s bonus plan. To keep next year’s target low and achievable, the CEO may reach into the accounting bag of tricks and look for expenses to charge against this year’s books.
Gopalan and Milbourn emphasize that they don’t want to abolish performance-based pay. A purely discretionary system would be a step backward.
They do suggest several ways of improving pay practices. One is to get rid of the target. It should be possible to reward executives for each additional dollar of earnings without putting so much emphasis on a single number.
Alternatively, Gopalan says, firms could reduce manipulation by having several targets rather than one. Express Scripts uses earnings per share, cash flow and sales to determine its bonuses.
Or, he adds, they could focus on relative criteria, which measure a company’s performance relative to its peers, rather than absolute ones. The other companies’ numbers should be harder to manipulate.
There’s been plenty of so-called innovation in executive-pay practices, Gopalan points out, not all of it good. If companies mean what they say about paying for performance, they need to take a hard look at this research into what they’re doing wrong.