Introduction

I was at a City lunch in a conversation with a senior executive of an American bank and her partner, a gifted financial analyst.  We discussed the impact of bonus accrual accounting standards on balance sheets.  Then she made a startling statement.  “The accruals cost us millions, but the executives value their bonus at a fraction of its face value.”   We then spent two hours discussing that statement.

In both women’s eyes the issues are the trends in executive compensation to long deferral periods, bonuses held in stock and the potential value reduction through future downward adjustment and claw back. The issue for executives is economics 101.  A dollar has less value tomorrow than today and uncertainty over the number of tomorrow’s dollars reduce the value still further.  Yet, the increasing costs of executive incentives weigh heavy on the corporate balance sheet and in the eyes of the shareholder advocacy groups.

Pressures on bonus structures

The demand for longer bonus deferral periods reflects the perceived risk horizon of the impact of executive decisions.  The driver for deferral into stock is to increase executive alignment with shareholder interests.  Increasing conditionality around claw back of bonuses paid and value reduction of unvested payments is a reaction to executive misdemeanors.  All of these are worthy objectives – but they come with unintended consequences.

Impact

The cumulative impact of these changes is that the face value of the incentives becomes close to meaningless to the recipients.  Future value becomes unknowable.  Long deferral periods lead to great uncertainty as to value (the very basis of the Black Sholes calculation).  Stock value is heavily impacted by external events such as market crashes. Decisions made in good faith can, with several years’ hindsight; look wrong if not negligent, leading to high levels of management risk aversion.  The cash flows on which an executive has to base her future become smoke and mirrors.

Organisational penalties

The core of a reward strategy is to attract, retain and motivate.  If the recipient of a reward does not value the payment at the same level as the cost to the organisation, the strategy fails. Motivation and retention is reduced if lower value than the cost is attached to the award.  Yet, the balance sheet, P&L and share dilution have heavy organisational effects in both dollar and reputational terms.

The impact on the individual executive’s behavior is also meaningful.  Risk aversion becomes important to avoid penalty.  Capital protection rather that appreciation becomes a driver to reduce future uncertainty.  As we have seen in some labor markets, upward pressure on base salary and thus dollar certainty is increasing.

Unintended consequences – lose lose…

We are at a tipping point.  Remuneration costs are rising, for executives value is falling; external criticism is increasing rapidly as is remuneration regulation. There is a vicious circle of increasing face value to make future value meaningful; something of a tail chasing strategy. The system is broken.  Not yet beyond repair, but the longer the malaise festers the more painful the eventual solution.

A root and branch review is needed and needed now.  Executive compensation has always been complex and opaque.  Its death rattle is now being sounded – at least in its current form.  The reward profession needs to move contemplation from its navel to this vexed subject before it is too late; although what the alternatives are I shudder to contemplate.