Executive compensation generally consists of a base salary, bonuses and other benefits. This article digs into the problems with existing executive bonuses, and suggests a general solution to these problems. In this discussion I will ignore the type of compensation; whether it is cash or stock options or anything else, the basic concepts in the discussion still hold.
##Executive bonus Performance bonuses are intended to motivate executives to reach organizational objectives. In general, organizational objectives are thoroughly formulated, such that great clarity is provided on the expectations of executives. Executives then receive a bonus based on the extent to which they achieve the formulated objectives. The measurement of executives' effectiveness in achieving these goals may be done in a number of ways, ranging from the use of predefined metrics to judgements by the board of directors.
##Performance metrics In case the bonus is appointed according to metrics, it is often clear to the executive what metrics his performance measurement is based on. This can range from share price performance to obtaining a position on the Dow Jones Sustainability Index. At the end of the period the board of directors looks at the predefined metrics, and pays a bonus accordingly. The kind of metrics that are included in the assessment often depends on whether the bonus is part of a long term or short term incentive plan.
###Myopia It has become clear that the use of the majority of the metrics favors short-term profit maximization over long term company performance. This is commonly known, and companies accordingly have taken action to combat myopism by taking into account measures of long run performance. There are numerous ways of disincentivize a focus on short run performance, including the use of clawback provisions. Also, I recognize that the myopism can be somewhat mitigated by compensating executives with company shares instead of stock options or cash.
###Objective orientation My main problem with the use of performance metrics that are formulated and communicated in advance is that executives have the incentive to optimize processes in such a way that they maximize performance along those metrics, ignoring the effects of their decisions on factors that are not covered by the performance metrics. Instead of executives doing what they think would be best for the company, they do what would be best for the metrics they are evaluated on.
###Proposition This problem can easily be solved. In fact, the board of directors has to ensure the executive is unaware of the metrics on which his bonus is based. If the executive can not optimize along predefined metrics, the executive's best guess is to optimize on what would be best for the company overall. What is best for the company should be broadly formulated in the company's business strategy. To ensure that the processes are conducted in full honesty, the board of directors should formulate objectives and their corresponding bonuses, but keep them hidden from the executives. The formulated bonus scheme should be placed with a notary, such that the executive can have full transparancy in hindsight. Each period the board of directors pick a new set of objectives and metrics. The metrics they choose may range from customer survey results to foreign expansion data, or even to stock market performance relative to competitors. I have already explained how this proposition combats the optimization along metrics, thus preventing the neglection of other metrics. Also, because the executive is unaware of the active performance metrics, the executive has to consider the term of his decision, discouraging purely myopic decision making.
##Case One day during the first months of 2012 temperatures in Holland reached -17 degrees Celcius. Together with a bit of snowfall, this caused a number of railway switches to freeze, causing great dtrain elays nationwide. The following days the weather cleared up. In the meantime executives of the Dutch national railway organization NS, came up with the idea to cancel over half of the train fares, and kept this measure in place for an extended period of about two weeks. The customer experience was awful. People would on average be waiting at the station for over half an hour, and would then enter overcrowded trains, while seemingly the problem with the frozen switches was mostly solved. It turned out that NS executives had a bonus scheme that was based on the delay of its trains. If they cancelled fares, this didn't count as a delay. Executives didn't want to run the risk of having new delays eat up their performance bonus, so cancelling trains is exactly what they did. Had this performance metric not been in place, or had they not been aware of it, things would have gone a different way.