Executive Compensation with a Downsizing Incentive

5. August 2015

Financial Times columnist Andrew Smithers in London is convinced that profit-focused companies are saving far too extensively and blocking future growth in the process. This is understandable, because in the short term it is much easier to increase profits by cutting costs than by increasing sales or making investments. As a result, profit-sharing programs lead to exactly the opposite of what is desired, namely to a reduction instead of an increase in profits. For the first time we were able to demonstrate the downsizing effect of profit-sharing in the Swiss stock market (NZZ am Sonntag).

Profit-sharing is an incentive to downsize

Obermatt evaluated 40 Swiss annual reports with regard to incentive structures and their effects on growth, profit and stock returns. The result: companies with balanced compensation systems grow three times more than those with profit-sharing. The study defines profit-sharing as companies with compensation systems based on EPS (earnings per share), ROE (return on equity), ROCE (return on capital employed), RONOA (return on net operating assets), ROS (return on sales, EBIT%revenue) and economic profit.

Companies with balanced incentives even had a 6.5 percentage points higher ROE in 2014 and ultimately delivered even more profit than the profit-focused companies (see figure).

What does profit focus mean for shareholders?

Obermatt divided the SMI Expanded companies (excluding financial institutions) into two groups: Companies with an exclusive focus on profit sharing (12 SMI Expanded companies) and those with a broad mix of compensation elements, such as growth criteria and market comparisons for performance measurement (17 SMI Expanded companies). Financial institutions were excluded for the analysis because their compensation practices differ significantly from those of other companies.

Profit focus has negative implications for Swiss shareholders. Profit sharing lowers growth prospects and thus reduces stock returns, as Andrew Smithers has shown for the US and UK and Obermatt has now determined for the Swiss market as well.

The good news: the majority of companies use growth incentives

Fortunately, only a minority of one-third of all companies in the SMI use only EPS, ROE, ROCE, RONOA and Economic Profit - i.e. pure profitsharing. The majority use growth incentives. SIKA, for example, has been measuring its sales growth for years based on whether it is higher than a typical peer group of listed competitors. This is referred to as indexed compensation. SIKA also measures profit growth relative to the market. Thus, management is not penalized if it grows above the market, because if performance is above average, its compensation is above average. Last year, SIKA outperformed all of its competitors.

In the case of compensation without market comparisons, or indexed compensation, good performance tends to lead to higher targets in the following year. Executives are therefore penalized for their good performance. No wonder growth then suffers.

Absolute growth targets are dangerous

In some cases, growth targets are set in absolute terms, i.e., compared to the previous year. This creates the problem that growth rates turn out much more differently than one would reasonably expect. We have demonstrated this with the largest 80 companies in Germany over 10 years. For these relatively large companies, we found that the changes in sales show a very wide range. The results of the study show that the growth rates are between 4% and 14% in only one third of the cases:

In two-thirds of the cases, growth rates are less than 4% or more than 14%. In both cases, these are values that are usually not reflected in bonus systems because they are far too high, or too low, to be considered reasonable targets. However, this means that the incentive of the growth target outside these limits is not in favor of growth, but against it, because postponing growth to the following year is rewarded. Managers who invest in growth at growth rates below 4% are penalized for doing so because they have fewer growth opportunities in the following year and receive no compensation for doing so in the current year. The same applies to growth rates above 14%. Even then, it is better to wait for the next year before investing in additional growth. At least that's how the bonus system pays.

In other words, growth bonuses based on absolute growth targets pay exactly the opposite of what is desired in two out of three cases.

Market comparisons are more stable, especially with long-term incentives

For compensation committees and boards of directors, indexed remuneration has the advantage of encouraging growth and does not provide an incentive for downsizing. It is also much more stable than budget-based compensation because external fluctuations are neutralized. This is particularly important for long-term incentives (LTIs). Experience shows that indexed LTIs fluctuate by no more than ten to twenty percentage points; even with three- or five- year terms. Stability in the LTI means satisfied executives who receive even better incentives as outlined above. Last but not least, indexed compensation is easier to plan because unexpected market fluctuations are neutralized. Indexed compensation is therefore never an inexplicable surprise - neither for the executives, nor for the supervisory and board of directors, nor for the shareholders.