Importance and Key Contribution
U.S. CEOs received an average annual cash bonus payment of $2.5 million in fiscal year 2014. These bonus payments are typically awarded based on CEO achievement of pre-determined performance targets. Due to a lack of easily-accessible data until recent years, shareholders have struggled to identify the link between these payments and CEO actual performance. As a result of changes to the compensation disclosure requirements in the U.S., firms are now expected to disclose specific performance target data when discussing CEO performance-based compensation. The current research contributes further to our understanding of target-setting in CEO bonus plans by exploiting this new data source. Prior to this narrative disclosure (titled the Compensation Discussion and Analysis), data on executive performance targets were mainly obtained through compensation consulting firms (Bushman et al., 1996; Ittner et al., 1997; Murphy, 2001; Indjejikian and Nanda, 2002). The new compensation disclosures provide a more complete picture of CEO performance targets for bonus purposes.
Theoretical Base
In general, CEO compensation research falls into one of two competing schools of thought. The optimal contracting theory assumes that compensation contracts are designed by boards of directors in an efficient manner in order to maximize shareholder value (Edmans and Gabaix, 2009). In contrast, the managerial power theory assumes that CEO power over boards can result in a lack of arm's-length negotiating over CEO pay (Bebchuk and Fried, 2004). Until recently, it has been difficult to observe in practice which of these theories might best explain firms’ target-setting practices in CEO bonus plans. The new compensation disclosures provide us with a more detailed insight into the performance target choices that firms are making, which should help to contribute further to the ongoing theoretical debate.
Research Questions and Method
Utilizing a new data source on performance targets, the paper addresses a number of key questions that have arisen in the previous literature. In the area of target revision practices, the main empirical question is whether firms ratchet targets upwards in response to favourable past performance, or whether they disregard past performance in order to better motivate their executives. We provide some additional insights on this. With respect to firms’ choice of performance metrics, we consider if firms are choosing metrics that are more informative of CEO actions, or whether CEO power has a role to play here. We also investigate the difficulty of CEO performance targets in bonus plans. Performance target data are manually obtained from the Compensation Discussion and Analysis section of the proxy statement for a sample of 200 S&P 500 firms. A cross-sectional multiple regression analysis is carried out on the data.
Findings
Initial findings suggest that firms are incorporating past performance information into CEO performance targets ex ante. The paper reports an average target difficulty of 6%; that is current performance targets are set 6% higher than historical performance. When actual performance outcomes are compared to targets ex post, CEOs earn a payout of approximately 19% above target bonus. Therefore, boards appear to be setting challenging targets, and CEOs appear to be appropriately motivated to meet and beat these targets. Firms choose from a wide variety of metrics when evaluating CEO annual performance, but income-based measures play the most important role. Finally, almost two-thirds of the sample firms rely on some element of subjectivity in evaluating CEO performance. On average, one third of CEO performance targets are qualitative in nature, with boards placing an emphasis on aspects such as leadership, strategic planning and overall individual performance.
Implications
This paper provides an important insight into the specific performance targets that influence CEO bonus payments, and considers the choices that firms are making when designing bonus plans. The findings will be of particular interest to the investor community, who expect bonus plans to be designed in a manner that motivates and rewards the CEO to take value-enhancing actions. By providing shareholders with a clearer picture of how CEO annual performance is evaluated for bonus purposes, this should lead to more informed say-on-pay voting decisions in the future.
References
Bebchuk, L., and J. Fried. 2004. Pay Without Performance: The Unfulfilled Promise of Executive Compensation. Cambridge, MA: Harvard University Press.
Bushman, R. M., R. J. Indjejikian, and A. Smith. 1996. CEO compensation: The role of individual performance evaluation. Journal of Accounting and Economics 21 (2):161-193.
Edmans, A., and X. Gabaix. 2009. Is CEO Pay Really Inefficient? A Survey of New Optimal Contracting Theories. European Financial Management 15 (3):486-496.
Indjejikian, R. J., and D. Nanda. 2002. Executive Target Bonuses and What They Imply about Performance Standards. The Accounting Review 77 (4):793-819.
Ittner, C. D., D. F. Larcker, and M. V. Rajan. 1997. The choice of performance measures in annual bonus contracts. The Accounting Review 72 (2):231-255.
Murphy, K. J. 2001. Performance standards in incentive contracts. Journal of Accounting and Economics 30 (3):245-278.
