Wages →
- 12 Nov 2012
- Research & Ideas
Pay Workers More So They Steal Less
New research by professor Tatiana Sandino confirms what many top companies have long believed: Good wages and benefits are linked to a company's low turnover and to happier, more honest workers. Closed for comment; 0 Comments.
- 30 Aug 2012
- Working Paper Summaries
Incentivizing Calculated Risk-Taking: Evidence from an Experiment with Commercial Bank Loan Officers
Recent research presents convincing evidence that incentives rewarding loan origination may cause severe agency problems and increase credit risk, either by inducing lax screening standards or by tempting loan officers to game approval cutoffs even when such cutoffs are based on hard information. Yet to date there has been no evidence on whether performance-based compensation can remedy these problems. In this paper, the authors analyze the underwriting process of small-business loans in an emerging market, using a series of experiments with experienced loan officers from commercial banks. Comparing three commonly implemented classes of incentive schemes, they find a strong and economically significant impact of monetary incentives on screening effort, risk-assessment, and the profitability of originated loans. The experiments in this paper represent the first step of an ambitious agenda to fully understand the loan underwriting process. Key concepts include: High-powered incentives that penalize the origination of non-performing loans while rewarding profitable lending decisions cause loan officers to exert greater screening effort, approve fewer loans, and increase the profits per originated loan. In line with predictions, these effects are weakened when deferred compensation is introduced. More surprisingly, they find that incentives actually have the power to distort loan officers' perceptions of how a loan will perform. More permissive incentive schemes lead loan officers to rate loans as significantly less risky than the same loans evaluated under pay-for-performance. Closed for comment; 0 Comments.
- 07 Feb 2012
- Working Paper Summaries
Earnings Management from the Bottom Up: An Analysis of Managerial Incentives Below the CEO
Many studies as well as anecdotes document a link between the structure of chief executive officer (CEO) compensation and various measures of earnings manipulation. In this paper, HBS professors Oberholzer-Gee and Wulf analyze all components of compensation packages for CEOs and for managers at lower levels in a large sample of firms over more than 10 years, between 1986 and 1999. Results suggest that the effects of incentive pay on earnings management vary considerably by both type of incentive pay and position. Overall, it appears that the primary focus of compensation committees on equity incentives for CEOs overlooks a critical component in curbing earnings manipulation. If one wanted to weaken incentive pay to get more truthful reporting, diluting bonuses-particularly that of the chief financial officer (CFO)-would be the place to start. This may be the first study to analyze the relationship between CEO, division manager, and CFO compensation and earnings management. Key concepts include: It is important to look at positions below the CEO because it is unclear if all or even most financial misreporting is decided at the top. In addition to division managers, the importance of the CFO's role in financial reporting and the numerous recent corporate fraud cases suggest that CFOs can significantly affect accounting quality. Companies report significantly higher discretionary accruals and excess sales and have a higher incidence of future lawsuits when CFOs are paid larger bonuses. Importantly, the magnitudes of these effects are much larger for CFOs in comparison to both CEOs and division managers. Since the quality of financial reporting is difficult to assess, the researchers have used various measures of earnings manipulation in this study, including discretionary accounting accruals, end-of-year excess sales, and class action litigation. Closed for comment; 0 Comments.
- 04 Jan 2012
- What Do You Think?
Income Inequality: What’s the Right Amount?
Summing Up Comments were large in number and broad of opinion reflecting on Professor Jim Heskett's question, Does income inequality promote or stunt economic growth? Is there a "right" right amount of income disparity? Closed for comment; 0 Comments.
- 09 Nov 2011
- Working Paper Summaries
CEO Bonus Plans: And How to Fix Them
Discussions about incentives for CEOs in the United States begin, and often end, with equity-based compensation. After all, stock options and (more recently) grants of restricted stock have comprised the bulk of CEO pay since the mid-1990s, and the changes in CEO wealth due to changes in company stock prices dwarf wealth changes from any other source. Too often overlooked in the discussion, however, is the role of annual and multiyear bonus plans—based on accounting or other non-equity-based performance measures—in rewarding and directing the activities of CEOs and other executives. In this paper, Kevin J. Murphy and Michael C. Jensen describe many of the problems associated with traditional executive bonus plans, and offer suggestions for how these plans can be vastly improved. The paper includes recommendations and guidelines for improving both the governance and design of executive bonus plans and, more broadly, executive compensation policies, processes, and practices. The paper is a draft of a chapter in Jensen, Murphy, and Wruck (2012), CEO Pay and What to Do About it: Restoring Integrity to both Executive Compensation and Capital-Market Relations, forthcoming from Harvard Business School Press. Key concepts include: While compensation committees know how much they pay in bonuses and are generally aware of performance measures used in CEO bonus plans, relatively little attention is paid to the design of the bonus plan or the unintended consequences associated with common design flaws. These recommendations for improving executive bonus plans focus on choosing the right performance measure; determining how performance thresholds, targets, or benchmarks are set; and defining the pay-performance relation and how the relation changes over time. In the absence of "clawback" provisions, boards are rewarding and therefore providing incentives for CEOs and other executives to lie and game the system. Any compensation committee and board that fails to provide for the recovery of ill-gained rewards to its CEO and executives is breaching another of its important fiduciary duties to the firm. Closed for comment; 0 Comments.
- 23 Mar 2011
- Working Paper Summaries
Do US Market Interactions Affect CEO Pay? Evidence from UK Companies
CEOs of UK firms receive higher total compensation if their companies have interactions with US product, capital, and labor markets. Moreover, the compensation package is often adopted from American-style arrangements, such as the use of incentive-based pay. Researchers Joseph J. Gerakos (University of Chicago), Joseph D. Piotroski (Stanford), and Suraj Srinivasan (Harvard Business School) analyzed data on the compensation practices of 416 publicly traded UK firms over the period 2002 to 2007. Key concepts include: The reason to compare similarity with the level and style of US pay is because CEOs of US companies typically are among the highest paid in the world. The UK firms' interactions with US markets were measured on four variables: the relative importance of US sales to the firm, the level of prior US acquisition activity, the presence of a US exchange listing, and the US board experience of the firm's directors. All four US market interaction variables correlated with greater pay, but only US operational activities (sales and acquisitions) were associated with pay similar to US-style contracts. The increased compensation alleviates internal and external pay disparities arising from the presence of US operations and businesses, and compensates CEOs for bearing the additional risk and responsibility associated with exposure to foreign securities laws and legal environments. Closed for comment; 0 Comments.
- 28 Dec 2010
- Working Paper Summaries
The Psychological Costs of Pay-for-Performance: Implications for Strategic Compensation
In studying pay-for-performance-based compensation systems, economic scholars often adhere to agency theory, which hypothesizes that firms should prominently use performance-based compensation—it alleviates the problems of employee "shirking" and ensures highly skilled employees' desire to work for the company. However, firms use performance-based pay far less frequently than agency theory predicts. This paper posits that the psychological costs of pay-for-performance systems often dominate their benefits to firms, and proposes an integrated theory of strategic compensation that takes into account the economic and psychological benefits and costs of pay-for-performance. Research was conducted by Harvard Business School professors Francesca Gino and Ian Larkin, and Lamar Pierce of Washington University. Key concepts include: Three psychological factors most prominently influence compensation strategy: social comparison processes, overconfidence, and loss aversion on the part of employees. Social comparison processes imply that employees care not only about their own pay but also about the pay of relevant others. If employees are overconfident about their abilities, which is often the case, they may become unmotivated or even engage in sabotage if they perceive unfair pay gaps between their and others' pay. Loss-averse employees are more motivated by potential failure to meet sometimes arbitrary levels of desired pay than they are by potential gains. This phenomenon implies that employees may work less hard than firms desire even if paid for performance. In response to these psychological factors, firms rely on flat salaries or "scale-based" systems where the pay-for-performance relationship is much less prominent than predicted by agency theory. Closed for comment; 0 Comments.
- 21 Apr 2010
- Working Paper Summaries
Why Do Firms Use Non-Linear Incentive Schemes? Experimental Evidence on Sorting and Overconfidence
The use of "non-linear" performance-based incentive contracts is very common in many business environments. The most well-known example is salesperson compensation, though many other types of performance-based pay, including stock options, bonus systems based on defined metrics, and pay based on subjective performance, often exhibit non-linear characteristics. Research has demonstrated that non-linear incentives are highly distortionary because employees manipulate their work in order to maximize their pay. While some scholars have recommended that companies stop using non-linear incentives, little research has been done to investigate the possible benefits of non-linear schemes. In this paper, HBS professor Ian Larkin and Ross School of Business professor Stephen Leider (HBS PhD '09) explore the role that the behavioral bias of overconfidence may play in explaining the prevalence of non-linear incentive schemes. They conclude that the linearity or non-linearity of an incentive system could play an important role in sorting employees according to their level of confidence; in addition, there may be three possible benefits to having overconfident employees. Key concepts include: First, overconfidence is valuable for certain job functions; for example, salespeople lose deals much more frequently than they win them, and being overconfident may help them be effective despite the many failures they go through. Second, absent non-linear contracts, employers and overconfident employees may have a difficult time agreeing to a compensation scheme in the first place. Non-linear systems allow employers and employees with fundamentally different beliefs form compensation agreements. Third, the non-linearity of an incentive system may allow firms to lower their wage bill. A convex scheme, for example, may allow firms to take advantage of overconfident employees' systematic and persistent bias toward believing they will perform well. The study confirms recent findings in psychology literature that overconfidence is not an individual trait so much as a trait around a specific task. Closed for comment; 0 Comments.
- 18 Mar 2010
- Working Paper Summaries
Matching Firms, Managers, and Incentives
Do different kinds of firm ownership drive the adoption of different managerial practices? HBS professor Raffaella Sadun and coauthors focus on the difference between the two most common ownership modes, family firms and firms that are widely held, namely that have no dominant owner. They find that the greater weight attached by family firms to benefits from control induces a conflict of interest between family-firm owners and high-ability, risk-tolerant managers. Key concepts include: Family firms systematically offer low-powered incentive contracts to external managers compared with widely held firms. The differences are economically large. Where incentives are more powerful, managers exert more effort, are paid more, and are more satisfied. Firms that offer high-powered incentives are associated with better performance. This result holds even after controlling for the type of ownership. Economies where family firms prevail because of institutional or cultural constraints are also economies where the demand for highly skilled, risk-tolerant managers languishes. Closed for comment; 0 Comments.
- 02 Nov 2009
- Research & Ideas
Shareholders Need a Say on Pay
"Say on pay" legislation now under debate Washington D.C. can be a useful tool for shareholders to strengthen the link between CEO pay and performance when it comes to golden parachutes, says Harvard Business School professor Fabrizio Ferri. Here's a look at how the collective involvement of multiple stakeholders could shape the future of executive compensation. Key concepts include: "Say on pay" means shareholders hold an annual advisory vote on executive pay based on a report prepared by the firm's board of directors. Say on pay might create more communication and awareness between shareholders and boards because it forces both entities to grapple with an extremely complex issue. Ferri advocates tailoring executive pay to a company's individual circumstances. Closed for comment; 0 Comments.
- 03 Sep 2009
- What Do You Think?
Are Retention Bonuses Worth the Investment?
There is a time and place for retention bonuses but they should be used sparingly, wrote many respondents to this month's column, says Professor Jim Heskett. Others challenged the value of bonuses, and suggested compelling alternatives. (Online forum now closed; next forum begins October 2.) Closed for comment; 0 Comments.
- 24 Sep 2008
- Working Paper Summaries
CEO and CFO Career Penalties to Missing Quarterly Analysts Forecasts
(Previous title: "CEO and CFO Career Consequences to Missing Quarterly Earnings Benchmarks.") This paper investigates whether the failure to meet quarterly earnings benchmarks such as the analysts' consensus forecast matters to CEO and CFO careers, after controlling for both operating and stock return performance and the magnitude of the earnings "surprise" revealed at the earnings announcement. In particular, it evaluates a comprehensive set of career consequences such as the impact on compensation, in the form of bonus and equity grants, and the dismissal of both the CEO and the CFO, conditioned on the failure to meet quarterly earnings benchmarks. Key concepts include: Missing analysts' consensus forecasts can potentially damage senior executives' careers. CEOs and CFOs also experience compensation penalties if their firms fail to meet the analysts' consensus forecast. Most of these career penalties for missing earnings benchmarks have increased in the post-Sarbanes-Oxley environment. Closed for comment; 0 Comments.
- 01 Jun 2007
- What Do You Think?
How Should Pay Be Linked to Performance?
Online forum now CLOSED. Professor Jim Heskett sums up 98 reader responses from around the world. As he concludes, is there another subject as important as this one about which we assume so much and know so little? Closed for comment; 0 Comments.
- 25 Oct 2006
- Op-Ed
Fixing Executive Options: The Veil of Ignorance
Who says you can't rewrite history? Dozens of companies have been caught in the practice of backdating options for top executives. But this is only part of the problem with C-level compensation packages, which often motivate top executives to act in their own best interests rather than those of shareholders. Professors Mihir Desai and Joshua Margolis turn to philosopher John Rawls for a solution: Reward the execs, but don't give them the details. Key concepts include: Too often executive incentive packages are not aligned with the best interests of shareholders. Why create long-term value if your bread is buttered by quarterly performance? Option compensation could be restructured to ensure that managers were aware of the value of their compensation without any knowledge of the details of their compensation—a concept inspired by philosopher John Rawls' work on distributive justice. These options may only be useful for CEOs, senior officers, and directors—not middle management. Closed for comment; 0 Comments.
- 13 Sep 2006
- Op-Ed
Rising CEO Pay: What Directors Should Do
Compensation committees are under pressure to keep CEO pay high, even as shareholders and the media agitate for moderation. The solution? Boards of directors need better competitive information and an ear to what shareholders are saying, says Jay Lorsch. Key concepts include: CEO compensation in the U.S. continues to soar—American CEOs make twice what their European counterparts earn. Shareholders want to moderate pay hikes for top execs, but board members often give more weight to internal organizational pressures. Boards must be more critical of consultant reports, listen to shareholders, and align CEO pay with what is earned by other top management in the company. Closed for comment; 0 Comments.
- 30 Aug 2006
- Op-Ed
The Compensation Game
Do CEOs deserve "star" compensation? The idea that CEO pay is driven by the invisible hand of market forces is a myth from which chief executives have long benefited, say Harvard professors Lucian Bebchuk and Rakesh Khurana. Key concepts include: It is wrong to use sports stars' salaries to justify high CEO compensation. When setting CEO pay, board members can be influenced by economic incentives that are reinforced by social and psychological factors. Directors must be given strong incentives to focus on shareholder interests. Closed for comment; 0 Comments.
- 01 Aug 2005
- What Do You Think?
Is There an “Efficient Market” in CEO Compensation?
There appears to be little or no relationship between the size of American CEO compensation awards and actual corporate performance. Will change come from the increased level of competition among global companies with significantly different approaches to the compensation of senior managers? Closed for comment; 0 Comments.
- 02 Dec 2002
- What Do You Think?
- 12 Oct 1999
- Research & Ideas
Pay Harmony: Peer Comparison and Executive Compensation
This paper demonstrates how horizontal wage comparisons within firms and concerns for "pay harmony" affect firm policies in setting pay for executives. Using a rich dataset of pay practices for the senior-most executives within divisions, Gartenberg and Wulf ask whether horizontal comparisons between managers in similar jobs affect pay. The authors also evaluate evidence in support of a tradeoff between pay harmony and performance pay. Findings are consistent with the presence of peer effects in influencing pay policies for executives inside firms. These results contribute to the ongoing policy debate on the consequences of transparency and mandatory information disclosure and potential ratchet-effects in executive pay. For practitioners involved in designing the structure of executive compensation and pay disclosure policies for firms -- including compensation committee directors, senior human resource executives, and compensation consultants -- it is important to recognize the tradeoff between the incentive effects of performance-based pay and costs of peer comparison that arise from unequal pay when designing executive wage contracts. The research also raises questions on the costs of pay disclosure and on labor markets more generally. Key concepts include: Pay policies of firms respond to concerns about internal equity. An SEC ruling in 1992 led to greater awareness of pay and greater peer comparison throughout all managerial ranks, particularly in geographically-dispersed firms that had natural information barriers prior to the ruling, as well as in firms with less ex ante pay disclosure. From the perspective of firms, the consequences of increased pay disclosure may range from pay ratcheting to aggregate shifts in worker effort or firm-specific investments and turnover. From the perspective of employees, increased pay disclosure may influence decisions to join firms and shift the relative importance of internal and external benchmarks, thereby having larger labor market consequences. Closed for comment; 0 Comments.