Executive Compensation with Incentive to Downsize
Profit-sharing leads to downsizing instead of growth: Obermatt study shows that companies with balanced compensation systems grow three times more than those with a profit focus.
Andrew Smithers, a Financial Times columnist in London, is convinced that companies focused on profit cut costs far too aggressively, blocking future growth in the process. This is understandable, because in the short term it is much easier to increase profit by cutting costs than by increasing revenue or investing. As a result, profit-sharing programs produce the exact opposite of the desired outcome: they reduce profits instead of building them. We have now been able to demonstrate the downsizing effect of profit-sharing for the first time in the Swiss stock market as well (NZZ am Sonntag).
Profit-Sharing Creates Incentives to Downsize
Obermatt analyzed 40 Swiss annual reports to assess 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. In this study, profit-sharing refers to companies whose compensation systems are 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 as a percentage of revenue) and economic profit.
In 2014, companies with balanced incentives even achieved stock returns that were 6.5 percentage points higher and ultimately also delivered more profit than companies focused on profit.
Obermatt divided the SMI Expanded companies, excluding financial institutions, into two groups: companies focused exclusively on profit-sharing (12 SMI Expanded companies), and companies 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 from the analysis because their compensation practices differ substantially from those of other companies.
A focus on profit has negative consequences for Swiss shareholders. Profit-sharing reduces growth prospects and therefore stock returns, as Andrew Smithers demonstrated for the United States and the United Kingdom and Obermatt has now also found in the Swiss market.
The Good News: Most Companies Use Growth Incentives
Fortunately, only a minority of one-third of all companies in the SMI use EPS, ROE, ROCE, RONOA and economic profit exclusively, in other words, pure profit-sharing. The majority use growth incentives. SIKA, for example, has for years measured its revenue growth by whether it exceeds that of a peer group of listed competitors representative of SIKA. This is known as indexed compensation. SIKA also measures profit growth relative to the market. Management is therefore not penalized for growing faster than the market, because above-average performance receives above-average compensation. Last year, SIKA outperformed all its competitors.
With compensation that does not use market comparisons, meaning compensation that is not indexed, good performance tends to lead to higher targets the following year. Executives are therefore penalized for their good performance. It is no surprise that growth then suffers.
Absolute Growth Targets Are Dangerous
Growth targets are sometimes set in absolute terms, meaning relative to the previous year. The problem is that growth rates vary far more widely than one would reasonably expect. We demonstrated this by examining Germany's 80 largest companies over 10 years. We found that even these relatively large companies showed a very wide range of revenue changes. The study's results show that growth rates fall between 4% and 14% in only one-third of cases.
In two-thirds of cases, growth rates are below 4% or above 14%. In both cases, these values are usually not reflected in bonus systems because they are either too high or too low to be considered reasonable targets. This means that, outside these limits, the growth target creates an incentive against growth rather than for it, because postponing growth until the following year is rewarded. Managers who invest in growth when growth rates are below 4% are penalized: they have fewer growth opportunities the following year and receive no compensation for that investment in the current year. The same applies when growth rates exceed 14%. Here too, it is better to wait until the following year before pursuing additional growth. At least, that is how the bonus system pays.
In other words, in two out of three cases, growth bonuses based on absolute growth targets reward the exact opposite of the intended outcome.
Market Comparisons Are More Stable, Especially for Long-Term Incentives
For compensation committees and boards of directors, indexed compensation has the advantage of encouraging growth without creating incentives to downsize. It is also considerably more stable than budget-based compensation because external fluctuations are neutralized. This is particularly important for long-term incentives (LTIs). In our experience, indexed LTIs fluctuate by no more than 10–20 percentage points, even over three- or five-year terms. Stable LTIs mean satisfied executives who also receive better incentives, as explained above. Indexed compensation is also easier to plan because unexpected market fluctuations are neutralized. Indexed compensation therefore never comes as an inexplicable surprise to executives, supervisory boards, boards of directors or shareholders.
