It’s Easy to Talk About Bonuses

In recent years, top manager compensation has become one of the most heated battlegrounds for companies, investors, and regulatory authorities. After the accounting scandals of the early 2000s and the global financial crisis, the idea that paying a CEO well was enough to ensure good performance was definitively shelved. More and more companies, particularly in the US, have ditched stock packages linked simply to length of service in favor of so-called performance equity grants, i.e., packages that only vest if certain objectives are met. But what objectives? And above all, how can they be combined without creating perverse incentives?

Inside the bonus plans

In their paper “Multi-Metric Vesting Schemes in Executive Performance Equity Grants”, Francesca Franco (Department of Accounting, Bocconi University) and Oktay Urcan (University of Illinois Urbana-Champaign) go through over 52,000 stock incentive plans for executives of US-listed companies between 2006 and 2019.

The starting point is quite simple: most previous studies have focused on which metrics are used (profits, share price, revenues), neglecting how these metrics are combined within contracts. Yet this is precisely where the problems lie. The authors show that today, over 60% of stock plans are based on multiple objectives simultaneously, often combining accounting indicators such as profits with market or operating metrics. But not all combinations are equal.

Addition or binding scheme: two different approaches

The core of Francesca Franco and Oktay Urcan’s research lies in the distinction between two broad families of multi-objective schemes. In the first case, the objectives are added together: each metric has a weighted value, and a manager can pocket a larger or smaller portion of the equity grant even if they do not meet all the targets. It is a flexible but risky system. In the second case, however, so-called binding schemes come into play: some objectives act as a real barrier. If they are not achieved, the grant does not vest at all, even if profits exceed the target. As the authors write, these schemes mean that “the grant will vest only if both the earnings targets and the non-earnings binding conditions are met.” In other words: no shortcuts.

Less obsession with profits (and fewer accounting tricks)

Why is this distinction so important? Because accounting profits are notoriously “manipulable”. Pushing managers to meet an EPS target can encourage opportunistic behavior: anticipating revenues, deferring costs, smoothing the numbers just enough to clear the bar. However, research shows that plans that tie profits to other objectives significantly reduce profit volatility during the grant vesting period.

According to the paper, “binding schemes are more effective in mitigating the risk of executives prioritizing earnings relative to other targets.” And it’s not just about more stable numbers: the reduction in volatility is mainly due to less variability in the discretionary components of earnings, i.e., those most easily subject to manipulation. In other words, when the grant also depends (and in a binding way) on factors such as stock performance or operating indicators, there is less incentive to “adjusting” the accounts.

Proof: earnings just above target

The study goes beyond statistical regressions and looks directly at the behavior of companies around performance targets. Studying the distribution of actual earnings relative to set targets, the authors find a strong concentration of cases just above target in add-on plans. In binding plans, however, this “step” is much less evident. This is consistent with the idea that binding schemes reduce the temptation to push earnings just high enough to collect the bonus.

It is therefore not enough to multiply performance indicators to say that an incentive plan is “sophisticated”. The structure of incentives matters, not just their number.

The study shows that introducing binding targets can be an effective way to better align managers’ interests with the long-term interests of the company. From an investor’s perspective, however, it is an invitation to look more closely at compensation disclosures.