The Advisors' Blog

– Irv Becker and Peter Christie, Hay Group

Since the collapse of the financial markets last spring, regulators, politicians, the media, and a wide range of stakeholders have been assailing the financial-services industry for its compensation practices. Few practices have caught more flak than executive bonuses. Examples of outsized executive compensation packages have been well documented: billions of dollars in bonus pay to executives for their performance in 2008—just when their institutions were in crisis and when the US government stepped in to staunch the bleeding with a federal bailout.

Understandably, the main focus has been on the sheer size of bonus awards paid to executives at organizations already hurtling toward financial disaster. Specifically, the sector’s critics turned their wrath on three aspects of bonus-plan design:

– Performance measures out of line with the realities of the business (that is, not taking into account risk-adjusted performance).

– Dominance of annual bonus payouts based on an employee’s performance over 12 months, in businesses where the economic value of an individual’s performance might take years to realize.

– Timeframe when awards are paid out. Most banks pay at least half of the annual bonus in cash and the balance in restricted stock or restricted stock units. These deferred bonuses are not usually tied to future performance goals; individuals receive the balance of their bonus provided they remain employed for a two or three-year holding period, regardless of their performance during the period.

In January, troubled Swiss bank UBS announced its response to these criticisms. In a move closely monitored across the industry, UBS revised its entire approach to rewarding staff in its institutional and investment-banking businesses. A key plank of the new compensation model: the introduction of bonus banking, a concept now being touted by some as the holy grail of incentive structures.

Bonus banking is an incentive plan where part of the bonus earned in a year is ‘banked’ in a bonus account, to be paid out in subsequent years. It differs from recent practice by allowing for the declaration of a negative bonus (sometimes called a ‘malus’) where the amount in the bonus bank is reduced if subsequent corporate or individual performance declines, or if the initial assessment of performance upon which the bonus was based turns out to be wrong. It’s closely related to a bonus ‘claw-back’ (where the company demands the repayment of a bonus that has already been paid to an individual), but has the benefit of providing the company with some security for repayment. The deferred portion of the bonus is held in escrow on the organization’s balance sheet, so it’s easier to recover funds in the future if the measure becomes necessary.

In essence, bonus banking allows companies to balance short-term and long-term value creation, satisfy stakeholders’ demands for accountability, and succeed in attracting, motivating, and retaining the talent needed. Initial reaction from regulators, such as the US Securities and Exchange Commission and the Financial Services Authority in the UK, has been favorable.

Unfortunately, bonus banking is far from a complete answer to the issues surrounding incentives in financial services. While it has some attractions, bonus banking is difficult to implement, unpopular with employees, and ineffective at driving performance.

An appealing idea, in theory

Bonus banking has an obvious appeal to compensation committees searching for an acceptable approach to offering incentives to top executives. It reduces the much-criticized reliance on annual performance measures, creating stronger alignment of incentives with medium-term or long-term creation of shareholder value. Depending on the measures used, it can lessen the opportunities for gaming the system by focusing exclusively on meeting bonus targets at the expense of overall corporate performance. And it reassures shareholders, regulators, and the wider community that the company has some leverage should it turn out that bonuses were earned by producing numbers that were later found to be less than solid.

Stern Stuart, the firm that created ‘Economic Value Added’ (EVA), the financial-performance measure that attempts to capture an organization’s true economic profit, has been advocating bonus banking for years. In fact, bonus banking has worked with the EVA concept in some companies that have stuck to that measurement year after year. For these companies, the practice of bonus banking smoothes out the payouts. Typically, an employer will bank an individual’s full bonus and offer a withdrawal opportunity each year. The employee can usually withdraw from 33 to 50 percent of the balance in the bonus bank. As time goes on, the employer has a better understanding of how the employee’s actions impact the organization. This mitigates a windfall in any one year, and in doing so, addresses some of the skeptics’ major concerns.

Harder than it looks

The primary challenge with bonus banking, in our experience, is the difficulty of managing and communicating the plan while maintaining its effectiveness as a performance incentive. A cardinal rule of incentive plans is that the more remote the payout, the weaker the incentive. Employees may feel their bonus payouts are less secure and may be unsure about the conditions for the receipt or adjustment of the portion of the bonus that has been banked. Complex multi-year performance measures can dilute the focus on maximizing performance in the current year, without setting clear long-term performance goals.

What’s more, bonus-banking plans often have an unintentionally punitive tone. Bonuses can usually only be adjusted down, which can lead employees to feel that failure will be punished, but sustained success will go unrewarded. This is one of the primary reasons for the limited popularity of bonus banking, with consequent risks to retention and performance. In the recent bull market, where talent was scarce, it was not in an organization’s best interest to consider adopting bonus-banking, proving the market is often the final determinant of incentive compensation practices.

Even where company leadership succeeds in overcoming these issues, bonus banking has other limitations. Depending on how it is structured, it can lead to bonuses paid out in years where overall corporate performance is down – one of the criticisms of bonuses paid to investment bankers this year, or to former employees who have not contributed to this year’s performance – a result that could be difficult to communicate to shareholders. Performance measures can be difficult to construct, so plans are often based on rolling annual targets, which are less effective in driving a focus on long-term performance. In the face of these obstacles, compensation committees faced with a challenging environment may opt for more conventional approaches.

The alternative

Of course, there are other options available. Deferring a part of the annual bonus into restricted stock or restricted stock units ties the final value of the bonus to the share price – useful for focusing top-executive attention on long-term shareholder value, though less effective for those employees without a line of sight to the share price. Basing some incentives on two- or three-year timeframes – for example, risk-adjusted returns based on cash returns rather than profit estimates – can reduce the danger of fostering a short-term focus. Bonus banking can work in some cases, but only as part of an overall strategy that focuses the organization on long-term value creation. In and of itself, however, bonus banking cannot guarantee the achievement of a responsible reward program.

This article is reprinted from Directorship’s April/May 2009 issue with permission.