Chapter 9:

Incentive Compensation Systems

Financial results controls
 Three core elements:
– Financial responsibility centers
» The apportioning of accountability for financial results
within the organization

– Formal management processes

» Planning & budgeting to define performance expectations
and standards for evaluating performance

– Motivational contracts
» To define the links between results and various
organizational incentives
Positive and negative incentives

 Incentive: a thing that motivates or encourages someone

to do something

 Positive incentives “rewards”

» Things employees value

 Negative incentives “punishments”

» Things employees like to avoid
Forms of rewards and punishments
 Punishments  Rewards
– Monetary – Monetary
» Salary increases
» Zero salary increase
» Bonuses
» Zero bonus
» Benefits
» Zero perquisites » Perquisites (perks)
– Non-monetary  Club memberships
 Vacation trips
» Interference in job
from superiors – Non-monetary
» Loss of job » Promotion
» Assignment to » Autonomy
unimportant tasks » Recognition
» No promotion » Participation in decisions
» Office assignments
» Humiliation
» Preferred parking places
» Titles
Purpose of incentives
 Motivation
– Motivation has two elements:
» Inducing effort: getting employees to work hard
 Employees typically put forth more (less) effort on
activities that are (not) rewarded.

» Directing effort: helping employees understand

what is expected of them
 Rewards attract the employees’ attention and inform
them of the relative importance of often-competing
results areas (e.g., cost, quality, growth).
Purpose of incentives
 Attraction/retention
– Paying employees only guaranteed salaries tends to
attract risk-averse employees.

– Paying performance-dependent compensation tends to

attract employees who are more risk tolerant, more
aggressive, more confident in their abilities.

– e.g., stock option plans often are geared towards

employee retention; they provide a form of “golden
handcuffs”.
The compensation package
(monetary incentives)
 Salary

 Benefits
– Pension and health benefits
– Perquisites of various types

 Incentive compensation
– Short-term incentive plans
» Based on the performance in the current year or less.
– Long-term incentive plans
» Based on the performance measured over periods greater
than one year and often related to the company’s stock price.
Short-term incentive plans
 Based on performance in the current year or less
» e.g., bonuses, commissions, piece-rate payments

 Calculation (by formula) of short-term incentives

» e.g., 2% of sales; 10% of net profits
» e.g., 20% of over-target performance
» e.g., 60% of “target bonus” at 80% of target;
100% of “target bonus” at 100% of target;
(where target bonus = 30% of salary).
» Suppose salary is 1000, target is 200, actual is 185, what
would be the bonus? Target bonus = ? Bonus = ?
Long-term incentive plans
 Based on the performance measured over periods
greater than one year.

» Usually restricted to relatively high management levels

» Based on accounting performance (e.g. EPS, ROE,
ROA) over a period of three to five years

» Based on market-based performance

 Stock options
 Restricted stock: stocks awarded with restrictions (vesting before
one can sell)
 Stock appreciation rights: have vesting period; expire in 7-10 years
 Performance stock or option plans
 These are broadly called equity incentives
Long-term incentive plans
 Stock options
 Right to purchase shares at the strike price after options vest but
before they expire
 Usually granted at the money
 when options are in the money, can exercise vested options for a
gain
 Improve incentive alignments and retention
 Create cash flows for firms when exercising options
 US GAAP (after 2006) and IFRS require expensing stock option
grants
 Potential future dilution and downward pressure on share price
 Motivate managers to take risky business strategies
 Underwater options are a source of morale and retention
problems
Long-term incentive plans: Options
Long-term incentive plans

 Options are suitable for firms:

– At start-up or rapid growth stages
– In highly competitive industries
– With strong reliance on human capital

 Stock appreciation right:

– No effect on ownership (dilution): good for SOEs?
– Requires a lot of cash
Long-term incentive plans
 Performance stock or option plans
 Make the stock/option grants contingent on the achievement of
stock or non-stock goals over a multi-year period
 Performance options: vesting or exercise of options contingent
on improvements in stock or non-stock goals, including:
 Premium options: exercise prices greater than the stock price on
the grant date
 Indexed options: exercise prices contingent on performance
relative to peer firms
 Performance-vested options: link the vesting of options to the
achievement of performance targets (ROE, EPS, sales growth)
 Provide stronger incentives to max shareholder value by raising
the bar
 for stock price improvement (premium options, indexed options)
 on conditions to vest (performance-vested options)
Long-term incentive plans

 More than 90% of the 7,000 listed companies in the US

use equity incentives
 Almost all high-tech firms in the US use equity incentives
 Firms in China mainly use options and restricted stocks
as equity incentives, and phantom stocks to a much less
extent
– Phantom stock (shadow stock): not real stock, with no voting
power, but otherwise enjoys the benefits of a real stock (paying
out resulting profits/dividends). After a period of time, the cash
value of the phantom stock (market value of company stock) is
distributed to holders: thus interest alignment
 Equity incentives in China
Observations:
(1) Restricted stocks and stock options are the main types of equity incentives
(2) State-Owned Enterprises (SOEs) tend to use more stock options,
while non-SOEs tend to use more restricted stocks
Performance
shares are
allocations of
company
stock given to
managers
only if certain
performance
criteria are
met, such as
EPS targets
Key incentive design elements
 Level of measurement (performance at the individual,
entity, or company level)

 Size of awards: proportion of variable pay (at-risk pay)

 Shape of the performance-reward function

 Use of “subjectivity” (subjective judgment about

performance; subjective weights on performance
measures)

 Type and number of measures (financial vs.

nonfinancial; bottom-line vs. basket of measures)
(to be covered later)
Proportion of variable pay
 Employees are risk averse

» Performance-dependent rewards impose risk on

the employees as performance is never fully
controllable.

» Employees will want to be compensated for bearing

that risk.

» Their compensation in expectation must be higher

than what it would be when offered a fixed salary.

» If a firm fails to provide the risk premium, then it will

be unable to compete for talent in the labor markets.
 Proportion of variable pay
Observation:
The larger the firm, the higher (lower) the proportion of equity incentives (fixed
pay)
Bonus determination approach
 Strict formula
» Rewards can be specified with precision.
» There is little uncertainty or ambiguity about performance
standards.
» Superiors cannot exercise any bias or favoritism in assessing the
performance of subordinates.
but
» Less attention for performance dimensions which are more difficult
to quantify (e.g. R&D).

 Subjective assessment
» Especially desirable when the manager’s personal control over the
business unit’s performance is low.
» Lack of explicitness increases the employee's risk.
Shape of reward function
 Mostly, the link between rewards and results is linear,
but over a restricted performance range only

MAX
Rewards ($)

Results (profit)
ZERO
LOW 80% of 100% of 150% of HIGH
budget budget budget
target target target
Cutoffs
 Lower cutoff

 Upper cutoff
Group rewards
 Team-based rewards are often used to implement
personnel/cultural controls.
– Group members monitor and sanction each others’ behaviors.

 They rarely provide a direct incentive effect.

– Stock-based plans, for instance, provide direct incentives only
for a small number of managers at the very top of the
organization.

– Hence, for lower-level employees, compensation is made more

volatile (with stock-based plans), but their motivation is not
(greatly) affected. –hard for action of lower-level employees to
affect stock price.
Equity incentives and risk taking

 Suppose the firm’s stock price now is $50. There are two
projects: project A is high risk resulting in future price of
$80 (1/2 chance) or $30 (1/2 chance). Project B is low
risk, resulting in future price of $55 (1/2 chance) or $45
(1/2 chance). The manger can only invest in one project

 If you were the manger holding restricted stocks, which

project would you choose?

 If you were the manager holding stock options with the

exercise price of $50, which project would you choose?
Equity incentives and risk taking

 Holders of restricted stocks gain when stock price goes

up and lose when the stock price goes down. Financial
wealth moves dollar-for-dollar (linearly) with stock price

 Holders of options face relatively little downside risk,

but huge upside potential. Wealth moves non-linearly
with stock price
– When price drops to below exercise price, simply do not
exercise the option.
– Options encourage risk taking by giving incentives to increase
volatility.
Equity incentives and risk taking

S0 current price
 price of a call option K exercise price
r risk-free interest rate
T time to maturity
σ stock price volatility
(standard deviation)
N( ) cumulative standard
normal distribution
function

The higher the volatility (σ), the higher the value of the option
Equity incentives and risk taking

 Equity incentives encourage risk taking

 But, options may motivate too much risk taking
– What behaviors can considered as (too much) risk taking?
– How much is too much? What is the appropriate risk level?

 Adjust the proportion of options and restricted stocks

in the compensation package to (try to) make
operating and investing decisions consistent with
company’s strategy and optimal risk level