Are bonuses fair?

When I wrote on the subject of bonuses in the middle of last year (Most bonuses are a waste of time) it was on the basis of my views on a subject that has long interested (and involved) me. The row over bankers’ pay had yet to reach the current level of political & public hysteria. Having first been on the receiving end of many different schemes and then being responsible for designing remuneration schemes in many other businesses (including my own), I have some experience of the subject.

Image courtesy of upscale-homes.org

Are bonuses really fair? Is boardroom pay too high? Have the multiples of executive earnings become too high relative to average workers’ pay? Let us consider some aspects of remuneration that don’t get a great deal of light and air in the highly charged political and media circus of today.

Too many issues concerning remuneration have become conflated into the one term ‘bonus’. The definition of bonus that I became familiar with and happen to prefer is ‘Something given or paid in addition to what is usual or expected’. It used to be customary in many large companies that, given a healthy overall company performance in any given year, then a bonus conforming to set formula (often a multiple of an individual’s weekly or monthly pay) was paid. Complex mechanisms were unnecessary and everyone in the company participated in what was a reward.

Sales people have traditionally been paid either commission on sales or a bonus on achievement of a sales revenue or profit target. Both of these two systems have usually included a basic salary. These sales ‘incentives’ often work well when a number of criteria are met – the target thresholds are realistic, the mechanisms are simple to understand, information on progress is readily available and the individual can measure what they are achieving in real time. However, not all schemes were or are well constructed; an old friend and colleague of mine tells the story of an employer who called him in at year end and informed him that he had failed to reach his target. “What target?” asked my friend, “What was it?” The answer came back “You’re not entitled to that information, it’s confidential”.

Sometime over the last 20~30 years, the concept of ‘performance related pay’ became the fashion item amongst consultants, senior management and HR departments. The siren song of a simple way to let money do the management and motivation of a company or department took hold like wildfire. There seemingly wasn’t a role that couldn’t be made to perform better when a carrot was dangled. Couldn’t fail, could it?  Seeds were sown.

Failure to differentiate between a bonus and a reward lies at the heart of the failure of many schemes. A suggestion currently being made is that no-one should receive a bonus (irrespective of their individual performance) until the company reaches a certain level of profit. This has a certain simplistic and populist appeal. However, it breaks most of the basic rules for incentives as detailed in paragraph three above. If I had moved heaven and earth and worked 90~100 hour weeks and had achieved all that had been set for me (or my department), I would be severely hacked off if I didn’t get my reward; a call to my favourite head-hunter would probably be the first call I made. If it’s an incentive, it isn’t or cannot be a reward or be discretionary.

Alignment of board room pay with shareholder interests became the next belief system; shareholder value became the new mantra. I may be in a minority of one but I do believe that managers are managers and shareholders are a different breed. Attempting to create alignment with shareholders via creation of long term incentives paid in share options doesn’t hack it when the vast majority of shares are traded over very short timescales. And as for the concept of paying for above average share price performance of the sector, sorry my friends, it’s laughable. Absolute performance is what counts. If management’s efforts produce satisfied customers, rising market share, cashflows and profits relative to competition then they have done a good job. These activities are the role of management. Linking executive pay to the share price won’t make management any more effective at their day job. If the sales force or managers have absolute targets, then don’t expect anything less at board level. There cannot be a salesman in the world who wouldn’t thank God for a system that retrospectively flexed his target down if the competition were failing. So why for the board?

Is there a better system for boardroom pay that rewards long term performance? There is hardly a main board director of a quoted company that struggles to live on his basic salary (unless he thinks he has a right to live like Bill Gates). Create absolute targets with performance up to the threshold represented by the basic salary and benefits package. For performance above the threshold (set at a genuinely tough level) pay an incentive. However, to ensure consistency of performance (and not short term gaming of the system) I would ensure one third is paid in cash, and two thirds of the incentive is paid over the next two years, but only if the targets for the next two years are met or exceeded.

Rewards for failure?  Executive tenure has been getting shorter for years. The executive who can move companies and go on repeating above average performance is rare (although no-one wishes to acknowledge the fact). Performance is a complex mixture that involves personal qualifications, experience, behavioural attributes and skills plus the right team and a complimentary company culture. If an executive is encouraged to move companies then there is a high possibility of failure (not infrequently due to the hiring management). A contract that requires the giving of a long period of notice on the part of the job holder (as a means of retention) also requires a matching period of notice to terminate. Trying to apportion blame when an executive fails is as complex as attempting to adjudicate where blame lies in a failed marriage. A contract is a contract.

Are high rewards ‘fair’? It very much depends upon the definition of ‘fair’. Most dictionaries have a long list of common meanings for the word – Just to all parties; equitable: a compromise that is fair to both factions; being in accordance with relative merit or significance; consistent with rules, logic, or ethics. It’s difficult to construct an argument that a contract freely entered into by the parties concerned is the business of anyone else by these definitions. The general population is not a party to the process. However, there is a further definition – superficially true or appealing; specious. Fertile ground indeed for politicians and the envious masses. Perhaps we should retain the use of the word fair but restricted to the under fives who seem to understand its meaning so much better.

Whatever your views, vast sums from taxation on the salaries, bonuses and incentives of high earners flows into the exchequer and help pay for much of which is taken for granted. Yes, there are those who find (legal) tax avoidance schemes but it lies within the remit of the Government to simplify the horrendous mess that is our tax system that permits (and encourages) such schemes. Government could also work far harder to eliminate the appalling waste that would never be permitted in the private sector. And evidence based programmes are far more effective than sound bite political dogma and knee-jerk legislation. And if chief executives have ratcheted up their rates of pay by the technique of comparability, isn’t this what unions have been doing for a lot longer?

Finally, by HMRC’s own figures the top 1% pay 27.7% of total tax in the UK; fair or not?

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3 responses to “Are bonuses fair?

  1. Thank you, I enjoyed this article. I am of the opinion that a “bonus” should come as a surprise to the recipient, not be used as an incentive to perform. One is paid a salary with an expectation that one performs at the very best all the time.

  2. The Retrospective Entrepreneur

    If the company culture is one one that fits that which you describe, then a discretionary bonus can be made to great effect and without it becoming the norm. I fully support the view that a salary carries an expectation of a performance that meets an agreed threshold of performance. It is essential that a clear distinction is made between a ‘bonus’ and an ‘incentive’ (unfortunately, these words are typically used interchangeably).
    However, I am not without support for a properly designed and appropriate incentive system. The challenge comes in deciding when to pay for (or what exactly constitutes) exceptional performance.
    Thank you for your contribution

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