Executive compensation continues to be large and, in many cases, controversial. But do the bonus packages offered to top corporate managers work as intended—and if so, how?
That’s a question of interest to John Kepler, an assistant professor of accounting at Stanford Graduate School of Business. “I’ve always been interested in the costs and benefits of different incentive schemes and how these motivate people to take different actions,” Kepler says. “For example, how well does a compensation package align managers to shareholder interests? It’s an economically and practically important area to research.”
In two recent studies, Kepler and colleagues studied key dimensions of bonuses. First, research that Kepler did with Wayne Guay at the Wharton School and David Tsui at USC Marshall School of Business found that cash bonuses — long regarded as less motivating than equity-based awards—have a much larger effect on individual and collective incentives than previous studies suggest.
Second, a collaboration with Stanford GSB associate professor of accounting Brandon Gipper, Wharton’s Matthew Bloomfield, and Tsui revealed that bonuses can be used to shield top managers from legacy costs incurred before their arrival, encouraging them to make strategic investments in growth and other areas without fear of monetary penalty.
Cash bonuses work
When it comes to traditional thinking on executive bonuses, cash hasn’t been king.
The conventional wisdom, according to Kepler, is that equity-based rewards are the holy grail of compensation. “Boards typically load up executives with equity,” he says, “and then all of a sudden they’ve got incentives to act in shareholders’ best interests.” It makes sense, given that ownership of equity makes the executives shareholders who benefit from strong business performance as their stock holdings rise in value.
But what about the cash bonuses included in the vast majority of compensation plans?
Some previous studies suggested cash bonuses “don’t really have much bite,” as Kepler notes. But their conclusions—that bonuses don’t serve to enhance performance beyond incentives provided by equity—may have been flawed. “The problem is that past papers had lots of errors in how they measured whether cash bonuses truly provided incentives,” Kepler says. “And boards spend a lot of time on compensation design, so it’s important to know whether and how these bonuses work.”
Consequently, Kepler studied executive bonus contracts in a sample drawn from the 750 largest public U.S. firms (S&P 750) between 2006 and 2014, including the performance measures (such as earnings) and goals involved in awards. The researchers also collected data on sample firms’ actual perforrmance, to compare to the bonus-related targets.
In contrast to previous work, this research found that bonus plans have significant impact on executives’ incentives to boost corporate performance. “We find the bonuses are actually providing an order of magnitude more incentives than previous studies suggest for a lot of these top executives, in terms of creating shareholder value,” Kepler says. “Even for some CEOs of top public companies, especially early in the executive’s tenure, they provide meaningful incentives.” His study found that the median CEO receives about $12,000 in bonus per $1 million of net income for the firm, a much larger amount than previous studies found.
The research also found that bonus plans ultimately facilitate better cooperation across top management teams, because they hold senior executives collectively responsible for key performance measures and promote “mutual monitoring” and other collaborative behavior among team members.
“The analogy we’ve used is that these incentives get a team of executives at a company all rowing in the same direction,” Kepler says. “So bonuses are especially valuable early in senior executives’ careers and help get management teams focused on the right goals.”
Bonuses and cost-shielding
A second study built on those findings.
“Bonus plans are pretty ubiquitous,” Kepler says, pointing to his original research. “But academically it’s still an open question about the types of problems they solve.”
Specifically, he and collaborators observed that many executive bonus structures don’t use a business’s bottom-line net income to gauge performance. Instead, they use figures higher up on the income statement, such as earnings before interest, taxes, depreciation, and amortization (EBITDA)—or even sales.
“We developed some predictions about why that might be the case,” Kepler says. To test their predictions, the researchers studied executive compensation contracts from over 1,400 publicly traded firms between 2006 and 2017, with focus on performance measures used for bonus compensation.
They found that tying bonus-related performance to non-bottom-line financials largely helped address issues related to timing: that is, the time lag between when an executive makes an investment in the business’s future and when that investment pays off. If there’s a timing mismatch, boards will sometimes disregard costs of certain investments when calculating bonuses — as a way to encourage investments in projects worth pursuing, especially the kind that are designed to promote long-term growth.
“They don’t want to penalize executives for costs incurred today that might not yield benefits until later on,” Kepler says.
The logic is similar to that behind the grace period observers give new coaches of major sports teams when they’re recruiting talented young players. It might take a year or more for talented draft picks to reveal their true worth, at which point the coach should be held accountable for those earlier choices.
Kepler found that new CEOs, especially those hired from outside a business, are most likely to be shielded by the board—through bonus-plan structure—from the impact of large costs already in place when they arrive. “The new executive didn’t have any say in the legacy costs of the prior management team,” Kepler says. “So boards take that into account in compensation.”
In line with this, the study found the use of EBITDA for bonus determination declines about 50% over a 10-year tenure, meaning less cost-shielding of top executives over time.
Context matters
Overall, Kepler’s findings point to the importance of context for designing executive bonus systems.
“Boards or consultants often ask, ‘What’s best practice for compensation plans?’” he says. “I tell them they really need to understand the challenges a company is facing at a certain point in time, for incentive design.”
A new top executive might need to be shielded from large legacy costs through a bonus tied to revenue growth, for example. Or a management team facing a large strategic challenge—like growth during a global pandemic—might be incentivized by cash bonuses to collaborate more effectively.
“When it comes to executive compensation, including bonus plans,” Kepler says, “there’s no one-size-fits-all solution.”
This piece was originally published by the Stanford University Graduate School of Business.
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Everyone knows artificial intelligence is moving aggressively into the job search field. The tradition of real people reading your résumé and assessing you in a face-to-face interview may be going away—at least in the early stages of the recruitment process.
Excluded candidates may wonder if they’ve been done in by an algorithm. Did they leave some keyword out of their résumé?
AI has certainly changed the hiring process. But the good news is that if you work with the new machine-based system you’ll do just as well—perhaps even better—than you would have in the traditional hiring process. Here are five ways you can befriend the bot:
1. Welcome AI’s outreach
First, be prepared to be pursued by a machine. Companies are using the intelligence of machines today to search the world for talent, and they may come after you.
I recently spoke with a senior vice president at Oracle, Nagaraj Nadendla, who is responsible for Oracle Recruiting Cloud, the platform that assists many companies in the hiring and onboarding process. Nadendla explained that employers are using “the power of AI to search through millions of profiles to find candidates.”
Even if you are not actively looking for a position, AI may pursue you. According to Nadendla, “AI also searches for talent among passive candidates: people who are employed, but may be open to a change.” So if you like being pursued, welcome to the new world. You’ll have greater access to more job opportunities than ever. That has to be good news for anybody interested in career advancement.
2. Use the bot to guide your choices
If a bot reaches out to you as a possible candidate for a job posting on LinkedIn or elsewhere, you’ll need to decide whether you want that job or not, and whether the bot would likely rate you as a top candidate. A tool, such as Oracle’s digital assistant, can answer questions—like “Is this a junior job?”—to help you decide if you should apply.
If you decide to go for that job but are rated as having only a few of the requirements, you’ll want to rewrite your online profile so that it better reflects the requirements of that posting. “A lot of people apply for jobs when they’re under-qualified or over-qualified,” says Nadendla. “This is the number one thing to avoid.” Align your profile with the jobs you want, and you’ll be far more successful. This will mean focusing your search on a few key areas.
3. Make sure your résumé appeals
Before submitting your résumé, take a pass and ensure all language is as concise and direct as possible. “The robot wants you to be clear and to the point,” Nadendla says. “Education levels and proficiency levels based on the job requirements are usually the first things evaluated by the machine. People often outline all their skills, but the machine wants to know what skills were actually used on the job and what problems applicants have solved. So instead of listing all your skills, incorporate them into your work experience.”
“The machine also picks up details,” Nadendla explains. “It looks for names of companies you’ve worked for, titles you’ve had, and how long you’ve been in each job.” It also looks for hard numbers that show your impact.
The machine analyzes your résumé for keywords and related concepts that are in the job description. If these terms are relevant, include them. If possible, incorporate the important words into your most recent job experiences. Make these connections and you’ll be viewed as having the required qualities.
“When it comes to formatting,” Nadendla says, “the machine doesn’t care what format you use, because it uses free-form text to understand who you are, regardless of how the content is displayed.”
4. Ensure your cover letter is bot-worthy
It’s important to spend time modifying your résumé, but don’t forget to give your cover letter attention too. This letter might be your first opportunity to appeal to a human being, but in many instances, you’re still dealing with a machine that treats your words as searchable text.
“If AI is involved at this stage,” Nadendla says, “a machine will take it and say ‘what is it telling me?’” If that’s likely to be the case, Nadendla notes, “Think of the cover letter more as a summary of the résumé.” That means including language that parallels the job description. Machine scans may also test cover letters for optimum length, contact information, measurable results, and hard and soft skills mentioned in the job listing. Keep those criteria in mind.
5. Impress the bot in an interview
Finally, you may encounter the bot at the interview stage. While many companies provide all candidates with human interviews, some have a machine evaluate you in a one-way taped pre-interview.
The machine looks at words used and what they indicate about the candidate. For instance, the bot can assess: (1) confidence based on active verbs such as “led,” “created,” and “delivered”; (2) enthusiasm conveyed by use of positive words (for instance, “astonishing” or “absolutely”); and (3) the ability to influence, as determined by use of collaborative language.
Happily, once you get through the bot-driven screening process, you’ll likely deal with human beings in live interviews. Here your interpersonal skills will come into play. But before that happens you’ll have to build a good relationship with the bot.
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